July Market Update 2021

 

Just when you think you know how the market is going to play out over the course of any given year something changes and the market takes a turn that no one expected. From time to time the market throws these curve balls and one has to decide whether it’s something to react to, or just wait for your original thesis to re-assert itself. The markets gave us just such a curve ball in June.

Experience has taught me that often these trend reversals are just short term reactions to macro economic events, and once the news is digested and better understood by the market, the longer term trends resume. I believe such is the case in the recent price action in June and July.

You could be excused for not even noticing that anything has happened. The broad market averages you see reported every day in the news shows a steady rise in stocks market indexes (TSX, S&P, DOW, etc). In fact, the market averages have hit new all-time highs every month this year as the market recovers from the 2020 selloff. But in June and July there has been a significant rotation out of cyclical stocks, the ones that do well when the economy is recovering, and into the growth and technology stocks that had been left for dead since last November when Pfizer announced it had a COVID-19 vaccine. This coincided with a sharp decline in the 10 Year US Treasury yield, from 1.6% to below 1.2% at one point. This is typically seen as the bond market telling you the economy is slowing down and investors are buying bonds for safety. But this time around the US economy is posting strong growth numbers and inflation is hitting new highs, not something you would associate with a slowdown.

What the bond market was focused on was the Delta variant and it’s rapid spread through the US, especially in states where vaccination rates are still low. This same worry is also playing out in countries around the world where new out-breaks occur, potentially impacting supply chain restoration and delaying the global recovery. This has investors questioning the durability of the recovery and wondering if we have seen peak earnings growth for the cycle. In other words, expect continued growth, but at a slower pace. With this comes questions about peak inflation, peak oil prices, peak commodity prices and peak demand for durable goods.

So is this something investors need to react to? The answer depends on what your current portfolio looks like. I have been recommending all year that clients have a barbell strategy that has high quality growth names on one side, and cyclical and value stocks on the other side. By doing so you always have exposure to what is working in the market, even when growth expectations fade. This is because when confidence in the re-opening trade weakens, as it will from time to time, investors have gone back into large cap growth stocks for safety. In some ways, large cap growth has become the new defensive sector to run to when volatility picks up, because of this group of businesses ability to prosper in any set of economic conditions (Amazon or Google, for example). On a sectorial basis, I am over-weight banks, industrials, materials, energy and consumer discretionary, equal weight large cap technology because of high valuations in some names, and under-weight consumer staples, utilities, healthcare and bonds.

Going forward though, is the market volatility telling us we need to re-think exposure to investments that benefit from a recovering economy and eventually higher interest rates? Is inflation going to persist in 2022, or will COVID-19 variants disrupt growth and pricing power?

My view on the market over the next year has not changed. What we are seeing is the markets short-term reaction to the variant activity. As more people become vaccinated and Canada and the US and globally, the wave of new cases will once again diminish, setting the stage for a continued economic rebound. This would mean the yield curve would steepen this fall and the 10 year US Treasury rate to move higher. This also means the FED will again be on the hot seat, with pressure mounting to begin tapering of their $120 billion per month bond buying program, once gain putting upward pressure on bond yields.

All this will benefit the same cyclical stocks that have been selling off in June and July. Provided the US dollar stabilizes, we should see a rebound in commodities and oil prices, which have also sold off. Rising demand for travel should support oil prices and oil companies are enjoying strong cash flows that can be directed to increasing dividends and share buybacks. OPEC+ seems to have come to an agreement, at least for the time being, to increase oil supply modestly over the coming months, matching rising demand and creating oil price stability. But at these elevated prices, the oil producers are seeing profitability levels they have not seen in years, and this is not fully priced into their stocks prices. Banks will also benefit from this same recovery dynamic, and should be in a strong position this fall to start raising dividends as regulatory restrictions ease and loan loss provisions from 2020 come off.

This market wobble has put many investors on edge, but my advise is to stick with the recovery trade and expect a slow steepening of the yield curve this fall and into 2022, benefiting all the same names that have done so well this spring. As inflation expectations rise, expect to see commodity stocks rebound, including oil producers. But also remember that when the recovery eventually has run it’s course investors will likely come back to the quality growth names that dominated in 2020, as they so often do.

As always, if you would like to discuss this or anything else regarding your portfolio at Wood Gundy, please call or email me or Terri and Nancy, we are always eager to help. Enjoy the great summer weather and stay safe.

 

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices services, investment banking or other services for, or have lending or other credit relationships if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2021.

 

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