There was a fair amount of news this past week, including data releases and comments from the Fed. When Chairman Powell speaks it often sends markets one way or another because he has a knack for shocking investors, although I’m not always sure I understand why. As Chairman Powell was addressing Congress this week, a smattering of US data was released for June which continued to show that inflation is running hot. CPI was 5.4% for the 12-months ended June (see BLS release here), the highest since 2008, whilst core inflation (excluding food & energy) was up 4.5%, the highest since 1991. PPI – perhaps a better leading indicator – was up 7.3% for the 12-months ended June (see here). Retail sales also surprised on the upside, with the US Census Bureau releasing data before the market opened on Friday (see here). After falling in May (vis-à-vis April), retail sales unexpectedly rose 0.6% in June compared to May. In spite of this confluence of data releases that would ordinarily push interest rates higher, yields on US Government bonds hardly moved at all. Perhaps they were soothed by Chairman Powell reiterating before Congress that he remains all-in on the Fed's view that inflation is transitory. Naturally, market pundits spent the week trying to explain this unusual relationship between higher inflation and lower yields, which seems to boil down to one of three things:
Inflation is transitory and as the base effects move out of the data and the “feel good” effects of fiscal stimulus wane, inflation will normalise close to the targeted 2% (the Fed’s philosophy that inflation is transitory).
Inflation will remain high (i.e., become persistent), and the Fed will move towards a hawkish stance too quickly, putting the brakes on the economy too abruptly and potentially causing a recession.
The Fed’s ongoing monthly $120 billion of bond purchases (of which $80 billion / month are of US Treasuries) is capping yields artificially, and until this is unwound, yields are not reflective of reality.
I remain in the camp that items two and three are the major cause, coupled with the fact that investors are simply getting accustomed to expecting data releases along the lines that we are getting at the moment.
With yields held in check for whatever the reason, it would seem a perfect time for equities to rally. However, even though we are at the beginning of earnings season that is certain to be strong vis-à-vis 2Q2020, the equity market is showing signs of fatigue, perhaps reflecting valuations that are nosebleed to say the least. The trailing P/E ratio of the S&P 500 is a whopping 46.2x (source: multpl.com), the highest in history aside from the Great Recession when the P/E ratio skyrocketed, not because of share prices but because earnings were plummeting so fast. To be fair, the forward P/E ratio (3Q21-2Q22) is 21.6x (source: refinitiv.com), more representative because the base effect of trailing four quarters are so low (due to the pandemic). Even so, according to data from Yardeni Research (here), the typical range of the forward P/E – at least since 2000 – has been in the 13x – 15x context. The price-to-sales ratio of the S&P 500 is currently 3.2x, versus a mean since mid-2001 of 1.6x (source: multpl.com). Choose whichever anecdote you wish but any way you slice it, equities in the US look expensive, at least based on historical valuation metrics. Perhaps companies (and their share prices) can “grow” into these valuations, but I have some doubts because expectations are so high. Also, once the Fed starts to unwind its stimulus (tapering and then raising rates), the period of near-free money for margin will fade away, eliminating another floor for stock prices. Perhaps I’m just feeling too negative today for some reason!
In other economic news, the Bank of England is also concerned about inflation. UK CPI was 2.5% for June (see Office for National Statistics for full release), just above the target of 2%. However, inflation was widespread across categories and price rises have sufficient momentum that economists can foresee a potential peak CPI in the UK of 4% or more later this year. The BoE has a history of moving quickly on inflation – much more so than the Fed – and this most certainly brings forward the possibility of QE tapering and / or short-term rate rises in the UK ahead of the US.
Other news this week included:
The Peoples’ Bank of China effectively cut its reserve requirements for its banks, interpreted as reflecting a weaker-than-desired post-pandemic recovery, not positive for the global economy given that China is the world’s second largest economy.
On-going manoeuvring in Congress regarding a potential $3.5 billion package of additional fiscal measures involving spending on infrastructure and social needs (autumn timeframe, approval path complicated).
The start of earnings season, in which the large US banks delivered strong earnings across the board, surprising on the upside. Even so, investors seemed to say, “so what?" Stock prices actually fell for four of the top six US banks following their earnings releases, with only Morgan Stanley (+1.0% W-o-W) and Wells Fargo (+0.8%) managing to eke out gains for the week.
Revolut also did another round of private capital, raising $800 million. This raise valued Revolut $33 billion, making the company the most valuable FinTech story ever in Europe.
SoHo House owner Membership Collective (“MCG”) did its IPO last week, selling shares at $14, which promptly flopped in the secondary market (closed the week at $12.50/sh).
Before looking at the tables for last week, it probably feels that I have a cautious bias towards the markets generally. Why? It’s more of the same feelings that I have had for several weeks. We have come very far very fast. Coupled with concerns that the economic recovery and earnings will moderate going forward, my fear is simply that valuations might adjust accordingly probably when investors are least expecting it. In the background, there is also mixed news on the pandemic. On that topic specifically, I personally think that the press is too focused on the number of cases in the US and Europe and is not focused enough on what perhaps really matters: deaths and hospital beds. Pandemic concerns, including the ever-growing list of variants, are also inevitably playing a role as far as investor sentiment at the moment. Let's take a look at markets last week.
In global equities, the US, UK, and Europe all lost ground, whilst Japan managed a slight gain. Emerging markets were the best performers, and as its largest component – China – also gained ground last week as developed market indices faltered.
In US equities, I suppose you could say that there was a slight tilt towards reflation, as the large cap DJIA (-0.5% W-o-W) outperformed both the Russell 2000 (-5.1% W-o-W) and the NASDAQ Comp (-1.9% W-o-W). However, performance was weak across the board and US stocks really felt pressure the latter half of the week.
The value play has certainly worn off. For investors that piled too late into the crowded trade around the Russell 2000, it has not been a good run the last three months, and particularly in July.
Even though CPI, PPI and retail sales data all suggested higher-than-expected inflation, US government bonds were slightly better across the curve this week. Yields remain in a narrow range, significantly lower than several months ago in the intermediate and longer end of the curve. The yield curve also continues to flatten, perhaps signalling concerns about the US economy slowing.
The US government market is not alone in experiencing lower yields, as government bond yields in the Eurozone (Germany), Japan and the UK all have been trending lower, too.
In safe haven and other assets, gold was a touch better this past week, torn as usual between its status as an inflation hedge and a “risk off” asset. Both the US Dollar and the Yen strengthened. The US Dollar continues to defy gravity and hold its own, a reflection perhaps of the strength of the world’s reserve currency and the relative appeal – valuations and QE aside – of the US equity and government bond markets. WTI oil weakened even as OPEC+ has yet to reach agreement on increases in production, and Bitcoin and most other cryptocurrencies remain under severe pressure. Having said this, Bitcoin seems to have found a comfortable range in the $30k-$33k area, and once its lower bound is tested the currency seems to find support.
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