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Back in the headlines: Earnings season, inflation and China’s economy

With more noise than signal this week, have any of our core views changed?


Our Top Market Takeaways for July 16, 2021.

Markets in a Minute

Time is a flat circle. Nothing happened this week that hasn’t happened before. A hot CPI report sparked a debate over inflation. Bond markets parsed every tea leaf from that inflation report and Jerome Powell’s congressional testimony. A global rise in COVID-19 cases caused stocks exposed to mobility and social mingling to underperform. Investors worried about a slowdown in the Chinese economy and the possibility that regulatory pressure could damage the case for investing in China’s tech giants.

Despite the focus on the risks, the S&P 500 has made 11 new all-time highs in the last 15 trading days, and global equities have gained 13.5% so far this year.

Investors have heard all of these stories before, but let’s take a deeper look to see if anything changed this week.    

  • The U.S. CPI data for June showed that core consumer prices rose at their fastest year-over-year pace since November 1991. For the third month in a row, used cars were the largest driver of price gains. The confluence of the semiconductor shortage, supply chain issues and strong demand in a reopening economy is going to distort the inflation data for a while longer than we expected. Those who believe these price increases will be sustained will likely point to the latest NFIB Small Business survey, which suggested that the net percentage of small businesses raising their selling prices is at 50%, the highest since the early 1980s.
  • We believe the current pace of price gains isn’t sustainable. The Manheim Used Vehicle Value Index already seems to be rolling over, and many industry experts expect the situation to improve through the end of the year. Hotel prices were also an outsized contributor last month, but they are now back to pre-COVID levels, and should moderate from here. Finally, median CPI, which controls for outliers such as used cars, is only rising at a 2% year-over-year pace, down from 3% pre-COVID. We believe core inflation will settle back into a 2–2.5% pace (which is still stronger than it was in the post–Global Financial Crisis period) by the second half of next year as the economy continues to normalize. 
  • The real question for investors is: How much inflation will the Federal Reserve tolerate before it starts raising policy rates? The bond market reaction this week gives some clues. The yield curve, which measures the difference between long-term and short-term interest rates, flattened materially as long-term yields declined. This is consistent with the bond market believing the Fed will raise rates to slow down the economy in an effort to deal with inflation. Indeed, options markets now suggest that the Fed will start raising rates toward the end of 2022.
  • A flattening yield curve may eventually mean trouble for stocks, but we are probably a long way from that outcome. Since the 2-year–10-year yield curve peaked at the end of March, the S&P 500 is up almost 11%. Secular growth sectors such as technology and communication services have led. True, the sectors most levered to economic activity (financials, energy, industrials, materials) have lagged, but so have “safe havens” such as staples and utilities.
  • The Chinese economy was also in focus after policymakers announced they were lowering the Reserve Requirement Ratio for banks late last week. But the bigger news, to us, is the continued regulatory crackdown on the burgeoning publicly traded technology sector. The investigation against Didi, the largest ride-hailing business in the country, days after its $4.4 billion IPO on the NYSE, is just the latest in a series of steps that have led to an almost 30% decline in the Hang Seng Tech Index from the February highs. At this point, opportunities could be emerging for investors. The combination of lower valuations with earnings expectations starting to move higher could mean that investors are being compensated for the continued risk of regulatory action.
  • Back in the States, earnings season is off to a hot start. Out of the 36 S&P 500 companies that have reported earnings, 33 have exceeded analyst estimates. In each of the last four earnings seasons, analysts have been underestimating corporate earnings by 20%. The trend looks set to continue. Robust earnings have powered the stock market through all the risks that investors have grappled with. Over the last year, we had the most contentious presidential election in history, hedge funds have blown up, vaccines have been paused due to safety questions, inflation has surged, China has slowed, variants have emerged, and tax hikes are on the horizon. Through it all, the S&P 500 has delivered a 40%+ return, driven entirely by improving earnings expectations. Bull market, dude.

All in all, there was probably more noise than signal from the data releases and price action from last week, and nothing happened that changes our core views. We still think this current spike in prices is transitory, that interest rates will move higher, and that an overweight to stocks relative to bonds is appropriate. The consumer has low leverage and excess savings. Interest rates are well below expected returns, which incentivizes investment. Corporate earnings are stellar. 

The outstanding question is how changing perceptions of the path of Fed policy will influence the near-term path for interest rates and sector-level performance. Perceptions of the Fed change on a whim, so we think that a balance between cyclically exposed sectors and those that have the best long-term growth prospects is prudent. Time is a flat circle.

 

All market and economic data as of July 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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  • The MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g., ADRs). With 459 constituents, the index covers about 85% of this China equity universe. Currently, the index also includes Large Cap A shares represented at 5% of their free float adjusted market capitalization.
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