“Stranger Things” – When Do We Emerge from the “Upside Down”?

• The unpredictable nature of the pandemic has caused unexpected reactions to positive earnings, revenue surprises, and ebullient economic data. 
• Overwhelming across-the-board inflation data has been met with muted and even slightly lower interest rates, perplexing investors.
• The pandemic has resulted in an unusually broad dispersion of forecasts.
• Only the reality of reopening economies will align forecasts and provide a foundation for more predictable markets. 

Stocks making sense…but whither bonds?

On May 4, anomalies abounded: Materials and financial stocks sat atop the S&P 500® as its best-performing sectors, while technology trailed the pack. The most defensive sectors were generally the worst performers. Yet the bellwether 10-year Treasury yield was slightly lower.

Moreover, this pattern was no one-day wonder. Through mid-week, energy, materials, and financials were the top three sectors, while tech was second to worst. Meanwhile, the 10-year Treasury yield fell by 5 bps, from 1.62% to 1.57%. For the past few months, this type of sector performance closely correlated with rising interest rates. In addition, rates have been trending gently lower or have been stable for a few weeks.

Why did this anomaly occur? Many explanations are possible. For example, the dramatic divergence in sector performance suggests that equity investors are more convinced of the “reopening” trade. With cyclicals and value stocks recently returning to outperformance, perhaps investors see buying Treasuries as a hedge while they rotate into a more aggressive, reopening-biased equities stance. And maybe short sellers have been covering their positions as stagnating interest rates seemingly refuse to be buoyed by continued economic optimism and generally strong economic data.

A more predictable pattern

During the early stages of the pandemic, interest rates trended lower, and defensive stocks with relatively predictable earnings—which would benefit from lower rates—generally traded higher. Stocks of “stay at home” companies were great beneficiaries as well.

Yet from fall 2020 through March 2021, strong gains in cyclical and value stocks generally accompanied interest-rate rises. Given these dramatic rotations, investors seem preoccupied with figuring out whether all of the good news is already reflected in stock prices. The generally muted response to great earnings announcements only has made investors even more wary of this possibility. The trajectory of rising interest rates is probably merely on “pause.”

Strong economic and inflation data, but…

The economic and inflation data continue to justify equity portfolios that emphasize reopening positions. But this alone is not enough. Containing COVID-19 amid high and rising vaccination rates and appropriately targeted restrictions must continue. Indeed, the perceived progression of the coronavirus is the most overwhelming factor in disrupting traditional correlations. An April 30 Goldman Sachs study found that G10 currencies (including the U.S. dollar, euro, and yen) have been unusually insensitive to economic data surprises over the past year. Instead, data reflecting the coronavirus outbreak seemed to be the determining factor in how currencies reacted to one another.

There seems to be a temporary pause in the correlation between rising interest rates and rising inflation data. In March 2021, the Federal Reserve’s preferred inflation gauge, the core PCE (personal consumption expenditures excluding food and energy) index rose to 1.83% above its March 2020 level, while the core consumer price index (CPI) was up 1.65% year over year.

Meanwhile, in its May 1 report, Goldman Sachs said it expects core (minus food and energy) PCE to peak at 2.43% in April and headline PCE, which includes those more volatile sectors) to peak at 3.03% in May. Both core and headline CPI are expected to peak in May at 2.44% and 3.86%, respectively. (This is just one of many forecasts, which are often precise despite uncertainties. As many forecasters will tell you: It’s dangerous to predict levels as well as timing. Moreover, these indices’ components are showing various rates of change. For example, motor vehicles, furnishings and health services are among the categories boasting the greatest recent price gains, while hotel share prices have lagged. We expect the latter to rebound soon, however, as a reopening economy boosts the service sector.) Various gauges used by the Federal Reserve have shown that households, businesses and financial markets expect inflation to increase:

Sources (bottom chart): Year over year data as of April 30, 2021. BlackRock Investment Institute, U.S. National Federation of Independent Business, Bureau of Labor Statistics, Reuters News, with data from Haver Analytics, April 2021

Virtually all economic and inflation data continued to show a lot of strength this week. Even at somewhat slower growth rates, the trajectories have remained buoyant. In fact, it appears that slowing production growth is largely attributable to supply, inputs, raw materials, and labor shortages. In cases like these, the headline data can obscure a broadening sense of optimism.

Friday’s disappointing jobs report

In April, U.S. jobs (nonfarm payrolls) grew by 266,000 (including 218,000 in the private sector)—sending shockwaves given consensus expectations of more than 1 million. Meanwhile, employment data was revised lower for the previous two months by a combined 78,000. The unemployment rate for April edged up to 6.1% (from 6.0% for March and below the 5.8% consensus estimate), while the labor participation rate was roughly the same in April as in March. The average hourly earnings increased by a surprisingly strong 0.7% m/m.

Do these numbers change our thinking? The short answer is, no. The lower-than-expected April employment gains are at odds with generally very strong U.S. economic data. Many factors could account for Friday’s surprise. For instance, Goldman Sachs believes the main culprit could be seasonal adjustments—when not adjusted for seasonal employment, fully 1.1 million jobs were added in April.

Other possible factors: Additional $300 weekly unemployment insurance has made it unattractive for anyone earning under $32,000 to return to work (this extra benefit expires in September); a mismatch of workers to vacancies; employers finding it difficult to attract workers; and more time needed for closed businesses to reopen their doors given the U.S.’s unexpectedly quick economic reopening. All indications are that this is a tight labor market, and higher wages will be required to attract needed workers. Our thesis is merely delayed, not denied; the trends we anticipate remain intact.

The early market reaction: The 10-year Treasury yield dipped below 1.5% before recovering to unchanged for the day (at 1.57%), while the U.S. dollar traded down by over 0.5% versus the yen, euro, British pound and CNH (offshore yuan). Among major equities averages, Nasdaq was the top performer—up at least 1.3%—with tech and defensive stocks making an especially good showing. Once again, pandemic-related considerations make an analysis of what’s happening “under the surface” necessary. Things are simply not how they first appear.

Shopping for sectors

Semiconductor stocks would normally be expected to appreciate at this point in the economic cycle, when strong demand is expected to continue. Yet despite March sales data from the Semiconductor Industry Association that confirmed positive industry trends, Bloomberg noted that the Philadelphia Semiconductor index fell 1.4% on May 4—down more than 7% from its April peak (and 0.5% below its average for that month), compared to a 5.2% gain for the S&P 500 for the same period. While the semiconductor index was experiencing a three-week decline, the Dow Jones Transportation average was enjoying a record 13 straight weeks of advances. (The transports are expected to be a great beneficiary of reopening.)

For its part, the semiconductor industry has largely benefitted from the pandemic—investors apparently believed that some demand was “pulled forward,” creating a shortage. But in an ironic twist, the level of semiconductors needed in today’s cars is now so low that it has affected auto production both in the U.S. and abroad. Indeed, German semiconductor maker Infineon—a major supplier to the auto industry—reported very strong demand for its products but warned of bottlenecks in its supply chain. Result: Its stock traded 1.7% lower on the warning. Again, a comprehensive understanding of the coronavirus progression—not the business cycle — appears to be a critical factor in determining whether to invest in firms like Infineon.

If you ease it, will they come?

The latest Federal Reserve survey of senior loan officers, released May 3 and covering the past three months, showed that banks have eased their lending standards for commercial and industrial firms of every sizes. Unfortunately, while loan demand from small companies held steady, the relaxed standards were met by weaker demand among large and mid-size firms. The large money center banks reported generally disappointing loan totals for the first quarter. But wait—shouldn’t favorable terms and rising confidence in future economic growth correlate to increased demand for loans?

In a pre-pandemic world, yes. But coronavirus concerns still appear to make people (and companies) hesitant. Perhaps they fear variants, mutations, and unexpected spikes in virus cases that could jeopardize their investments. The current, unprecedented surge in Indian COVID-19 cases, and the recent spike in Brazilian cases, underscore why investors who would normally be borrowing are instead playing wait-and-see. India’s economic activity is estimated at 15–20% below that of pre-COVID levels, and mobility among residents is about 35% lower—with more impact on longer distances than local travel.

Once economies actually reopen and lift restrictions, people’s confidence could rise relatively quickly and lead to even stronger economic activity. And with the U.S. shortly about to lift most restrictions we won’t have to wait long to better determine how much greater confidence will affect already expected increases in spending and investing. Once again, the pandemic will be the determining factor.

Information as of May 3, 2021

Tip o’ the cap (gains taxes)

Some investors have expressed concern about President Biden’s proposed capital gains tax increases for the wealthiest Americans (those earning over $1 million a year). Many studies have shown that while such tax hikes have led to short-term downturns in stock prices, equities tend to recover quickly. For example, JPMorgan Chase reports that in 1986 (when the capital gains tax rate rose from 20% to 28%) and 2013 (from 15% to 25%), equities fell about 5% in December—the last month before the new rates took effect in each case.

Goldman Sachs estimates that $1–1.5 trillion in unrealized capital gains—about 3% of total U.S. equity market capitalization and 30% of average monthly trading volume—resides in those wealthiest U.S. households. Goldman estimates that the technology and consumer discretionary stocks have been the largest sources of capital gains over the past three, five and 10 years.

Even so, most analysts doubt that in the end, any capital gains tax increases won’t come close to the President’s proposals. Beyond the initial day’s trading (down roughly 1%) after the proposals were reported, there appears to have been no discernable overall market reaction. But given the concentration of unrealized gains, this week’s sales of big, quality growth stocks could mean that investors are merely being cautious. Should they? For one thing, it’s very doubtful that any capital gains tax increases would be retroactive. For another, if rate hikes are enacted, long-term investors could simply continue holding their positions until such rates are lowered again. Moreover, we expect the new focus on capital gains taxes to enhance the appeal of ETFs, which are generally more tax-efficient than their mutual fund cousins. Besides, only about 25% of U.S. stocks are now held in taxable accounts.

Bottom line

The short-term outlook for interest rates and equities remains uncertain. A stock market correction at any time would not be surprising. Many investors and market pundits are still trying to call the “tops” of trends, and forecasts are all over the map. This has led to unpredictable reactions in financial markets. It’s made many investors hesitate—they need more conviction before they pull any triggers. The ultimate surprise could be that economic growth—and inflationary pressures—will re-accelerate. Most analysts expect growth to slow heading into next year.

In a nutshell, we are all guessing. But that’s precisely the point. As economies reopen or get closer to it, financial markets and investor reactions will become more predictable and more closely follow historic trends and correlations. Judging by the recent reopening announcements in the U.S., we may be on the verge already. Friday’s dramatic “miss” in U.S. April employment growth may not be what it appears to be. Our assumptions regarding underlying trends remain unchanged, if somewhat delayed.