Eye on the Markets - 2021

The Market Might be Ready to Refocus on Cyclicals

By Ketu Desai

January was the tale of two halves. For the first couple of weeks of the month, yields rose, and value, cyclical, emerging markets, and risk-on trades took off. By mid-month, most of these trades started to fade. Many of these risk-on trades fell by more than 10 percent from their high earlier in the month. The broader indices continued to hang in there for a few more days, masked by large cap tech. It came to a head towards the end of the month driven by a massive short squeeze, causing significant hedge fund de-grossing. According to Goldman's prime desk, we saw the largest US equity de-grossing since February 2009, a 3.5 standard deviation move. As these hedge funds de-grossed, it violated technical levels and stop losses, which triggered more selling, which is what happened at the end of the month.

Post-financial crisis, investors (including the GS HF VIP basket) have built up massively overweight deflation and duration-oriented trades including fixed income, long dollar, long tech, and long defensive yield equities. These types of trades have been among the most crowded for a while now. Fundstrat points out that since 2008, 94 percent of retail flows have gone into bonds, not stocks. I think we are in the process of unwinding these deflation-oriented trades. This process started in September and gained some momentum after the election and vaccine approval. While the broader indices continued to hit all-time highs, much of big cap tech is below its high and trades in the range. Companies such as Apple, AMD, and Facebook reported terrific earnings and their stocks fell. I think this highlights the crowded nature of these trades; there are simply not many investors left to own these names. During the risk-off move at the end of the month, yields and the dollar were essentially flat. Yields are approximately double that of the lows of 2020 and the dollar is at multi-year lows. I think the unwind should gain even more momentum as the year progresses, as the news on the virus gets better, and as we start to see higher inflation prints.

Headline inflation numbers are very likely to show meaningful increases this year, at the very least from the base effect. The Markit PMI said that, “manufacturers registered the sharpest rise in selling prices since July 2008." The Fed has made it clear, at least initially, it will let inflation run hot, keeping front-end rates as they are. So, we could be in a situation, where inflation picks up, but real rates are even more negative. This could make the equity risk premium even more attractive, thus supporting the equity markets.

In general, more inflation and the unwind of deflationary trades will mean more market breadth. It will favor equal-weight strategies over market weight, it will favor small caps to large caps, international over domestic, floating rate over fixed rate, and shorter duration to long duration. This will continue to support financials, small caps, developed market equities, gold, silver, bank loans, and TIPs. Reflation trades will also focus on the global manufacturing boom we are seeing. PMIs across the world are indicating a strong expansion, with particular strength in the new orders index. Certain countries such as the US and Brazil have recently printed all-time high PMIs. This should favor emerging markets, materials, industrials, transports, and commodities. So far through fourth quarter earnings, these inflation focused sectors are beating earnings estimates by 22.1 percent. With very easy comps, earnings beats and / or analyst price boosts are likely for the rest of the year. Cyclicals are expected to account for 62 percent of S&P EPS growth in 2021. While the broader market was liquidating, cyclicals had relative outperformance. With a recent improvement in the number of COVID cases and potentially more vaccines available, on the other side of this de-grossing, the market might be ready to refocus on cyclicals.

Looking forward the market will continue to focus on earnings, vaccine distribution, further stimulus and policy plans, and the economic data.


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