The upcoming week will be an important one for the markets. A combination of the peak of the 4th quarter earnings season, political wrangling over the Biden Administration’s $1.9 trillion policy proposal to stimulate the pandemic-damaged US economy, a Federal Reserve meeting of the FOMC and the latest GDP data will test sentiment.
The bottom line is that investor risk appetite will likely remain intact, but there is more to the story.
On the corporate side, over 100 companies – with a number of Dow anchors like Apple, Facebook and now Tesla – will release quarterly results in the next few days. Consensus is that results will be strong. Large capitalization growth stocks are expected to report stellar earnings based on their dominance in online retail, search and information services. One important market indicator of uncertainty, the level of short-selling, is the lowest it has been since 2011. This should make an investor pause. It might be worth considering that financials have had an uneven start to the reporting season, perhaps presaging greater doubts for cyclical, value and small cap shares, which have rallied strongly in recent months and may be vulnerable to earnings disappointment.
On the fiscal side, although President Biden’s $1.9 trillion stimulus plan is hitting some Republican objection, all signs indicate major fiscal stimulus is coming. Last week the Labor Department reported that 900,000 Americans filed for state unemployment benefits and the overall unemployment rate came in at 6.7% last month – the highest level since March 2014. These are not good numbers and they will make it hard for Republicans to fundamentally derail the proposed stimulus. The total number may change, but the key is direct transfers to households will increase, stimulating economic activity.
On the monetary side, the all-important FOMC is not expected to change its highly accommodative monetary policy stance. Chairman Powell continues to make clear the Fed will maintain its posture of low interest rates and asset purchases.
Finally US GDP for the final quarter of 2020 will come in, with economists assuming an annualized growth rate of around 4% — a significant drop from the 33% Q3 number, but still indicative of a recovering economy. The likely details, however, will be important: consumer spending down, business spending on infrastructure down, lower state spending, and a growing international trade deficit.
If we add up the above dynamics, the bottom line is that despite last Friday’s modest equity market sell-off, overall risk appetite remains underpinned. Bond yields are near their recent highs and the same is true for major equity indices. The dollar, which typically weakens when investors are in risk-seeking mode, dipped again this past week against the euro.
But how about if we look deeper?
Market internals, the movements in individual stocks, sectors, styles and regions just beneath the surface of broader indices, suggest something different than an ‘all-clear’ risk message. At a granular level, investors appear reticent to fully embrace cyclical recovery.
This past week ‘defensive growth’ outperformed more cyclical sectors, such as energy or industrials. Inflation protected securities have remained bid, whereas emerging market local currency debt has lagged. Real interest rates have only risen modestly. In short, the market remains in doubt about full-fledged cyclical rotation.
High rates of Covid-19 infection, hospitalization and death in the US may be one reason for market reticence. Reports that Covid-19 viral mutations in the UK or South Africa may spread more easily and could be resistant to current vaccinations are worrisome. More and more observers have taken note of rising inflation expectations, fueled by surging commodity prices, which if unchecked could raise doubts about the durability of central bank commitments to sustained monetary easing.
Models also suggest grounds for hesitancy. According to our estimates, prevailing ten-year Treasury note yields are only sustainable if US manufacturing activity accelerates sharply or inflation rises further. In the near term, the former appears improbable, given Covid-19 concerns, whereas the latter – higher inflation – could be an unwelcome development for risk assets. On the other hand, earnings models are more favorable for risk assets, given positive momentum and easier comparisons through mid-2020. In short, models are sending conflicting signals, which may be another reason for investor hesitancy.
What are the broad conclusions for market performance?
Prudence suggests diversification, both across and within asset classes. For instance, the sound business models and proven earnings power of large capitalization growth stocks will likely serve investors well as a complement to more cyclical shares, which ought to benefit from greater immunization and economic opening later this year. Duration fixed income looks less risky, given the sharp rise in bond yields since the autumn. Absent shocks, the dollar is likely to weaken modestly further. But commodity prices, which have risen strongly, are unlikely to extend their strong performance unless the pandemic is brought under control soon.
This will be an interesting week. As always, the key is to look beneath the headlines.