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11 May 2021: Prudence Says Positive

“I’m not afraid of storms, for I’m learning how to sail my ship.” - Louisa May Alcott

An accelerating economic recovery, the largest U.S. fiscal stimulus outside of war times and the Fed’s commitment to keep monetary policy easy until higher inflation is sustained has stoked concerns that inflation will overheat. With commodity prices and inflation breakevens (the breakeven inflation rate is a market-based measure of expected inflation) at multi-year highs, we understand the trepidation. The overheating debate has cast a spotlight on earlier episodes in U.S. history when inflation rose sharply in a booming economy.

The inflation surge after World War II was a unique event caused by factors with little relevance to today’s backdrop. The other example of high inflation, in the 1960s and 1970s, has some similarities. The job market became very tight as fiscal policy turned expansionary and monetary policy remained unnecessarily easy. Wage growth and inflation spiraled upward as inflation expectations became unanchored.

However, the growth outlook wasn’t as good as we have it now and the starting point for inflation was much higher. The Consumer Price Index (CPI), a common inflation measure, was 4% in the mid-‘60’s and moved up to 7%. Currently, we are coming off decades of deflation with CPI’s consistently running below the Fed’s target of 2%. Technological innovation (i.e. the Amazon effect) and globalization, not nearly as prevalent fifty years ago, serve as deflationary forces helping to keep prices in check.

The world economy is set to grow at its fastest rate in decades, powered by fiscal stimulus, vaccination progress and excess savings built over the past year. Economic forecasts have seen a steady stream of positive revisions over the past few months and GDP growth for 2021 is expected to be the strongest in forty years. With many economic readings already above pre-pandemic levels (e.g. ISM manufacturing, corporate profits, etc.), and others well on their way (e.g. employment), it is natural for prices (inflation) to follow.

A key question going forward is not whether inflation will pick up (it already is), but whether it will be strong enough to stress the current consensus call on the Fed and force the market to price in a more aggressive interest rate path. Low-interest rates and accommodative monetary (and fiscal) policy have been a key driving force behind investors’ willingness to allocate more and more money to stocks.

Recoveries tend to have loose policy backgrounds, and this one has been turbo-charged (i.e. despite only a fraction of the GDP damage relative to the GFC, we have had four times the stimulus). Expansions, on the other hand, particularly those with concerning inflation readings, have historically carried with them, tighter policy.

We don’t think investors should fear the pickup in inflation readings, or the Fed’s reaction. We believe a sustained expansion is coming, interest rates will continue to adjust to the robust outlook and, while rising inflation over the coming months will test some nerves, policy makers seem committed to looking through it and holding the accommodative line. Importantly, we have seen little pushback in terms of consumer spending (it continues to expand) nor interest rates (they remain historically low).

For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. Since the beginning of the pandemic we stated that the retrenchment in economic activity, while necessary, is self-inflicted, not structural, and prone to snapping back as re-opening resumes or vaccines enter the narrative (read previous market commentary here). We are seeing that snapback happening now with the recovery in full stride.

While we recognize a sustained expansion is quite different than quick normalization, we suspect favorable policy decisions, economic growth, and earnings will continue to support a further grind higher in equities. We have noted for months that the promise of vaccination-induced economic normalization could lead to pronounced investor enthusiasm as investors discount what the backdrop will look like six-to-twelve months from now. Arguably, a lot of that optimism is priced in now, but we believe upside remains, and we see no reason to change that view.

April got the second quarter off on solid footing with a sizable gain (e.g. the S&P 500 was up +5.2%). As the recovery broadened, former laggards continued to pick up relative strength (e.g. materials, financials, economically sensitive groups like industrials, etc.). The rise in inflation expectations added fuel to the rotation as many deep cyclical groups (e.g. energy stocks) benefitted. We see ample room for these rotations within the market to continue, but don’t want to completely fade secular growth stocks that have been recently under pressure. We continue to believe there is room for both.

At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends are increasingly painting a more optimistic picture (positive).

The current macro discussion starts with an understanding of vaccination trends (and thus the reopening). Coupled with the recent passing of a new $1.9 trillion stimulus bill, all signs lead to a robust rebound in economic growth in 2021 and 2022. And this is before the infrastructure and family stimulus packages are included.

The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low-interest rates, a series of government support packages and a commitment by the Fed to highly accommodative policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. While we begin to transition to an expansion, we believe they will continue to be tailwinds and see little tightening in the cards before mid-2022. The Fed is anchoring short-term interest rates and has expressed unequivocal accommodation, despite longer-term rates sniffing out a recovery and pushing higher. We will need to monitor any change here, but so far, the rate backup feels warranted, and hasn’t altered the Fed’s stance.

The current technical backdrop remains in decent shape. Most major indices remain in well-defined price channels with shallow pullbacks doing little to alter their longer-term trend. Leadership has turned less risk-on (e.g. IPO/SPACs are performing poorly, volumes are anemic, stock reaction to quarterly earnings results has been muted and equity inflows are slowing). Internal metrics are a little extended (e.g. the percentage of stocks trading above key moving averages), and sentiment is a bit stretched, and those factors increase the odds of tactical consolidations. However, we still don’t think investor sentiment is euphoric. There are still trillions of dollars in money market funds and, despite the advance, flows into equities over the past few years are far below those of bonds and cash.

Absent a negative catalyst, stretched technicals and bullish positioning alone is unlikely to cause a sharp correction, despite making the market more vulnerable to bad news. We feel pullbacks present opportunities to deploy capital for the long term. Rotation within the market continues to be a weekly theme. Recovery optimism, and higher inflation forecasts, will boost cyclicals, value and yields one day, only to see longer duration assets (e.g. Treasuries, growth stocks, etc.) take the lead the next day. We expect this churning behavior to continue as uncertainty over the pace of the recovery remains. Despite the back-and-forth among asset classes, we were glad to see most major indices hover near all-time highs.

Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Earnings estimates continue to be revised higher and we suspect 2021 will end with profit levels at record highs. Recent earnings results have underpinned the acceleration theme. The most recent quarter has seen earnings growth rates move up to +49%, from +25% at the start of earnings season and the +16% expected at the start of the quarter. Of course, we are focusing on sustainability and fully recognize supply chain constraints along with input cost pressures may impact the linearity of upcoming quarters, if just temporarily.

Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. Valuation dispersion is at record levels with a big gap between the secular growers and more economically sensitive recovery plays. During the recent rotation, it has been the cyclicals that have benefited most. We expect that trend to continue, albeit with less dispersion.

The credit backdrop has improved with both investment-grade and high-yield spreads vs. Treasuries back to pre-pandemic levels. Because continued tightening here is consistent with a rally in stocks, it has been encouraging to see. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations’ confidence in their outlook continue to improve, we expect share buybacks, and M&A, to follow.

In sum, we are comfortable with the inflationary backdrop. We believe pressures are building, but systemic risks are low at this point given the accompanying growth backdrop. Interest rates will be the fulcrum by which the story is played out, and we suspect they are biased higher. Our forecast for a sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.

Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to destabilize, we will take a more defensive stance.

Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.

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