Market Update: June 28, 2021
Although the S&P 500 sits at its all-time high, the market has taken on a sloppier feel of late. While the top line index value does not bear strong witness to this, under the surface there are signs of growing divergences:
- After a strong run in late 2020 and early 2021, small cap stocks have lagged large cap stocks during each of the last three months. This is notably pronounced within growth stocks.
- Despite the recent stellar economic data, consumer discretionary stocks merely have treaded water against consumer staples stock the last four months and bond yields have stagnated the last few months after consistently rising between August and early March.
- High beta stocks have not outperformed low beta stocks in over three months. Within the high beta group, notably the semiconductor stocks have stagnated and continue to underperform many other aspects of the market.
As we have previously mentioned, we do not think any of this is going to be a death knell for the bull market, especially in the face of credit spreads that have shown no meaningful deterioration. However, these developments do bear watching in accordance with the “Year 2” discussion mentioned in our April missive as signs that the challenging period has run its course.
Maintaining an Effective Market Position
If history is a guide, this challenging period will last until the Fall (i.e., at least six months after the bottom). During the interim, we will remain overweight Market Risk per our Tier 1 model signal. We believe holding this position will allow us to prepare for the next leg of the bull market while waiting for the consolidation to run its course.
While we maintain our overweight Market Risk, we will continue to be diligent about maintaining the most effective positions within it. Attesting to this, 77.5% of our portfolio has turned over from the beginning of the year (Figure 1) with the recent reallocation in our largest Market Risk position, from U.S. Large Cap Growth to U.S. Large Cap Value.
So, given our updated positioning, two big items are on our mind right now:
1. Understanding Recent Inflation
Is recent inflation transitory, and if not, how much is recent inflation going to hinder consumer discretionary spending?
The April and May inflation numbers, out during the second week of May and June, respectively, were fairly eye-popping. Examples include:
- Year-over-year numbers were up 4.2%, the biggest increase since 2008.
- The used car and truck index was up 10%, the largest one-month increase since 1953.
- Core inflation numbers were up 0.9% during the month, the largest monthly increase since 1982.
We could list more examples, but suffice it to say, we saw historic figures with the last inflation reading. This will likely bring back horrible memories of the 1970s and the long gas lines (especially here in the Southeast where we concurrently experienced long gas lines in late May for quite another reason!). However, we think it is too early to overreact. Keep in mind that much of what is behind the magnitude of the figures is the denominator effect – a year ago, prices were in a deflationary collapse. The math suggests that had things progressed normally last year and were we in the same place this year, then many of the numbers would be somewhat reasonable. In other words, to ameliorate the effect of last year’s deflation and then the resulting inflation, we need to focus on the two-year rate of change. When viewed through this lens, the inflation figures are still above normal, but with far less of a historical magnitude.
Also, when digging more in depth, we see one-time effects (e.g., the aforementioned used car and truck index), which would have to continue for the inflation numbers to continue at this pace. We continue to posit that the inflation we have seen of late will be transitory and largely results from pandemic supply and demand imbalances, as evidenced by the sharp declines in all sorts of commodities over the second half of May and all of June from parabolic runups resulting from the fear of a new inflation regime. Once the supply and demand imbalances are rectified, which will continue to take time, we believe inflation will dissipate. Having said that, we recognize there are signs that the market is concerned about inflation being more than transitory; after all, breakeven rates are higher than they have been in recent years (Figure 2). In addition, we believe the simultaneity between the recent performances of consumer discretionary stocks and inflation figures is not coincidental timing. It is often the case that the markets move in advance of fundamental factors; recall our lesson from the 2019 Capital Markets Forecast. Of course, we will monitor developments, but at this point, we have yet to see enough data to move us off our current thesis.
2. Where are Taxes and Spending Headed?
Clarity in both areas is crucial in understanding the likely trajectory of both the economy and the capital markets. The outcome in both areas is anything but binary. President Joe Biden is making a bold bet that he and his congressional mandate can get their agenda done in the first two years of the term despite historical precedent, which dictates the party will likely lose control of the House of Representatives in the midterm election (not only is a party switch typical at this point during a president’s first term, but adding to that dynamic this year is the redistricting that will occur on the back of the 2020 census by state legislatures mostly controlled by the party in opposition to Biden). The Biden Administration’s strategy is to put money into voters’ pockets via an explosion in spending in healthcare, education, and social services to keep The House, even though they know that is not likely. And that is before we get to looking at the desired infrastructure projects.
Of course, such desired implementations come at a cost, as is the case with all negotiations. There is no resolution in sight to these discussions, as each side is trying to achieve its own agenda. At this point, both sides are still incentivized to negotiate in a bipartisan way, as shown by the bipartisan agreement reached in late June. If Republicans continue to play ball, they may meet Democrats in the middle on further spending. Democrats may also be motivated to compromise, as some moderate party members, such as Joe Manchin and Kyrsten Sinema, prefer a bipartisan approach and are loath to allow the majority to override the minority in every vote. Additionally, bipartisan measures tend to have more permanence, with anything partisan likely being torpedoed after the 2022 elections if historical precedence holds.
This puts the administration in a tough spot, as the proposed 2021 budget of $6 trillion would likely put the resulting deficit as a percent of GDP almost as high as the World War II years and potentially on pace to beat those 1940s figures in the subsequent years. The budget contemplates both an increase in the top capital gains rate to 43.4% for families with income over $1 million as well as estate tax adjustments related to basis step ups, to which Biden was originally opposed as a senator over 40 years ago. It is highly unlikely all of these will come to pass unless the Congress does it through reconciliation, which as we said, is not the preferred route. And even that is not a guarantee given the perspective of not only Sens. Manchin and Sinema, but even some in the more left-leaning camp.
So, there will be compromises, but the question is in which areas and at what magnitudes as it relates both to taxes and spending. We need to see more details over the next couple of months to gain more clarity of the possible outcomes.
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