How investors can play a market in transition.
Cyclical upswing is now in the rear-view mirror
The evidence continues to mount that the stock market is moving away from the reopening/reflation trade that has been a dominant theme, especially after the “Pfizer Monday” announcement on Nov. 9, 2020.
This can be traced to several factors. First, the highly contagious Delta variant has raised the herd immunity threshold and, thus, pushed out the timeline for a return to a more normal economic backdrop globally. Second, the first half of 2021 was always going to represent “peak growth” in the United States (on a rate-of-change basis) due to the impact of prior fiscal stimulus measures. Third, the prospect of tapering from the U.S. Federal Reserve later this year points to less supportive liquidity conditions.
For now, the economic backdrop can best be characterized as “growing but slowing.” The only real question now is how fast the slowdown is likely to be. This is where we diverge from the consensus.
Economists are projecting growth in excess of potential until at least the end of 2022 (according to Bloomberg data), but we think we could be in for a period of below-trend growth as soon as the back half of this year. If we are right in this view, inflationary pressures are going to ease with a lag and disinflationary forces will become more pronounced.
With this in mind, we believe there are opportunities for investors to take advantage of the still-too-rosy assessment from economists and strategists. This view is reinforced by our in-house S&P 500 sector indexes, which very clearly illustrate what is, and what is not, currently working within the equity market. As a reminder, we have four S&P 500 buckets we track: inflation (energy, materials), pro-cyclical (industrials, financials, consumer discretionary, interest-rate sensitive (utilities, telecommunication services, real estate investment trusts) and defensive growth (health care, consumer staples, technology).
There are some key elements worth pointing out. Notably, our S&P 500 inflation index peaked in midmay and is now down nearly 10 per cent. This is exactly the time 10-year Treasury break-even rates peaked. Together, these two dynamics suggest the market is becoming less concerned about inflationary pressures on the horizon.
In addition, our pro-cyclical basket, despite being up 16 per cent year to date, has range-traded since late April.
The result of this is that its relative strength ratio versus the S&P 500, after rising steadily for the better part of a year, put in a peak on May 10 and is now down five per cent. This is a clear indication that the stock market is flagging that economic growth rates have peaked.
What is working? Well, both our interest-rate sensitive and defensive growth baskets remain in uptrends. This makes complete sense since easing inflationary pressures, all else being equal, means lower Treasury yields. This is a boon for rate-sensitive segments such as utilities, telecommunication services and REITS.
In addition, as economic growth slows, investors pay up for areas of the market that can continue to grow profits despite the slowdown. This generally means essential goods and services such as health care, consumer staples and, increasingly, technology.
We are in a transitional phase of stock market leadership — the cyclical upswing that transpired is now in the rear-view mirror. As such, investors need to re-weight their portfolio accordingly, moving away from inflation/pro-cyclical exposure toward interest-rate-sensitive and defensive-growth segments. If you need further proof that this is a sound strategy, the price action speaks for itself.
NOTABLY, OUR S&P 500 INFLATION INDEX PEAKED IN MID-MAY AND IS NOW DOWN NEARLY 10 PER CENT.