We’re going to dedicate several days this week to various 2H 2021 outlook topics. Here are our first three:
#1: Let’s start with the proverbial elephant in the room: how markets are thinking about trends in US inflation?
This chart shows the future inflation expectations priced into 5-year and 10-year Treasury Inflation Protected Securities (blue and red lines, respectively) from 2011 – present.
As you can see, so far in 2021 “peak inflation fear” was back in mid-May (the 12th, to be precise). Since then, expected future inflation has come down by 26 basis points on 5-year TIPS and 20 bp on 10-years. Yes, 5-year forward inflation expectations are still higher than the September 2012 peak (2.39 points) but 10-year expectations are not (old high 2.64).
To us, this signals that markets are starting to give up on the idea of structurally higher US inflation. We went to the 2012 highs (back when crude oil was trading +$95/barrel) but have started to pull back. Even May’s 5.0 percent CPI inflation report didn’t take us to new highs.
Looking into the back half of 2021, this may well be the single most important data point to watch. If inflation expectations start to pick up again, markets will rightly worry if the Federal Reserve will have to raise rates sooner. If they continue to trend lower, then the market’s expectation of one rate increase in 2022 will be a safe assumption.
Takeaway: we remain in the “transitory 2021 inflation” camp and are therefore positive on US stocks. First, there’s just too much evidence that current inflation is idiosyncratic (used cars, gasoline) rather than structural. Second, it’s hard to make an argument for an old and aging population generating much inflation (higher savings rates = slower money velocity). Lastly, the old line about “you are what your record says you are” applies in economics as well. The US economy has a long record of low structural inflation.
#2: Wall Street analyst sentiment on the S&P 500 and the sectors they like most/least.
Based on the Street’s individual price targets for S&P companies, the index has 12.2 percent upside from here over the next 12 months. One could reasonably question the utility of this usually optimistic measure. But consider that at the start of 2021 Wall Street analysts only saw 7 percent upside and the year did get off to a slow start (up just 0.3 pct from year end 2020 to March 4th, 2021). As a rule, any time the Street sees less than 10 percent upside we view that as a bearish near-term signal since it points to excessive market optimism. We’re on the right side of that line at present.
As for which sectors the Street currently favors, a few data points courtesy of FactSet:
- The 3 sectors with the greatest percentage of “Buy” recommendations: Energy (64 percent of total recs), Health Care (63 pct), and Technology (63 pct).
- Of these 3, analysts see the best upside in Tech (13.4 pct expected 12-month gain). Their aggregate price targets for Health Care (+10.7 pct) and Energy (8.6 pct) are below the 12.2 pct expected gain for the market.
- The 3 sectors with the lowest percentage of “Buy” recommendations: Consumer Staples (44 pct), Real Estate (50 pct) and Financials (50 pct). All 3 have aggregate price targets below the 12 pct expected market return (10.2, 5.6 and 9.2 pct, respectively).
Takeaway: our approach to using Street recommendations and price targets is to consider where these will go in the near future. Energy is still our highest conviction idea, so even if Wall Street doesn’t see much upside at present we think they will raise their price targets during/after Q2 earnings. Financials, as the data here shows, is a straight-up contrarian investment idea. This remains the cheapest group in the S&P 500 and now that we are past the Fed’s stress tests we think strong economic growth will be a tailwind for the group.
#3: Federal Reserve tapering of bond purchases. This will certainly be a 2H 2022 event, at least as far as more information about the Fed’s timing. Some economists think we’ll get more color at the July 27-28 FOMC meeting. Others think it will be at the August 26 – 28 Jackson Hole conference. But tapering is certainly coming …
This chart gives some historical perspective, showing the yield on 10-year Treasuries (blue line, left axis) and the S&P 500 (red line, right axis) for 2013 – 2014. We’ve highlighted May 22nd, 2013, which was the start of the “Taper Tantum”. This is when then-Chair Bernanke made his ill-advised comments on the topic at a congressional hearing. Actual bond purchase tapering did not begin until early 2014. Yes, that peak for 10-year yields at the end of 2013 (3.04 pct) occurred before any tapering had commenced. When it did, yields actually fell.
Note that the S&P 500 (red line) saw no real ill effects from tapering aside from a 5 percent decline from May 22nd to June 24th, 2013. After that, every swing of its price pendulum was to higher highs and higher lows. For the year 2013 the S&P 500 returned 32.2 percent, its best annual performance since 1997 (33.1 pct) and a return which has not been equaled since.
Takeaway: the Fed is doing everything it can to avoid a 2013-style Taper Tantrum, which was caused not by any actual change in policy but rather by sloppy communication. So far, it is succeeding. If it does fumble, the 2013 experience says you buy any 5 percent (or greater) dip in the S&P 500. The reason 2013 was such a stellar year was because corporate earnings were rising at a decent clip (5-7 percent annually). We have better growth than that now, so stocks should continue to work even if rates suddenly tick higher.