Since equities bounced in March and Treasury yields hit bottom in July of last year, both have moved pretty much in one direction: up.
In November, positive news on coronavirus vaccines made this one-way market still more emphatic: Cyclical sectors and value stocks began to lead equity market performance for the first time in years, commodity prices rocketed, and the 10-year Treasury yield doubled.
It didn’t seem that inevitable at the time. It never does. As we outlined in last year’s quarterly Asset Allocation Committee Outlooks, however, the economic fundamentals for the rally were there: massive fiscal support; inflation expectations that were rising, due to the low base being set, but contained; highly accommodative central bank policy keeping short rates low and credit markets open; and strong GDP and corporate earnings growth.
Three of those four early-cycle characteristics now have question marks against them, however. That is why, over the past two months, our one-way markets have become much more two-way.
It’s also why the strongest conviction to come out of our most recent Asset Allocation Committee (AAC) meeting is for anticipated higher volatility during the rest of this year. Look out for more detail in the AAC’s forthcoming quarterly Outlook.
Early Cycle or Mid-Cycle?
To borrow a phrase, investors are “talking about talking about” what to expect when we go from early cycle to mid-cycle.
Markets are forward-looking discounting mechanisms. And while fiscal stimulus is very high today, investors are thinking about mid-2022, when much of it is due to roll off and leave us with a negative fiscal impulse.
On inflation and monetary policy, data in April and May were hot enough to make investors worry about the Federal Reserve’s plans for tapering its asset purchases and implementing its first rate hike.
When the central bank’s messaging became suddenly more hawkish at its mid-June meeting, it stoked those concerns and added impetus to a reversal of reflation-and-recovery trades. Yield curves flattened and breakeven inflation rates fell, cyclical and value stocks lost ground against defensive growth, commodities stumbled and lumber slumped, and the U.S. dollar strengthened.
Could this mean the post-pandemic rally is over? Not in our view.
For one thing, the story remains highly uncertain. You are most likely familiar with the debate around transitory versus structural inflation by now. The U.S. jobs market poses a similar puzzle. Unemployment appears stuck at around 6%, well above its pre-pandemic level. Is that because we are still at the start of the recovery, or because we’ve already filled all the jobs there are to be filled?
For another, as the Fed will likely have noticed, while investor rotations below the surface appear dramatic, ultra-loose financial conditions have barely moved and nothing much has happened at the index level in the markets. A marginal rotation into growth equities is still a bet on equities, after all.
That brings us back to the fourth of our early-cycle characteristics: GDP and earnings growth. Here, the consensus remains in place, and it says growth will be strong this year and respectable in 2022. Analysts are calling for S&P 500 earnings per share to be 35% higher this year than last, which would leave us with some 20 percentage points of upside still to come should valuations remain constant.
In short, while both the debate and the pricing in markets has moved decisively from one-way to two-way in recent weeks, over a 12-month horizon we do not see much of a change in the fundamentals. To the extent that this two-way volatility provides more attractive opportunities to ease client portfolios towards our preferences for value, cyclical and other recovery exposures, we regard that as a positive development.
For more detail on the Asset Allocation Committee’s latest views, look out for our forthcoming AAC Outlook on nb.com and register here to attend an online discussion with Erik Knutzen and Committee member Raheel Siddiqui.
In Case You Missed It
- U.S. Existing Home Sales: -0.9% to SAAR of 5.80 million units in May
- Japan Purchasing Managers’ Index: -1.5 to 51.5 in June
- Eurozone Purchasing Managers’ Index: +2.1 to 59.2 in June
- U.S. New Home Sales: -5.9% to SAAR of 769,000 units in May
- U.S. Purchasing Managers’ Index: +0.5 to 62.6 in June
- U.S. Initial Jobless Claims: +411,000 for the week ending June 19
- U.S. Durable Goods Orders: +2.3% in May (excluding transportation, durable goods orders increased 0.3%)
- U.S. 1Q 2021 GDP (Final): +6.4% annualized rate
- U.S. Personal Income and Outlays: Personal spending was unchanged, income decreased 2.0%, and the savings rate decreased to 12.4% in May
What to Watch For
- Tuesday, June 29:
- S&P Case-Shiller Home Price Index
- U.S. Consumer Confidence
- Wednesday June 30:
- Eurozone Consumer Price Index
- Thursday July 1:
- ISM Manufacturing Index
- U.S. Initial Jobless Claims
- Friday July 2:
- U.S. Employment Rate