Weekly Summary: September 20 – 24, 2021
- The Fed previously had focused on looking through coronavirus cases so that it could label inflation as “transitory.” This is the first time it is looking through the negative effects resulting from the Delta variant in regard to employment. Looking through in regard to inflation enabled the Fed to delay the reining in of its easy monetary policies. The “employment look through” will enable it to accelerate the reining-in process.
- The Fed pivot to considering measures of a tight labor market in lieu of the headline U.S. employment numbers underscores its determination to begin tapering as quickly as possible.
- The latest Fed narrative supports a rotation into Value and Cyclical-type stocks.
The Upshot: We believe that the Fed is now “all in” regarding looking through the negative effects of the Delta variant. We surmise that the Fed anticipates, as we do, that this variant will become more manageable in the near future. Many financial markets, including equities, seemed very willing to follow the Fed’s lead in interpreting inflation as “transitory.” We anticipate these same markets will eventually follow the Fed’s lead in looking through the recent spikes in coronavirus cases, to a time when economic growth will resume at a faster pace compared to its present rate. Such an outlook is very supportive of a rotation into Cyclical and Value stocks. The performance of financial markets, and particularly the sector rotation that occurred mid-week, is perhaps indicative that the markets are already following the Fed’s lead.
Here We Go
Taken together, the Federal Open Market Committee (FOMC) statement after its meeting this week and Federal Reserve (Fed) Chairman Powell’s statements during the subsequent press conference make it abundantly clear that the Fed is ready and willing to start “tapering” its asset purchase program as early as its November 2-3 meeting. The FOMC statement clearly acknowledged the Delta variant’s effect on slowing the recovery of sectors affected most adversely by the pandemic.
Since last December, the Fed has maintained that it would not begin tapering “until substantial further progress has been made toward its maximum employment and price stability goals. Since then, the economy has made progress toward these goals. If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.”
A New Focus
Underlying his statements during the press conference, Powell both tacitly and explicitly acknowledged the Delta variant’s effects on slowing economic growth and higher inflation. Although he previously exhibited his willingness to look through such effects when it came to inflation (previously referring to inflation as “transitory”), he was not willing to do so when it came to achieving substantial progress towards “full” employment.
The Fed’s focus had been on the headline U.S. employment figures. But now the Fed is also willing to look through the Delta variant’s effect on employment. Powell attributed the recent shortfall in jobs, largely related to the travel and leisure industry, as “clearly” due to the Delta variant. But now, in his words, Powell was ready to consider “many measures of labor market tightness.”
In fact, Powell indicated that the employment test before tapering could begin had been “all but met.” Everything else being equal, all that was needed for Powell to feel that the employment test had been met was for there to be a “reasonably good employment” report for September. The focus on the headline employment number was replaced by the notion of a sufficiently tight labor market.
Why We Anticipated the Fed’s Pivot
In our “Positioning” weekly commentary dated September 10, we anticipated the Fed’s pivot to considering “many measures” of a tight labor market in the section titled, “Could the Fed’s Focus Shift from Headline Employment to a Tight Labor Market?” We surmised that the Fed might need to move to this new approach to ensure it could start tapering by year end. Unlike the Fed’s general reference to “many measures” of a tight labor market, we offered specific measures that could be referenced. We believed that “the Fed will find a way to introduce tapering by around year end.” The Fed did precisely what we thought was a very likely possibility.
Tapering is Right Around the Corner
Many “Wall Street” analysts interpreted Powell’s statements to suggest an announcement of the beginning of tapering at its November meeting and that tapering would subsequently start at its December meeting. But Powell was not very specific about what might happen at the November meeting. All he said was that if the economy continues to progress broadly in line with expectations “we could easily move ahead at the next meeting.”
Powell chose his words very carefully. We believe that Powell left open the possibility that his press conference statements were sufficient notice to indicate that tapering will soon begin and that he might actually start tapering in November. This is what we think the Fed will do. But Powell’s words are sufficiently vague that the Fed could merely announce tapering in November with the actual tapering to begin at its December meeting. Powell also stated that FOMC participants favored concluding the taper around mid-2022. This time-frame implies a taper of $15 billion per month.
Although the word “transitory” was closely linked to inflation in the FOMC statement, Powell notably failed to link the words “transitory” and “inflation” during his press conference. The Fed projections included a significant increase in its estimates of inflation for 2021, as well as a slightly more persistent and slightly higher future level of inflation. Powell might even be beginning to believe that inflation is not as transitory as he previously thought. Perhaps he might even be getting closer to our own view of a more persistent type of inflation. This would coincide with a desire to start tapering sooner than later.
The Fed’s slightly more hawkish “dot plot” is perhaps yet another indication of the FOMC’s increasing concern about rising inflation. The dot plot is a chart that maps out the FOMC members’ expectations of future interest rate levels. The September meeting’s dot plot was skewed to indicate earlier and more frequent interest rate hikes than were indicated by charts from the FOMC’s previous meeting.
Fed Narrative Supports Value and Cyclical Buys
We believe that the Fed’s narrative supports our assumption (as stated in many of our recent weekly writings) that the recent best risk/reward opportunities from a “long” (buying) perspective continue to be in Value/Cyclical-type stocks. According to Goldman Sachs in its U.S. weekly “Kickstart” report of September 17, its proprietary “Cyclical basket [of S&P 500 stocks] underperformed Defensives by 7% since May.” In our opinion, Value and Cyclical-type stocks should outperform more Growth and Defensive type stocks in the short to intermediate term from the point where the S&P 500 index was lower by about 4.7% on Monday from its recent high.
Long vs. Short Duration Stocks
Goldman Sachs’s report also highlighted that the combined market cap of the Info Tech and Communications Services sectors now comprise about 40% of the S&P 500 market cap. Included in these figures are the five largest stocks in these two sectors — AMZN, AAPL, FB, MSFT and GOOGL — which account for about 23% of the index market cap.
Goldman characterized Tech as the sector with the “longest equity duration” and Energy as having the shortest duration. By “longest duration” Goldman is referring to the assumption that long-duration stocks have more stable and predictable earnings and therefore future earnings can be discounted with much more certainty. But Cyclical stocks have much more unpredictable earnings, so future earnings can’t be discounted with any certainty. This is why increasing interest rates typically would more adversely affect the prices of long duration stocks, everything else being equal.
It is our expectation that the quicker interest rates rise, the more adverse the effect on long duration stock prices. The composition of any interest rate rise should also be important. A rise in real (inflation-adjusted) rates historically has had a more adverse effect compared to nominal interest rate rises. Rising rates due to strengthening economies have typically accompanied increasing Cyclical and Value stock prices.
Fed “All In” on Looking Past Delta Variant
After the publication of the latest FOMC statement and Powell’s press conference this week, we are convinced that the Fed is “all in” on looking past the negative effects from the Delta variant. This has consistently been our approach in believing that Cyclical and Value-type stocks recently presented the best risk/reward “long” opportunities.
For those so inclined, we had been advocating patience and buying desired positions only on downturns, given the relatively lofty valuations of the S&P 500 and Nasdaq indexes. Such a day happened Monday when the S&P 500 reached a low of about 4.7% off its recent high. In our weekly commentaries of August 27 and September 10, we noted that “market volatility could begin at any time” and “extremely one-sided positioning make these averages very vulnerable.”
Catalyst for Monday’s Downturn
The catalyst for the Monday downturn was the default risks presented by China’s second largest property developer, Evergrande and the possibility of contagion, especially in regard to Chinese financial institutions. It appears that later in the week, Chinese authorities were able to allay fears of contagion. Nevertheless, we find it difficult to accept that Evergrande was the only property developer or financial institution in China that was overextended.
According to a Citi Research September 21 report, approximately 41% of China’s banking system assets were either directly or indirectly associated with the property sector as of the end of 2020. It should come as no surprise that property developers are experiencing difficulties, given that China’s policymakers have been targeting the property sector for a substantial part of this year, in order to rein in excessive debt levels generally associated with this sector.
Why the Downturn Accelerated
Once Monday’s downturn began, it was exacerbated due to extremely bullish positioning by many market participants. Moreover, the prior Friday was a significant quarterly options expiration day that left many market participants, including Commodity Trading Advisors (CTA’s), with relatively unhedged long equity positions.
According to a J.P. Morgan September 20 report, “technical” selling, CTA’s and “option hedgers” were primarily responsible for the acceleration of Monday’s downturn. Put option pricing on the S&P 500 index was indicative of a “fear” of an accelerating downturn once certain moderate declines were breached. Those fears were realized on Monday.
Flattening Yield Curve
The Treasury yield curve flattened (longer-duration Treasury yields moving lower relative to the movement of shorter-duration yields) on both Monday and Wednesday, the day of the Fed announcements. Monday’s equity downturn was accompanied by a drop in the 10-year Treasury yield. Not surprisingly, the Financial sector was the ninth-worst-performing S&P 500 sector that day. On Wednesday, with the 10-year Treasury yield flat to down, the Financials were the second-best- performing S&P 500 sector after the Energy sector.
Evidently, the Financial sector chose to follow the Fed’s lead and look past the negative effects from the Delta variant to a time when stronger economic growth could be assumed to reaccelerate. We expect that most, if not all, of the flattening of the yield curve will be over in the short to intermediate term. We also believe that by its statements and actions, the Fed might even think it is “behind the curve” — not reining in its easy monetary policies in a more timely manner. If the market adopts this view, we would expect a “steepening” of the yield curve to follow.
We have recently been expecting that USD would resume its downturn in the short to intermediate term. DXY (a USD index that measures USD against a basket of currencies used by U.S. trade partners) closed higher by 0.27% to close at 93.45 on Wednesday, nearing its 52-week high. The next day, DXY was lower by as much as 0.46% to 93.03 at one point. We expect a lowering trend to continue as expectations of the easing of the Delta variant becomes the norm, especially in foreign countries, enabling them to reopen and thereby spurring faster economic growth relative to the U.S. (since many of these countries lagged the U.S. in being hurt by Delta variant effects).
Rotation Into Value and Cyclicals
The flat to lower 10-year Treasury yields of Wednesday were replaced by an increase of at least 13 bps to 1.43% the next day. As we expected, the Value and Cyclical type stocks were clearly the best performing S&P 500 sectors on both Wednesday and Thursday. We now expect that Value and Cyclical stocks will continue to outperform the more Growth and Defensive-type stocks in the short to intermediate term.
Unlike the last few months, we expect this outperformance will now be more consistent. It should be noted, however, that tech stocks continue to perform very well along with the better performing Cyclical and Value stocks. Given the lofty valuations of many tech stocks and that the MegaCap quality growth tech stocks are long duration, we believe they will underperform as interest rates rise.
Foreign Equity Exposure
We believe that stocks with significant foreign exposure, as well as European and emerging market (EM) stocks should perform very well in this environment. As we have previously noted, these foreign markets typically have greater sensitivity to Cyclical and more economically sensitive factors, compared to the U.S. A weaker USD would further boost foreign markets along with commodities.
We believe that the Fed’s pivot to focus on the tightness of the U.S. labor market in lieu of the headline employment numbers is expressly meant to convey that it is “all in” with respect to looking past the negative economic effects stemming from the Delta variant. This new focus underscores the Fed’s determination to start tapering its asset purchase program as soon as possible.
This approach is supportive of a rotation into Cyclical and Value stocks. One of the critical elements necessary in anticipating higher prices for these types of stocks is that one must look through the Delta variants’ negative effects on economic growth rates. By its statements, the Fed has encouraged the financial markets to adopt a similar viewpoint. The other compelling piece of this rotation is that the risk/reward of these types of stock at their recent prices was very attractive relative to potential price appreciation. In our opinion the recent pricing provided a very attractive entry point to acquire such stocks if an investor was so inclined.
Cyclical and Value-type stocks often perform very well in an increasing interest rate environment where the rise is due mostly to expectations of a strengthening economy. We believe that we’re currently in such an environment and anticipate a continuing, if somewhat variable, rise in interest rates. We were especially encouraged on Thursday by the dramatic increase in the yield on longer-maturity Treasuries, including the 10-year yield. The dramatic steepening of the yield curve between the 2-year Treasury yield and the longer dated maturities was equally impressive. We are also anticipating a weaker USD over the short and intermediate term.
Charts of Interest
Source – Goldman Sachs, US Weekly Kickstart Trading interest rate risk through equities: Rebalancing our Long and Short Duration baskets (9/17/2021)
Source – J.P Morgan, The J.P Morgan View: Technical selling represents a buying opportunity (9/22/2021)
Source – Goldman Sachs, Global Economics Analyst: Supply Chains, Global Growth, and Inflation (Bhushan/Struyven) (9/20/2021)
Source – Citi, US Economics: Markit PMI: Production hampered by supply chain disruptions (9/23/2021)
Source – J.P Morgan, Equity Strategy: German elections event risk is unlikely to derail the constructive case for Eurozone equities (9/20/2021)
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