Globally, stocks finished the week higher with the MSCI All Country World Index rising 1.0%. In the U.S., the S&P 500 climbed 0.9% while the Dow Jones Industrial Average rose 0.8%. Emerging markets rebounded after the previous week’s sharp sell off – rising by 1.2%. The 10-year U.S. Treasury yield climbed 7 basis points to 1.30%. This is the first week that the 10-year yield closed higher since June 25th.
Falling interest rates and concerns about the Delta variant have led to a pause in the reopening trade with cyclical stocks taking a step back and technology stocks rallying since early June. The economic impact of the Delta variant and the path of Fed policy remain open questions, but investors may not need to wait much longer for answers.
It is possible that we are nearing a peak in the most recent wave of U.S. Covid cases. In both India and the UK, the Delta surge peaked after about 45 days. The U.S. is nearing that threshold as well, but a potential return to offices and schools in September remains an uncertainty. If the pattern does hold, then it could reignite investors’ interest in cyclical stocks and potentially push Treasury yields higher as concerns about a potential U.S. slowdown abate.
The Week in Review
Fed Vice Chairman Clarida stated that he anticipates rate hikes starting in 2023.
The policymaker told the Peterson Institute for International Economics that, “Given this outlook and so long as inflation expectations remain well anchored at the 2% longer-run goal….commencing policy normalization in 2023 would, under these conditions, be entirely consistent with our new flexible average inflation targeting framework.” Despite those comments, fed fund futures continue to price in a first rate hike in September 2022.
The Centers for Disease Control and Prevention (CDC) recommended universal masking indoors for all K-12 school teachers, staff, students, and visitors.
The CDC cited concerns over rare cases of vaccinated individuals getting infected and potentially spreading the Delta virus variant. Separately, New York City announced that it would require workers and customers to show proof of at least one dose of vaccine for indoor dining and other activities (like gyms and performances). However, it is unclear at this stage how such a mandate will be enforced. While restrictions may be implemented within regions with high transmission rates, we see it as highly unlikely that renewed lockdowns will be put in place.
The Waiting Game
The ongoing threat of the Delta variant and the potential for a Fed tapering announcement later this year have left investors playing the waiting game as conviction about the economic outlook is seemingly weakening. Investors should get more clarity in September when the August employment report shows the potential impact of surging Covid cases and the Fed potentially announces its plans to taper bond purchases. However, financial markets rarely wait with some investors already hedging their bets by moving into higher quality assets.
At the start of the year, investors were largely full tilt into cyclicals and value stocks as they bet on a largely uninterrupted reopening. However, since about mid-June, investors have been moving back into U.S. large caps with technology stocks rallying as concerns over the Delta virus contributed to a decline in real yields (see figure 1). Healthcare stocks rallied noticeably as well (see figure 2).
This seems to imply that investors are seeing the mega-cap names as the new defensives with their solid free cash flow and “bullet-proof” balance sheets. Likewise, healthcare stocks are often seen as defensive because their earnings stream is extremely consistent and resilient. Reasonable valuations (the sector’s estimated 2021 price-to-earnings (P/E) ratio is about 19.1x versus 23.0x for the broader market) make the sector attractive as well. These trends fit well with the patterns that Citi’s Global Investment Committee (GIC) highlighted in its call for a shift towards higher quality portfolios as the business cycle matures into a more mid-cycle like expansion.
This move into higher quality assets has also likely been supported by seasonal trends with the S&P 500 averaging a minus 0.4% monthly return in August and a minus 0.2% monthly return in September since 1990. With these lingering uncertainties occurring amid a weak seasonal period, it would not be surprising to see choppy markets in the months ahead. That said, seasonality works both ways with the S&P 500 averaging a 5.1% return in the fourth quarter (see figure 3). While concerns about peak economic growth and peak earnings growth seem to argue for a weaker trajectory for U.S. stocks in the months ahead, the U.S. may be nearing yet another peak as well…a peak in the number of daily Delta infections. We acknowledge that the path of the virus is difficult to predict (especially with much of the population set to return to either the office or school in September), but it is possible that we may have already reached a peak in U.S. infections. In both India and the UK, the Delta variant surge peaked after about 45 days (see figure 4). If that pattern holds in the U.S., it could be an unexpected positive catalyst for risk assets that reignites the reopening trade, which likely still has some room to run.
Particularly, as U.S. economic data continue to come in strong. In July, the Institute for Supply Management (ISM) manufacturing index remained at a lofty 59.5 and the ISM services index jumped to a record high 64.1 in July from 60.5 in June. Both of these monthly measures are consistent with real GDP growth of about 6.5% (see figure 5). That does not seem to signal stalling demand. As we have said before, “ peak growth does not necessarily mean weak growth ahead.” While growth may moderate in 2022, most signs are still pointing to a strong economy. That includes the labor market with the U.S. economy adding back 943,000 jobs in July.
The underlying details were quite positive as well with the leisure and hospitality sector adding back 383,000 jobs (more than half of the 703,000 private sector jobs added). That is important because the leisure and hospitality sector accounts for about a third of the jobs lost since the start of this pandemic. The unemployment rate fell to from 5.9% to 5.4%. Importantly, the survey period did not include the most recent surge in U.S. Covid cases, but thus far, weekly initial jobless claims have yet to show any material signs of a weakening labor market.
There are still a lot of crosswinds and we cannot rule out a market correction as they are quite common and can occur for any number of reasons, but we think that U.S. stocks can likely still move higher over time as the economy continues to recover. Will we hit some bumps along the way? It is seems almost assured, but there are few signs that we are anywhere near the end of this new economic expansion and that should keep the long-run trajectory of the stock market largely intact.
|Index||Weekly Chg (%)change in percent||YTD (%)year to date change in percent||12 Months (%)12 month change in percent||Div. Yield (%)division yield in percent|
|Instrument||Weekly Chg (%)change in percent||YTD (%)year to date in percent||12 Months (%)12 month change in percent||Level|
|10-Year Treasury Yield (%)||7.4 bps||38.3 bps||76 bps||1.30%|
|Index||Weekly Chg (%)change in percent||YTD (%)year to date in percent||12 Months (%)||Div. Yield (%)division yield in percent|
The Week Ahead
|8/9||10:00||JOLTS Job Openings||Jun||9270k||9209k|
|8/10||6:00||NGIB Small Business Optimism||Jul||102.0||102.5|
|8/10||10:00||Fed's Mester to Discuss Inflation Risks||NA||NA||NA|
|8/11||8:30||CPI Ex Food and Energy YoY||Jul||4.3%||4.5%|
|8/13||10:00||U of Mich.University of Michigan Sentiment||Aug P||81.2||81.2|
|8/13||10:00||U of Mich.University of Michigan 1 year Inflation||Aug P||4.6%||4.7%|