Eye on the Markets - 2021


Spring Markets

By Ketu Desai

The story of the month was the move in rates. Part of the move was due to plumbing issues, changes in bank reserves, a poor 7-year auction, an increase in supply, Japanese fiscal year-end, and minor changes in Japanese monetary policy. The other part of the move was the market fearing runaway inflation and the Fed not having control of it. We all expect a jump in inflation numbers in the coming months due to the base effects. The question is whether this jump is transitory or not. The Fed has been steadfast that it will be transitory. The case that the move isn't transitory includes the 26 percent jump in money supply, huge fiscal stimulus with potentially more to come, onshoring, tariffs, commodity inflation, and the potential for an overheated economy.

The case for transitory inflation includes, technology is deflationary, the supply chain will adjust to meet demand, we have no wage inflation, there will be a positive supply shock to the labor market when schools open fully in the fall, still a weak reading on average hourly earnings. It seems to me that the net effect could be that there is an increase in inflation to a low to mid-2 percent range, but not runaway inflation. A level that I think the Fed would be comfortable with. I think the market is starting to believe this as well, as 5-year, 5-year forward inflation rates are below 5-year break evens. After all, while growth will boom this year, it is likely to moderate in 2022, and moderate even more as we look to 2023 and beyond.

As for rates, they do appear oversold on many metrics in the short-term. That said, the trend is up, but there are reasons to believe that the pace should moderate. First, central banks such as the ECB and RBA committed to accelerating bond purchases to keep a lid on rates. Secondly, the move up in rates has caused very significant losses in bond portfolios, many forced fixed income investors such as pension funds, 60/40 investors, insurance companies, are likely buyers of bonds to rebalance to their target weights. Third, the yield on the 10YR is now above the dividend yield of the S&P. Fourth, the Fed continues to buy $120bn / month, including $80bn / month of Treasuries. Lastly, with negative rates across Europe and Japan, our positive rates are very attractive for foreign investors. Japanese investors can earn 1.3 percent on the 10YR after hedging costs, double the yield of the Japanese 30YR.

For equity investors, the question is whether it is safe to get back into tech. Many growth names are off 20-50 percent from their high. For tech that has a reasonable valuation, such as certain names in semiconductors and certain large cap tech, it might make sense to start a position. For instance, Microsoft and Google trade at the same multiple as Caterpillar and Honeywell. Or Qualcomm trades 5 multiple points cheaper than Exxon with upside to 5G. For growth in general, I think it will be a lower Sharpe strategy. In other words, you can generate return in tech, but it will be with higher volatility than tech investors in recent years have been used too. Further, I think it will be a lot more stock specific. All software names are unlikely to go up together anymore, a few major winners are likely to see sustained gains, while others will continue to reprice. For the broader markets, the bull case remains intact, 26 percent money supply growth, 13 percent savings rate, trillions in fiscal stimulus, 25 percent earnings growth, 7 percent+ GDP growth, negative real interest rates, and globally supportive monetary policy.

Looking forward the market will focus on the latest economic numbers, earnings, rates, stimulus plan details, and the latest on COVID.

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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