The Quick Summary:
1) U.S. equity markets are near all-time highs.
2) The Democratic party is in control of the legislative agenda with a narrow majority.
3) More fiscal stimulus is coming on top of large existing fiscal stimulus.
4) Monetary stimulus may continue for some time after the pandemic is over.
5) Inflation risk should be watched carefully.
6) Optimism about the pandemic ending soon is high, but there are still significant risks.
7) Recent S&P 500 earnings reports have been strong in aggregate.
8) Market extremes may not be diminishing. Valuations remain high and speculation is rampant.
9) The current environment embeds high exposure to both upside and downside.
10) GLOBALT’s positioning remains conservative.
January markets started off as a continuation of the same trends as in 4Q20, but then…a couple of things changed. One of them was not small cap outperforming large cap by a significant, margin which did continue. Nor was it emerging markets, which also continued to outperform U.S. large caps. What changed first was the yield on the ten-year U.S. Treasury, which had been trading. The changes were ostensibly driven by thoughts of potentially resurgent inflation from vaccine traction, anticipated re-openings, reaccelerating economic activity, resilient corporate earnings, additional fiscal stimulus and continued monetary stimulus. The next thing to change, closer to the end of the month, were stock prices that started to fall enough to garner some attention, and growth started to outperform value again.
A “Blue Wave” after all, but the amplitude is small. The election uncertainty is finally over, but even though the Democratic party controls the Presidency and both sides of Congress, it is by a slim margin. We have replaced “election uncertainty” with “legislative uncertainty.” The range of likely legislative outcomes is narrow and more moderate than some constituencies might have been able to accomplish had there been a mandate, one way or another. Even within that narrow range, the proposed policies encompass significant change and the policies passed will have a meaningful impact. Aside from the fiscal package, there are taxes, foreign policy, trade, regulation (big tech, financial and environmental) and other economic policies, such as minimum wage, various subsidies funded by additional debt and/or redistribution of income/wealth.
And then there was more stimulus and more stimulus. Another $1.9 trillion is on the table and the horse trading is in swing (there was a ≈$618 billion counter). This is expected to be followed by an infrastructure package which has not been given a firm number yet, but seems to be ruminating north of the counter-offer. Bipartisan seems to mostly mean, “Why don’t you just do it my way,” but the needle may have moved somewhat in the loose direction of more cooperation. The urgency of the effects of the pandemic on people’s lives may nudge that along. Whatever finally passes, more money will be borrowed and the “pay me later” column will get bigger. The markets, for now, are counting that as a positive underpinning on the side of taking more risk. The bringing of the check is far in the future, there isn’t a lot of looking around for that chair to sit in when the music stops.
The Fed sends mixed messages. Not. Sure, there are 12 Federal Reserve Bank Presidents and seven Board of Governors, and they all make public appearances to discuss what they are thinking. In January, a few notably talked about “tapering,” with some comments suggesting that if the economy was stronger earlier, then maybe tapering could start earlier. They also suggested that rising inflation is OK (it is what they have been trying to achieve over the past few years) and that rising rates are also OK as long as they don’t rise far enough to hurt the stock market, whatever level that is. If there were any doubts as to the Fed’s intentions, that was cleared up in Chairman Powell’s press conference later in the month when he said it is just too early to be talking about dates on tapering. He also added the focus on a Fed exit is premature, emphasizing the need for the Fed to remain accommodative even after the economy fully reopens to help those workers that were displaced by the pandemic or technology get back into the work force. Lower for longer means lower for longer.
The Inflation watch is on. Inflation expectations have been on the rise from very low levels, but are still well contained below 2.5% and are only back to where they were at the beginning of 2019. Some actual prices have been rising as well, such as Asian container rates. Some of these prices are driven by supply issues, some by demand, some by the pandemic itself and some by knock-on issues. Labor costs have been influenced both up and down, but in aggregate have been subdued. Core CPI remains well below 2%. The Fed, for its part, remains far more concerned about deflation than inflation for the time being, and has said that even if inflation ticks up in the near term, it is likely to be transitory. Inflation on the other side of the visible horizon may end up being a problem, but getting from here to there may take a while.
Optimism regarding the overcoming of the Coronavirus abounds. Mostly this seems to be the result of the astounding quickness at which very high efficacy vaccines have been developed, manufacturing has been ramped up, and distribution has been deployed. Add in that, despite a degree of skepticism, interest in getting vaccinated has been on the rise. It hasn’t been smooth, and it hasn’t been fair to people all over the world, but it is moving in the right direction.
There is more uncertainty about the future path of the disease under the surface, however. Here are some things we don’t know that will affect this future path. How long is the vaccine effective, what happens when it “wears off,” and how will a vaccinated person know? How effective are the current vaccines against the new strains that are blooming, and the future new strains that may be on the way? If a vaccinated person is exposed to COVID, is it in their body and can they infect someone else who is not vaccinated? What will the level of understanding be by the average person about what getting the vaccine means, and how will the behavior of vaccinated people influence transmission? If some of these questions turn out to have an experience on the negative side, the pandemic may persist longer than anticipated and the optimism may be dented.
The virus still rages in the meantime. It has come off its recent peak in terms of cases, hospitalizations and deaths, but the lockdowns or activity curtailments are still stretching out into the future in many countries with some still contemplating further extensions. New strains are indeed hitting the mutation jackpot, resulting in what looks to be more transmissible and deadlier versions. The virus remains widespread and there are enough pulls available on the evolutionary handle that future unpleasant developments may be possible.
The recent economic and earnings news has been on the positive side. The economic news from PMIs to employment, has been more like treading water, but that is better than it could have been given with the December and January virus surges. The S&P 500 earnings news has been decidedly better. A little less than halfway through the reporting season for 4Q20 earnings, the blended 4Q S&P 500 earnings growth was slightly positive. Surprisingly, this compares to the -12.7% decline expected at the start of 4Q and the -8.8% decline forecast just before the banks unofficially kicked off earnings season in January. Just over 82% of companies reporting beat consensus forecasts, well above the 75% one-year and 74% five-year averages. In aggregate, companies are reporting earnings 16.3% above expectations, better than the 11.9% one-year average rate of positive surprises and the five-year average of 6.3%. Perhaps more significantly, corporate commentary has been more upbeat and 1Q21 estimates are moving higher. The big themes revolve around WFH/LFH tailwinds, the accelerated e-commerce shift, stable credit, an accelerated digital transformation, strong semi demand, residential construction, cost control, renewed capital, and the continued coronavirus drag on epicenter industries.
The Jeopardy answer is: The market extremes are not diminishing. The Jeopardy question is: What does all this have to do with the markets? Put simply, inflation is low, interest rates are low, stock market valuations are high, positioning is crowded, and speculation is rampant. There is a connection between the first two and the last three. It can be captured by TINA—There Is No Alternative. And by that, it is meant “…to investing in stocks.” Where else can you potentially get a “return?” This is not new. The last time the 10-year U.S. Treasury yield saw 4% was back in 2010.
Is that so low that TINA comes into play? Federal Reserve Chair Powell has recently downplayed the connection between low rates and asset values. You can count a significant number of market pundits as skeptical.
Valuations are high. If you use stock prices or some broader equivalent as the numerator and choose-your-own-fundamental as the denominator, valuations will be high relative to most historical norms. John Hussman likes to use a measure that is based on Market Cap/GVA & Margin Adjusted P/E, to estimate where the historical norm is. This measure shows there is a lot of distance (downward) between where we are now in terms of the S&P 500 Index and a longer-term sustainable level, to which the market could trade sometime in the future. It almost always has; it is just a matter of how long it takes. So far, we are beyond the longest timeframe from the past.
Positioning is crowded. Cash levels are low and the performance of “growth” relative to “value” is extreme even after its 4Q20 underperformance. How do you know when the line is crossed from “crowded positioning” to “speculation?” We are being schooled in the here-and-now.
Speculation is rampant. You could point to margin debt to GDP, which is at an all-time high. You could point to bitcoin’s meteoric rise. You could point to “eco” stocks’ also meteoric rises. You could point to surging options activity and IPO/SPAC/secondary trends. And of course, now you can point to Reddit’s WallStreetBets and the attack on the “shorts” (GME, etc.). Speculation can and does take place in “normal” markets and is part of a healthy financial market system. It is not bad in and of itself. Rampant speculation has been a past sign of market tops, coupled with high leverage, interdependent counterparties where the weak link is not apparent, aggressive risk sizing, and a complete disconnect with underlying fundamentals, creates the potential for a “dislocation”, which can act as a catalyst for a severe correction.
What to do? The current environment embeds high exposure to both upside and downside. Of course, no one wants to miss out on the former and no one wants to experience the latter. It is an uncomfortable environment and could persist for quite some time. Our approach may be summarized as protect but participate and be on high alert for signs when it is better to be one (particularly the former), than the other.
We continue to use a broad array of tools at our disposal to monitor the environment for possible changes to the positioning of our strategies. Fundamentals at the macro and company/industry level on a quantitative and qualitative basis. Technicals throughout the markets. We consider many scenarios, their potential implications and make judgments based on the weight of the evidence.
We continue to be conservative, emphasizing quality and diversification in this environment. Taking measured, thoughtful, prudent steps, and maintain a positioning away from extremes is what we believe is the best way to manage uncertainty. We recently reduced some risk by selling our small cap value position and leaving the proceeds in cash. Our strategies are now positioned with almost no exposure to credit, and lower, more style-neutral levels of equities. We retain significant exposure to gold. Our fixed income duration is neutral excluding cash, but we are now more overweight cash. We expect to remain conservative and measured in our positioning and look towards executing additional asymmetric risk/reward opportunities as they arise.
Data Source: FactSet and References by StreetAccount via GLOBALT Investments. Data and Analytics provided by FactSet. Author: Tom Martin, Senior Portfolio Manager – GLOBALT Investments.
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