Someone summarized the prevailing market conjuncture better than I’ve been able to.
But that feat merits little more than a golf clap. After all, I’m not known for brevity.
One of the key components of what I’ve dubbed the “can’t lose” dynamic is the extent to which falling growth expectations and decelerating economic momentum argue for i) a pivot away from reflation / reopening expressions in favor of heavily-weighted, secular growth large caps, and ii) the prolongation of accommodative policy or, at the least, a diminished sense of urgency around normalization.
Both of those things (a preference for growth and quality and expectations for indefinite easing) can facilitate a disconnect between investors’ growth outlook and equity benchmarks.
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In a note dated Friday evening, Goldman’s David Kostin captured it well — and in far fewer words than I typically employ.
“On one hand, weak economic growth poses a risk to corporate earnings [but] weak data also affects the timing of Fed tapering and eventual rate hikes, helping keep interest rates low and supporting equity valuation multiples,” he wrote, adding that “in part due to this dynamic, the S&P 500 has continued to climb even as our Cyclicals basket has underperformed Defensives by 7 pp since May.”
While investors’ growth outlook is deteriorating, fund managers think liquidity is the easiest since July of 2007. The figure (below) is from the September vintage of BofA’s Global Fund Manager survey.
Notwithstanding the second consecutive abysmal read on consumer sentiment, last week’s data had a Goldilocks feel. The cooler-than-expected read on inflation is plausible deniability for Fed doves, and the solid read on retail sales was enough to allay fears of an imminent slowdown without giving the hawks too much ammunition.
“While the August CPI data all but precludes a September announcement of tapering, the formal confirmation of the beginning of trimming asset purchases is well on track to be announced at the November or December FOMC,” BMO’s Ian Lyngen and Ben Jeffery wrote.
Those who insist the disconnect between, for example, equity allocations and growth expectations, necessarily presages a selloff in equities are effectively arguing (even if they don’t know it) for a slowdown severe enough to override investors’ penchant for viewing decelerating economic momentum as bullish for financial assets due to the read through for monetary policy.
Commentators have been on about economic surprises turning negative. Is that bad for stocks, though? It depends. “The correlation between the S&P and economic data surprises has recently been slightly negative, reflecting a ‘good news is bad news’ mentality among equity investors,” Goldman’s Kostin went on to say.
You don’t want an outright double-dip downturn, of course. On the other hand, though, if growth concerns dissipate, we’re back to pondering whether a rise in yields will undercut the heavyweights, especially if led by reals. Note that real yields are back “above” -100bps (figure below).
“US real rates breaking above -100bps in March was enough to drive some meaningful outright and relative weakness in the Nasdaq,” Morgan Stanley’s Andrew Sheets wrote last week. “That matches the recent correlations of US growth to bond yields.”
Of course, the same stocks that dominate the Nasdaq dominate the S&P. Commenting Friday evening, Goldman’s Kostin wrote that the S&P is “also particularly sensitive to real rate shocks today as the growing weight of technology has increased the implied duration of the index.”
Between them, Info Tech and Comms Services make up around 40% of S&P 500 market cap. “In part due to the growing weight of high-growth, long-duration companies, the sensitivity of equity returns to changes in real rates has turned increasingly negative since late 2018,” Kostin cautioned.
Unless you think inflation expectations are going to break even higher, “higher yields are likely to be the result of better growth, a more hawkish Fed or both,” as Morgan’s Sheets put it.
If that turns out to be the case, we could soon find ourselves in the opposite situation from where we are now. That is: Asking if relative weakness in big-cap tech and secular growth shares will pull the rug from beneath the “broad” market even as the economic outlook brightens anew.
Then we’d have another “odd” juxtaposition to ponder. Namely, an inflection for the better in the growth outlook set against falling equity allocations as the mega-caps derate into a real yield spike.
The irony, I suppose, being that we’re now classifying as long duration some of the very names most likely to be innovated out of existence before the market catches a breath.