Which black cloud should we worry about most?

 

ref :- "Forget about inflation - it's time to worry about growth", Tom Stevenson in the Daily Telegraph, Business section 22/7/21

Well, here we are at the end of another busy week and as if to make the week's market gyrations seem a little silly we're pretty much back to where we started. Both stock markets and bond yields (US 10yr currently 1.29%) have recovered from Monday's sharp reverse in tandem... which is noteworthy in itself as the two markets have seemed to be following different interpretations of the data of late, but more of that in a moment. 

Focus yesterday was on ECB boss Christine Legarde's statement on monetary policy and its increased emphasis on forward guidance. Ms Legarde reassured investors (and gave a little boost to the Euro) by making it plain that the ECB is NOT about to withdraw monetary support too early and jeopardise the recovery, something previous inflation-obsessed incarnations of the ECB have been guilty of in the past. But what was also clear was that the same old fault lines between hawks and doves still exist, and at the very least will need careful managing. In particular, the Bundesbank's Jens Wiedmann and Belgium's Pierre Wunsch are concerned about the ramifications of over-stimulating the Eurozone economy but there are others on the 25-strong governing board who share their anxieties to some degree or other. A new(ish) president and a modified policy notwithstanding, as far as the ECB is concerned, will it prove to be a case of "Plus ça change,..."?

Anyway, we were pointed to an article in yesterday's DT in which Tom Stevenson of Fidelity International gives his analysis of recent market action (actually, over the last few months) and what it might mean. Inevitably, like everything else it still revolves around the growth/inflation balance but Mr Stevenson's argument stresses the need to look beyond headline numbers like retrospective data and broad-based stock index prices. It's both a helpful explanation of some market moves that don't always seem entirely logical, and a reminder of some basic market truths that we forget at our peril.

As we know only too well, headline writers have been obsessed with the danger of long-term inflation sparked by the "great recovery". Until this week that is, when (as if it had just appeared) attention turned to what the galloping latest wave of Covid might do to growth projections - hence the sharp reversal in stocks at the beginning of the week. Essentially, we've got inflation anxiety and concern over too little growth in play at the same time, and in theory that shouldn't happen... not unless we're in a period of 1970's style stagflation. We are indeed living in very peculiar times, but whatever conditions we're having to deal with they are not akin to those experienced during that unhappy time.

Looking beyond the headlines offers an explanation to apparent contradictions, and reveals that the markets always operate far quicker than headline writers. 

The thrust of Mr Stevenson's piece goes something like this... For all the hand-ringing about inflation amongst various central bankers and commentators, investors are much more concerned about growth... and have been for months. Look at the bond market for example. There are of course special forces at work like bond-purchasing programmes, but a fall in yield in the US 10yr from 1.77% in late March to a low of 1.17% this week as investors piled into US Treasuries just shouldn't happen if they have genuine concern about inflation. But it's the closer look at share prices that is most revealing. The great move into the "Reflation Trade", predicated on continuing and robust economic growth, started in November last year, but began to run out of steam as early as late March this year. Shares that perform well in strong growth environments (cyclicals, small companies) began to underperform the indices. The Dow Jones Transportation Index which covers those that would most obviously benefit from a reopening of economies - shipping, railways, airlines - is OFF over 10% since May.

Stock pickers in value stocks that had been given a pasting by the previously all-conquering growth stocks were delighted by the reflation trade, but the joy was short-lived when value stocks started to lag again... as it happens, at exactly the same time as a widely watched inflation measure - the difference between nominal and inflation-protected bond yields - peaked. For many investors this is a much better guide to the real picture than retrospective headline data referencing comparisons with year-ago prices, and for them it marked the peak of the inflation scare, regardless of the still-increasing official numbers. 

There are concerns hidden behind wider stock indices at record highs, too. Market breadth, for example. The number of shares in the S&P 500 trading above their 50-day average is just 30% despite the performance of the headline index. In other words, 70% of the S&P's constituent shares are not performing as the index suggests. Now, we all know that the massive growth in certain sectors (FAANGs etc) has led to indices being misleadingly weighted but this kind of contradiction between the headline index and most of its constituent parts is rare indeed. Not particularly encouragingly, it happened before the big correction of 1998 brought on by the collapse of Long-Term Capital Management, and again two years later ahead of the dot.com bubble bursting. Well, it might not mean anything...

There's a lesson too in commodities and commodity-sensitive stocks. These started an upward tear way back in March 2020 (when other stocks were falling), but fell away just when the world started getting excited at the prospect of a commodity super-cycle (and other stocks were rising). Suffice to say, not many are still talking about a commodity super-cycle.

Recent highs in stock indices have been justified by some pretty spectacular corporate earnings numbers. They are indeed supportive, and may continue to be... but many commentators agree that they probably represent the peak of earnings growth. What happens if they too run out of steam? 

All in all, Mr Stevenson's piece is not terribly optimistic and he suggests investors should spread their risk around so that at least one sector might offer the right protection. As for us, we've read so many articles on overvalued stock markets (and written a few!) that we'll reserve judgement. But we will remember those market truths we mentioned:

Don't rely too heavily on backward-looking data when making decisions for the future...

Look beyond the headlines...

By the time you read about it, it's probably already happened...

The market is generally ahead of the curve, and always ahead of the headline writers...