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Key Points
- Ho-Hum Start to Earnings Season
- Stocks Remain Strong as an Asset Class…
- ...And Cyclical Rotation May Prove to be Short-Lived
- Margin Contraction Takes Junk Bonds Off the Table...Don’t Reach for “That” Yield
- Patiently Waiting For an Opportunity in Emerging Markets as Commodities Keep Working
Action Plan
The start to earnings season was not all that exciting as the banks were met with mixed reviews that saw the trading shops put up outsized profits thanks to the explosion of volatility in the quarter and the Fed backstopping the credit markets. The early tally has 73% of companies beating earnings estimates while 78% have produced a positive revenue surprise. Recall last week that we highlighted how estimates were widely dispersed, which is a polite way of saying that the analysts were completely in the dark when it came to modeling the quarter.
As we highlight below, the prospects for slowing growth remain strong while the odds are increasing that we will have to deal with inflation caused by the fiscal and monetary stimulus that has been unleashed on the economy (note that Europe passed a $2 trillion package last night). As the rest of the year unfolds, a key metric to watch will be profit margins. If there is no growth but costs are rising, margin contraction could be a major issue with implications across asset classes.
Commentary
Equities
Rotation was the name of the game for equities last week. Recall that we had highlighted the extended nature of growth vs value in these pages and others last week and the market promptly followed along with that view as the cyclical / value areas of the market outperformed the growth areas. Our view has been and remains that global growth continues to slow. In this environment, investors should favor growth themes in the equity space. The path will not be a straight line but this prevailing trend is likely to persist by our work. In fact, some areas that are plays on the theme may already be reasserting. The iShares Expanded Tech - Software ETF (IGV) became oversold last week and has now started to work higher once again.
Interestingly, the Invesco QQQ Trust (Very Bullish Rating) is working toward an oversold condition of its own. The trend here is still very much to the upside and while many are quick to call for a rotation and a new leadership regime, we are of the view that last week’s underperformance was simply a counter-trend move within the context of a strong secular uptrend. QQQ remains with a solidly bullish Power Bar Ratio, increasing the odds that it will continue to lead.
One scenario on which we have been vocal is the increased odds of inflation rising on the heels of massive fiscal and monetary stimulus. Recall on May 19th, we highlighted the improving nature of the Materials sector. The Materials Select Sector SPDR ETF (XLB) has subsequently seen its ETF rating turn bullish while relative strength vs SPY has spiked to the upside. At the same time the fund is trading near a 52-week high and has a bullish Power Bar Ratio.
The thinking here is that in a slowing growth world, we want to own growth. That is not a new view. However, if we are wrong, the cyclical areas of the market will begin to lead with the ones that are leveraged to rising inflation (Materials) outperforming. At the same time, growth is still likely to be a good store of value that will protect investors from the loss of purchasing power brought on by the fiscal and monetary responses. Frankly, the same can be said for equities as an asset class. Look no further than the recent weakness in the US Dollar for clues on what is happening to our purchasing power as the economy reopens in fits and starts.
Fixed Income
The current environment likely set ups well for equities and we have made our views clear that as long as the SPY is above $300, the odds favor an attack on the February highs and beyond. The fixed income landscape becomes more nuanced. If the views expressed above play out, the odds are that bankruptcies will continue to be a theme in the global economy. If we think of growth as demand / revenue and inflation as input costs / expenses, a world with slowing growth and rising inflation will lead to margin compression for companies that do not have pricing power. This is an environment where investors who choose to diversify with fixed income products will have to be extremely selective with the credit risk that they are taking. We have written before and we continue to believe that IG credit is preferable to HY credit. We are looking for the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) to offer a compelling entry point. In the interim, our long running bullish view on treasuries remains intact.
As purchasing power is eroded, having exposure to quality fixed income products that have higher yields than treasuries will be important. However, reaching for yield in the junk space in the face of what are likely to be a continued rise in bankruptcies and restructurings is not the best course of action in our view.
Commodities
Our view on commodities is largely unchanged. We continue with a bullish stance on gold and highlight the fact that silver and silver miners have also been working. These trends are likely to persist especially if the view on rising inflation is the proper call. Here are the silver miners breaking to new 52-week highs while outperforming the SPY with a Bullish ETF Rating. The same can be said for the gold miners (GDX). Both of these funds were highlighted in recent notes.
Global Equities
We noted last week that Emerging Markets would benefit in a world where commodities continue to move higher and that remains the case. In the interim, the iShares MSCI Emerging Markets ETF (EEM) is near overbought by our work, calling for a measure of patience for now.
We remain bullish on the growth theme outside the US as well. The iShares MSCI EAFE ETF (EFG) is trading close to new 52-week highs and has rallied by more than 5% since we began to highlight it in these pages on June 30th.
Last night a large COVID stimulus package was passed in Europe that has lent a bid to markets across the pond today.
Dan Russo, CMTChief Market Strategist
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