Morning Jog

Whiplash

The market’s proclivity for confounding the greatest number of investors is once again on display this year.

Heading into the summer, value investors at last saw some vindication. With the reopening and reflation thesis firmly entrenched, it was time for the laggard sectors from last year – Energy, Materials and Financials – to shine. And shine they did, evidenced by the 13% lead value stocks extended over growth through May.

Meanwhile, growth stocks floundered as higher interest rates took a greater toll on their valuations. So naturally, at the point of maximum acceptance of the “higher inflation, higher rates and rotation to value” theme, the tables shifted catching any trend chasers flat-footed.

Value stocks have gone nowhere for the last two months as growth names, driven by large cap tech, went on an uninterrupted winning streak erasing their deficit.

chart
(Source:FactSet)

As the pace of economic growth started to slow and concerns about rising global COVID case numbers from the Delta variant weighed on optimism, there was recognition that we may have run up too far too fast. These fundamental concerns about the pace of the recovery coincided with a period of reduced borrowing by the US Treasury. The US Fed meanwhile stayed with its monthly bond purchase program, effectively scooping up all the new Treasury issuance this year and pushing yields even lower than the economic concerns alone would justify.

U.S. 10 Year Treasury yields fell 0.45% to a current 1.3% and the record inflation readings this week did not dislodge the trend. The stats are certainly headline worthy: consumer prices rose by 5.4% and producer prices by 7.4% from 2020 levels. But given the trough in economic activity last year we expect the year-on-year increase to be substantial and to dissipate over time.

And as is Fed Chair Powell’s current position, there is evidence that the current pace of price increases is driven by the unique supply-demand imbalances as the economy reopens and is therefore transitory in duration.

chart
(Source: @RickRieder)

The outsized inflation increase in the last few months has been driven by surging prices of “reopening” services, such as airfares, hotels and car rentals and the lingering semiconductor chip shortage impacting the auto industry. Used car prices – up 45% from last year – accounted for more than a third of the gain in June’s Consumer Price Index, as a rush of buyers swamped empty dealer lots.

However, the best cure for high prices is high prices. Wholesale lumber prices, the poster child for supply bottlenecks earlier this year, pulled back 65% from sky-high levels erasing the entire gain for the year, as supply predicably increased to meet demand.

It is fitting that after running circles around each other, value and growth equities are now sitting neck and neck, waiting for direction on inflation, interest rates and earnings. If transitory high inflation from reopening sectors is replaced with sustained high inflation from wages and material costs, profit margins and earnings will be challenged. And peak valuations don’t leave much room for error.

Cheers,
Alex

Alexander Bass CFA, CFP®
Managing Director
Chief Investment Officer
Nucleus Advisors