Weekly Perspective: 2 Fast 2 Furious? A Catalyst List for Equities
We’re shaking things up again this week, with a different format for the Monday note. Today we are looking at a collection of potential catalysts for equity markets in the near and medium term.
It is when things are either very good or very bad that we have to start asking questions about how incremental news could either perpetuate the current trend or change it.
At the extreme points of good or bad, the bar is higher for new news to keep the current trend in place. When expectations are already very high (or very low), data has to come in significantly better (or worse) to move the needle. This is because there are few nonbelievers in the dominant market narrative left. Investors have fully expressed this optimism (or pessimism) in portfolios, meaning there are far fewer incremental buyers (or sellers) than at the start of the trend.
So, with the S&P 500 staging a 4 week streak of new all-time highs, +86% off of the March 2020 lows (the third largest in the last 100 years), +16% above its own 200-day moving average (has been a ceiling for rallies recently), reports of record inflows into equities, effervescent sentiment, high valuations, and strong economic data releases, we must assess what catalysts could drive a shift in this clearly “very good” state.
Of course, strong performance does not have to be a risk on its own. This is the very definition of momentum, when strong performance begets strong performance. For proof, when readings like the percentage of names above their 65-day moving averages reaches high levels, such as today’s 93%, forward returns over the next 12 months are actually still positive (not your typical interpretation of “overbought”).
But a lot can happen in 12 months, so let us assess a series of potential catalysts for the equity market through the remainder of 2021.
These catalysts will focus on U.S. equity markets in general, but we will note how certain catalysts could impact sub-asset classes (Cyclical vs. Defensive, for example). Further, a lot of these catalysts are interrelated and/or reflexive, but we’ll do our best to isolate the drivers.
We present an upside risk and a downside risk for each category, for an attempt at a balanced and holistic view.
We do not list valuation as a catalyst, because valuation in and of itself is rarely enough to drive downside in markets. It can contribute to the magnitude of downside, though, as extended valuations versus historical readings simply have more room to fall. We see current elevated valuations as a contributor to lower index returns on average over the next 5 and 10 years, compared to the last 10 years when valuations started from the depressed levels of the Great Financial Crisis (GFC). Of course, attractive returns can be made throughout this longer term period through rotations and opportunistic buying, so have those shopping lists ready.
Note, that this list is by no means comprehensive. After 2020, a year of living in the left tail, we should all be acutely aware of “unforeseen” catalysts. As Carl Richards writes in The Behavior Gap, “Risk is what’s left when you think you’ve thought of everything.”
|Upside Driver||Downside Driver|
|Data momentum continues given unique pandemic and reopening dynamics||Data momentum slows, putting pressure on cyclicals and resulting in sideways index performance at best|
|Earnings get revised higher thanks to better and faster reopening than originally expected||Tough Growth stock comparisons; Higher input costs (labor, material, transportation) all weigh on margins and cap upside to earnings; this creates distinct winners and losers|
Fed Policy & Inflation
|Fed remains ultra-accommodative and looks through better inflation and headline unemployment data in the near term||Fed begins tightening policy, first through a discussion about tapering, then actually tapering of bond purchases, long before rate increases; market very sensitive to changes in incremental liquidity, so it views high inflation readings as a risk that pushes the Fed to act sooner|
Long Interest Rates
|Long dated interest rates remain historically low, real interest rates remain negative; supportive of Growth and long duration stocks||Long dated interest rates continue to move up quickly, with real rates moving into positive territory; puts pressure on Growth and long duration stocks, while calling into question durability of investment related spending if rates move too much higher|
|Though stretched, risk seeking behavior and ebullient mood continues||Sentiment moderates, letting air out of the frothiest parts of the market|
|Continued flows out of bonds into equities given guaranteed negative real returns in some bonds||Record inflows YTD leave few “buyers on the sidelines” and reflect excessive optimism|
|Reopening dynamics powerful enough to overwhelm typical seasonality||May begins more challenging period of seasonal returns through summer months, primarily for cyclicals|
|VIX continues to move back towards pre-pandemic levels (started 2020 around 13)||VIX declining from a high of 85 in March 2020 to 18 today, indicates less risk being priced into markets and less room for improvement|
|A weaker dollar ignites the next leg of the cyclical rally; though this could cause inflation readings to push higher and bring about more discussion of Fed exit (negative)||A stronger dollar chokes off cyclical outperformance; but keeps inflation in check, allowing for continued ultra-accommodative policy support (positive)|
|Market continues to shrug off news of a 3rd wave, looking through virus data given the promise of vaccination||New variants emerge that are immunity/vaccine resistant and result in renewed fear of broader lock-downs|
|Further stimulus funded primarily through deficits, which has longer run risks, but does not impact earnings in the short run||Tax increases to pay for spending enacted and put pressure on earnings|
|China keeps policy accommodative leading up to centennial of the Chinese Communist Party this summer; tensions with China cool; Taiwan issue avoided||China tightens policy, leading to a slowdown in activity; China tensions flare over trade, Taiwan, technology, etc.|
We provide deeper detail on a handful of these catalysts below.
#1: Peak Data
DOWNSIDE RISK: Economic data momentum begins to moderate, putting the most pressure on cyclicals
The best returns for markets are when expectations are low and can be easily beat. Expectations and data are running hot right now, meaning upside surprises are harder to come by.
As we described in our note about PMIs, when indicators like the PMI reach historically elevated levels, growth momentum typically starts to wane, putting pressure on cyclical areas of the market. If the PMI moves off of its 30-year high of 64.7 over the coming months, we wouldn’t be surprised to see more defensive areas of the market outperform in the short run (utilities, staples, health care, real estate).
This does not have to lead to a large sell off for markets, but could put a lid on near term upside.
UPSIDE RISK: Economic data momentum continues due to unique disruption from the pandemic and reopening
There is potential for elevated data readings to continue thanks to the unique impacts of the pandemic and reopening. But as we included in our 2021 outlook, “nothing gold can stay,” meaning that this suspension of data at highs will eventually moderate, likely at the latest in the late-summer/fall when better data started to emerge from the early reopening efforts.
#2: Earnings Surprises
UPSIDE RISK: Rapid reopening drives upside to earnings expectations
Given the swift roll out of vaccines in the U.S. and plenty of pent up demand/energy/savings, there could be even more upside to S&P 500 earnings compared to the +41% growth already estimated for 2021. We do note, though, that just because earnings are being revised higher, there is no guarantee that stock prices will follow suit (as we experienced in 2018 when multiple compression offset earnings upside).
DOWNSIDE RISK: Tough comps for Growth/resilient stocks, while rapidly rising input costs (labor, material, transportation) begin to pressure margins and earnings
Many U.S. companies, mainly in the Growth category, thrived in 2020 thanks to changes in consumption patterns and the acceleration of secular trends that were already in place (such as e-commerce, cloud computing, and remote work). This robust performance does create tough comparisons in 2021, with the risk that growth was “pulled forward” into 2020 causing companies to over-earn.
We have noted multiple times how large earnings beats in 2Q20 through 4Q20 were a key driver of equity market upside in 2020 (2021 Outlook, p. 11). Looking one layer lower, we can see that the majority of the upside in earnings came from big beats to margins (and cash), as companies were able to exhibit extraordinary cost control, despite large disruptions to revenue.
Now in 2021, we must be aware of the risk that rapidly rising input costs could pressure margins, even as revenues rebound. There are three key areas of input cost increases we will address: labor, material, and transportation.
Despite unemployment at 6.5% and an estimated 9 million people still out of work compared to before the pandemic, there are increasingly frequent reports that employers are having trouble filling positions (such as this Florida fast food restaurant offering $50 for candidates to show up to an interview).
The NFIB indicator of small businesses reporting that job openings are hard to fill has now surged well above the pre-pandemic levels of 2019, when the unemployment rate was only 3.5% (see Chart 2).
Another way to see this is with the Beveridge Curve, which plots Job Openings vs. the Unemployment Rate (Chart 3). Here we can see that today’s reading is an outlier, with the Unemployment Rate being higher than normal for the amount of available Job Openings.
Why is there a “labor shortage” when unemployment is still elevated? There is a supposition that the direct stimulus checks and supplemental unemployment benefits are deterring lower-wage workers from returning to jobs, particularly in service areas that are just beginning to reopen. This could be acting as a de-facto increase to minimum wage, where employers have to offer workers higher wages in order to draw them back into the labor force.
Another factor is the surge in demand for durable goods soaking up spare U.S. manufacturing capacity and generating more demand for skilled labor. The manufacturing sector has been struggling with finding skilled labor for years, but the change in consumption trends from services to goods, along with desire to shorten supply chains (more re-shoring following trade disruptions), has exacerbated this shortage (see Reuters article here). Labor shortages in housing have been well-telegraphed (see WSJ article here) as one of the key components driving the shortage of nearly 4 million homes in the U.S. So, there appears to be a skills gap in the U.S., where the labor force does not have the trained workers in the right places to meet demand in the short run.
Chart 3: Job Openings are High Despite High Unemployment Rate
Source: U.S. Bureau of Labor Statistics
Large demand increases for goods occurring at the same time that supply is constrained (both in new production and very low inventory levels) is pushing up the costs for material inputs. This is captured by the ISM U.S. Manufacturing Prices Paid index soaring higher (see Chart 4) and the US Producer Price Index running at +5.9% YoY, the highest since the initial recovery coming out of the GFC.
Raw commodity prices have increased significantly year over year (see Chart 5), while other key components are in short supply. The shortage of semiconductor chips is notable, causing production slowdowns in goods like consumer electronics and automobiles (see Barron’s article here). These auto production challenges are now starting to push up prices for used cars and car rental (see BI article here).
The key question will be how successful businesses are at passing these higher prices on to customers. Some industries and companies likely fare better than others at passing on prices, creating clear winners and losers in earnings resiliency. This highlights how the period of easy gains, or the rising tide lifting all boats, is likely behind us. Returns get harder in year 2 of a recovery.
Transportation costs are soaring for companies given the dynamics listed above (labor shortage, low inventories, rebounding demand, pandemic production disruptions). Chart 5 shows Cass implied freight rates for trucks growing at the fastest pace in a decade, while Chart 6 shows driver availability being the tightest since 2018’s “mother of all capacity crunches”.
Ocean freight rates are also up significantly from a year ago (see Bloomberg article here). Chart 7 shows the WCI Composite Freight Rate for a 40 foot box now at over $4,900, up +226% from a year ago.
These costs will have to be passed on to customers, otherwise they will swiftly eat into companies’ bottom lines.
Chart 6: Trucking Rates Growing at the Fastest Pace in a Decade
Source: Cass Information Systems via The Daily Shot
Chart 7: Truck Drivers are Hard to Find, Putting Upward Pressure on Trucking Rates
Source: Act Research via The Daily Shot
#3: Fed Policy and Inflation Readings
UPSIDE RISK: Policy remains ultra-accommodative
The Fed could shrug off near term inflation readings and improvements in unemployment data in order to justify keeping crisis-level accommodation in place. The Fed would need to continue its jawboning and hammering of short rates lower, while banking on long rates not moving too much higher, choking off the investment portion of the recovery.
If inflation, as measured by the Fed’s preferred Core PCE, remains moderate and below the Fed’s target, then investors may need to walk back expectations for an earlier-than-planned lift-off of rates (back in March markets were pricing in a late 2022 lift-off, despite policy-maker commentary for a 2023/2024 lift-off).
DOWNSIDE RISK: Fed begins to remove accommodation, market very sensitive to incrementally reduced liquidity
The Fed could start to communicate an intention to tighten policy later in the year. The first step will be “thinking about thinking about” tapering the $120B of asset purchases. St. Louis Fed President, Bullard, commented last week that at a 75% vaccination rate the Fed could start debating tapering. The U.S. could reach this vaccination level by this June.
Higher inflation readings would have to exceed the Fed’s 2% target for “some time” before getting the Fed to act on tightening policy. The Fed is likely to ignore the next two months of inflation data, meaning inflation data in the back half of 2021 will be more telling about the rapidity of monetary policy change.
We continue to see the market as intensely sensitive to any deterioration in incremental liquidity support (see Chart 8 for the S&P 500 PE multiple and the Fed’s balance sheet), so signs of policy tightening are a key negative catalyst for a market that is trading near record valuations.
UPSIDE RISK: Investors could continue to flow out of bonds into equities, given continued negative real returns for bonds
With the prospect of guaranteed negative real returns in bonds, there could be further strategic reallocation out of bonds into equities, causing continued strong inflows into the equity asset class.
DOWNSIDE RISK: Record inflows into equities YTD raises the question of who is the incremental buyer and point to excessive optimism
As of April 9, 2021, BofA estimated that $576B of inflows into equities over the prior five months had exceeded the $452B inflows into equities over the last 12 years combined (see Reuters article)!
This degree of inflows is likely unsustainable, even with the “TINA” (there is no alternative) argument described above.
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