Good to add a layer of protection should those clouds turn into a polar vortex
Just like the leaves changing colour indicates that winter is coming, certain segments of the market and economy seem to be hinting that chillier times are ahead.
Overall, we still believe that the global economy remains on the path to recovery, but it doesn’t hurt to add a layer of protection should the storm clouds on the horizon turn into a polar vortex.
To help, here are three areas we’re keeping a very close eye on for any key developments.
Q3 earnings season
Earnings season has just kicked off and, as of Monday, 71 per cent of the S&P 500 companies that have reported cited the negative impact of supply chains on their Q3 conference calls, according to FactSet. We expect to see more of this in forward guidance as companies face supply constraints, rising labour and feedstock costs, and an escalating global energy crisis.
Combine this with the potential for higher rates and a stronger United States dollar, and it wouldn’t surprise us to see a P/E multiple compression and, therefore, a more moderate advance in equity markets going forward.
The S&P forward P/E has already compressed by three points (from 23x to 20x), according to Jurrien Timmer, director of Global Macro at Fidelity Investments Inc.
All these supply constraints are already starting to weigh on the average consumer and that is expected to get even worse as we enter the Christmas shopping season.
More than a third of adults in the U.S. had trouble procuring housing, groceries or new cars in August, according to Morning Consult . In particular, it’s rather concerning that 44 per cent who sought to procure a house or apartment indicated they had difficulty doing so.
Don’t kid yourself, this is important as the consumer is the primary driver of the economy, and a happy consumer means a happy stock market.
Morgan Stanley research has shown a near-perfect correlation of the S&P 500 index, year over year, to the year-over-year Conference Board Consumer Confidence Index. Interestingly, the S&P remains 25 per cent above last year’s level, but the Consumer Confidence Index has recently dropped to less than zero per cent.
It appears the financial markets are pricing these supply chain and inflationary pressures as if they were transitory, while consumer sentiment indicates otherwise. Let’s hope the market participants are right.
We think five- and 10-year U.S. Treasury yields are currently 50 to 100 basis points too low when compared to similar historical periods. Managing one’s duration exposure is imperative in this environment, but knowing sector correlations to interest rates is equally important.
For example, the weekly returns of the utilities and consumer staples sectors have a negative 10-per-cent correlation to five-year Treasury yields, according to a Fidelity Investments analysis, while technology is at negative 30 per cent. On the other side, energy and financials have a positive 30-per-cent correlation, meaning they should act favourably to rising yields.
Tying the three together, if things don’t improve, we could be facing the potential for stagflation, meaning continued inflationary pressures, including wage growth, but slowing economic growth.
t certainly doesn’t help that fiscal stimulus will eventually be removed from the economy while central banks start tightening and, as a result, reduce their support from buying their respective government debts.
For those wondering how to position around this, recent research on the 1960-to-2020 period by Goldman Sachs Group Inc. provides some good insight.
It identified health care, energy, consumer services (versus goods) and value stocks as the strongest-performing sectors with median quarterly excess returns compared to the Russell 3000 index during stagflationary periods. This compared to a negative relative performance in the industrials and technology sectors.
We also continue to like structured notes as a hybrid of equity and fixed income, which, if properly designed, can add some nice risk-adjusted returns to a portfolio while offering some reasonable downside protection.
We heard a great line this week that markets go up 60 per cent of the time, so what we do in the other 40 per cent matters. Being proactive by deploying tactical asset allocations will help keep you warm and the lights on during those long, cold winter nights.
Source: Financial Post