Eye on the Markets - 2021


Markets Moving Fast this Summer

By Ketu Desai

How quickly things change! These are fast moving markets. Just a few weeks ago many investors were afraid of run-away inflation, significantly higher rates, and that the Fed has lost control. The Fed meeting during the month effectively alleviated a significant portion of those concerns. The markets adjusted accordingly. The dollar rose, the yield-curve flattened, real rates rose, and certain commodities tanked. Despite the hawkish meeting, the market is not expecting much of a rate hiking cycle. The 5-year / 5-year OIS rate traded below 2 percent, which is a proxy for the peak Fed Funds rate the market is expecting this cycle. When debt-to-GDP is running over 100 percent, the Fed has limited capacity to raise rates. The most likely scenario is that the Fed announces a taper at Jackson Hole in August or their September meeting, which would likely commence a taper at year-end or early next year. It will likely be a very gradual taper, perhaps something like $10bn / month and with an initial focus on the mortgage bond portfolio. Depending on economic progress, the market will prepare for lift-off later in 2022 into 2023.

Early parts of the tightening cycle have historically been pretty good for the equity markets. More specifically, over the past four rate hike cycles ('94, '99, '04, '15) the S&P500 gained 9.5 percent in the 12 months prior to the first hike, and 26.0 percent over the subsequent three years. The damage from tightening occurs later in the cycle, which looks to be at least 2-years from now. The global growth picture should continue to support strong earnings growth. Global growth is expected to hit 6.5 percent this year, with domestic growth a significant driver. Next year as COVID and vaccination trends improve abroad, Europe and EM will lead global growth somewhere between 4 percent and 5 percent. Earnings are expected to grow 35 percent this year. With that kind of earnings growth, the market can take some multiple contraction from rate rises. Earnings are expected to grow another 12 percent next year.

For a few months now, the action below the surface of equity indices has lacked direction.

The market leadership shifts, seemingly on a daily basis, between the growth names that benefit from lower rates and transitory inflation and the reflation names. After the Fed meeting, it looks likely that rates are range-bound for now, which could lead to a more lasting market leadership. Much of large cap growth has consolidated for the better part of the past year, and it feels like now is a good time to take or increase a position in these names. Positioning has been cleaned up in these names, valuation is more attractive, and it is likely they start to break out of consolidation patterns. The NASDAQ 100 trades at just 13.6x price to cash flow, compared to 15.9x for the S&P, with a higher growth rate. The rally this month from higher growth, high multiple, low / no earnings tech does feel like a head fake. Valuation still is really difficult for these names. A proxy for such names is the Ark Innovation fund, which trades at 106x earnings and 42x cash flow. I think you want to barbell the large cap growth names with cyclical names. Cyclical names will continue to provide a rate and inflation hedge. As the economy opens up, the velocity of money should reach more normal levels, so having that inflation hedge in place is important. That said, I do think it makes sense to take some profit in certain materials, industrials, and commodity names, and concentrate the cyclical portfolio into energy and financials. I think energy and financials are more than just a cyclical trade, they have fundamental support for more upside. Financials are one of the cheapest areas of the market, a capital return story as we saw with the stress tests (>8 percent shareholder return), benefit from a new cap-ex cycle which is expected to hit 120 percent of the previous high later this year and next and are in the midst of a re-rating cycle in which they will trade on price-to-earnings from price-to book. Energy equities benefit from global growth, low valuation, trading at a discount to WTI, and recent activist campaigns and the green energy movement will evaporate cap ex and limit supply in a time where demand is growing quickly. OPEC's latest forecast is for a 2.2 million barrel / day deficit in the fourth quarter.

Looking forward the market will continue to focus on the Fed, COVID variants, and turn its attention to Q2 earnings and economic data.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com