Eye on the Markets - 2021


Market Entering Period of Reassessment?

By Ketu Desai

If there is one set of data that will drive markets in the coming months, it will be inflation data. Inflation data will drive Fed policy, rates, asset allocation, and specific sector/factor decisions over the coming months. If one wants to get even more granular in inflation data, it is wage inflation that could be most important. Wage inflation, compared to the commodity inflation we are seeing now, has a higher probability of being sticky. So far, the data has not shown significant wage inflation. With still high unemployment and the potential for a significant positive labor supply shock as schools reopen, wage inflation may be slow to come.

The Fed has been steadfast in its message that inflation will be transitory. Most market participants disagree, higher inflation is now the consensus. The economic data has been phenomenal. Retail sales nearly doubled expectations, initial jobless claims are at pandemic lows, and PMIs are above 60. While the economy will likely remain strong for a while, growth rates are very likely peaking this quarter.

The action across many asset classes is starting to reflect the peaking of growth rates. For instance, the 10YR is down 15 bps from its peak, 5Y break-evens have quietly flatlined, oil has backed off its peak and is stuck in a range. From an equity market perspective, the market is looking for leadership. Growth led for a decade, ending last fall. Since then, value and small caps have taken leadership, including sectors such as energy, financials, industrials, materials, and certain discretionary. In recent weeks, these trades have started to fade. Small caps traded down 8% from their high, and half of the index traded below its 50-day moving average. Energy stocks are off nearly 10% from their high. Sentiment is very bullish on the reflation trade, and it has the potential to disappoint.

We have witnessed sell the news action across many reflation-oriented companies this earnings season, such as United Airlines, American Airlines, Dow, Union Pacific, JP Morgan, Bank of America, Nucor, Freeport McMoRan, Kinder Morgan, Honeywell, American Express, Schlumberger, Boeing, Chevron, Caterpillar, and 3M.

I suspect the market will enter a period of reassessment, in which it will search for leadership. If it looks likely that growth is peaking, and inflation is transitory, the market will rotate back to the growth trades that have been the winners over the past decade. If it looks like inflation is going to be with us for a while, the Fed will have to act sooner than expected. In this scenario, this is the pause that refreshes the value trade. For now, equity sentiment and positioning are at an extreme. It makes sense to take some profit, especially in the value and re-opening trades, because, if it is peak growth rates, the sell-off in these names will come quickly and violently.

Looking forward the market will continue to focus on COVID, economic data, and earnings.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com