MARKET UPDATE | The Big Neutral | July 2021
As inflation fears fade, we focus this month on the reopening.
Figure 1: Market Performance as of June 30, 2021
The Big Neutral: Summary
- The reopening trade is a nuanced thing: while growth should be back in favor, it never went out of favor and market nervousness has driven value to lofty heights. This is not a normal cycle.
- Europe has quickly overtaken the U.S. in vaccination rates: cheaper valuations in Europe are far more attractive as the region looks poised to reopen.
- Reflation fading into the rearview mirror: transitory has turned out to mean less than three weeks as the bond markets reposition for higher rates, but lower inflation expectations.
You can read the full Market Update below.
Market Review: Back to Reality
Markets in June revealed a shift back to ground reality.
The U.S. markets touched new highs in June as investors remained bullish on the speed of economic recovery despite lingering concerns on short-term inflation due to the Consumer Price Index (CPI) rising by 0.6% in May. Change in nonfarm payrolls revealed that the U.S. economy added 559,000 jobs in May, up from April, but 116,000 short of economist expectations. Despite both the CPI and nonfarm payroll numbers falling short of expectations, the continued fall in weekly unemployment claims has kept the market sentiment buoyed, and the Federal Reserve has maintained the status quo by keeping rates unchanged as well as slowly starting to unwind their corporate bond holdings. Markets jittered when the Federal Reserve revised their estimates to two rate hikes by end of 2023, however a sudden spike in weekly jobless claims the same week pushed long term yields down and investors rushed back into the technology sector, which has emerged as the new beacon of stability during the pandemic. The real estate sector has continued to perform extremely well, returning 11.22% over the past 3 months, second only to technology. While the reopening economy is expected to boost the commercial real estate sub-sector, the sector as a whole has historically performed well during periods of recession thereby attracting investor interest. Towards the end of the month energy and banking stocks received a boost on news of the progress towards a bipartisan deal on President Biden’s massive infrastructure bill, and all participant banks clearing the Federal Reserve’s stress test this year, respectively.
The MSCI Europe Index has returned 2.85% over the past month and investors are expecting the continents’ major indexes to rise further as they emerge from lockdowns. While the delta variant has forced countries such as the U.K. to push back their reopening plans, the expectation that the reopening will have an identical effect on markets as it did in the U.S. has led to massive inflows from U.S. investors who hope to take advantage of the higher relative growth in the second half of the year.
MSCI Emerging Markets Index rose by just 0.51% in June, with the better performers including Brazil, Russia, South Korea and India. While many countries continue to struggle with COVID-19 variants, as the vaccination drive progresses, the impact of new strains on the population is expected to lessen. Emerging countries’ economies are expected to on average recover faster than their developed counterparts as the major emerging countries bypassed the traditional industrial stage and jumped right into a hybrid category of industrial-digital revolution. It is often easier to transition directly into newer technologies rather than trying to incorporate new ones into existing systems. China, the largest component of the MSCI EM Index was by far the biggest laggard as the government has clamped down on big tech for reasons ranging from anti-trust to data privacy to cybersecurity.
A low interest rate environment coupled with the Federal Reserve acting as a helicopter parent has emboldened investors in search of yields to continue pouring money into the high-yield bonds as opposed to investment grade bonds. Companies are taking advantage of the low rates to buy back bonds and estimates are putting new debt issuance in 2021 to be the highest of the past twenty years. While the news of the Federal Reserve revising their estimates towards two rate hikes by end of 2023 pushed up rates and temporarily drove out high-yield investors, a subsequent unexpected rise in weekly unemployment claims pushed down 10, 20 and 30-year yields by 12 bps, 16 bps and 19 bps each, reversing the prior outflows.
Commodities just like the rest of the market have been witnessing price spikes depending on the stage of economic recovery. Lumber prices spiked with the frenzy surrounding home buying, building, and renovating, leading to production shortages. However, with mills scaling up production to meet demand, lumber future prices have now dropped more than 40% over the past month. Oil prices rose above $75 per barrel in June, resulting in talks among the OPEC+ members on increasing production in August. However, prices are not expected to be stable in the near future as the Delta and Delta Plus variants surge across the world and the nuclear deal between the U.S. and Iran continues to remain on tenterhooks. In addition, while global crop production is expected to increase this year, a combination of high inflationary expectations and low humidity heatwaves across the Northern Hemisphere has pushed up crop future prices. Cryptocurrency prices continued to fall in June as financial regulators worldwide continue to crackdown on mining and transaction operations, while the sustainability momentum in the markets has brought to the front the massive energy consumption involved in mining cryptocurrencies.
Going Forward: The Big Neutral
When the World Health Organization first sounded the alarm on COVID-19, markets initially panicked in the vacuum of information combined with stringent lockdown measures, taking us back to levels in the U.S. stock market not seen since 2016. However, as we learned more about the virus, how it spread, how it could be controlled effectively causing many sectors of the economy to transition to working from home; the market clawed its way back up to pre-pandemic levels by the end of summer. And, although a fairly devastating second wave hit in the fall/winter, the outlook for a vaccine was looking positive and markets took the reopening for granted. It was coming. That said, cross markets remained bearish with lower risk assets rallying and higher risk assets treading water, vaccinations increased and lockdown measures were loosened. Meanwhile, vaccination accessibility remains a challenge in some parts of the world and a lack of urgency in other parts where the pandemic was well controlled through heavy handed lockdown measures. Either way, the U.S. remains an island in a global pandemic storm. And, the cross market bearishness remains a feature across the asset landscape.
Growth vs. Value
While value and growth at a reasonable price (GARP) style equity indices have been strong performers all year, it is worth noting that both styles are running hot, and well above sustainable long term averages. The catch up can explain some, but both are now well out of a range of comfort. Yet, growth, the seemingly ever over-priced segment of equities, is not that far below long-term fair value. This growth/value bet is essentially a coin flip at this point, so rather than get greedy, we close this trade out.
Follow the Vaccines
While the U.S. has managed a decent level of vaccinations, save pockets of vaccine hesitancy in the population, the results of the reopening are being felt across the markets from labor markets, to retail, to hotel, to travel. However, while Europe initially botched their vaccination rollout, Europe has largely overtaken the U.S. in terms of vaccination rates. Europe still has a significant amount of catching up to do and valuations are far more attractive, so this segment could continue to perform. However, in the international space, Japan remains a laggard with only 14% of the population fully vaccinated and only 25% of the population having received at least one dose with the Tokyo Olympics just around the corner. What should be a massive economic booster, could send the country into a spiraling lockdown. Perhaps the greatest convection we have is overweight Europe and underweight Japan. Emerging markets remains a decided lingerer and will likely remain so until COVAX, the global coalition run by the World Health Organization (WHO), the Coalition for Epidemic Preparedness Innovations (CEPI) and the Global Vaccine Alliance (GAVI) can make more vaccinations available in key hotspots.
Bonds have suffered the most in the reopening as anticipation of rate hikes have been moved up and concerns regarding inflation haunt the bond markets. Though high-yield has been a stand-out bond performer, it is a giant amount that dwarves. The continued upgraded cycle aided immensely by the availability of significant liquidity is likely to create some corporate zombies, but until the liquidity dries up (potentially in a few years), it will be hard to tell who is “swimming naked,” to harken back to one of Warren Buffet’s greatest dot com era quotes. Meanwhile, the yield curve is bear flattening with the short end rising in anticipation of higher interest rates and long end falling as the wind comes out of the sails of the reflation trade. This is not a great time to be a bank or be anywhere near bonds until the dust invariably settles.
We are closing out our small cap overweight as well as our Value and GARP overweights. We remain underweight Emerging Markets relative to U.S. and maintain a higher allocation to EAFE equities than usual, specifically Europe.
Past performance is not an indication of future performance. The information provided in this newsletter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. There is a risk of loss from investments in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.
The information contained herein reflects Lido’s views as of the date of this newsletter. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. Lido has obtained the information provided herein from various third-party sources believed to be reliable, but such information is not guaranteed. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Lido is not responsible for the consequences of any decisions or actions taken as a result of information provided in this newsletter and does not warrant or guarantee the accuracy or completeness of this information.
The MSCI All Country World Index is designed to represent performance of the full opportunity set of large- and mid-cap stocks across 23 developed and 27 emerging markets. As of November 2020, it covers more than 3,000 constituents across 11 sectors and approximately 85% of the free float-adjusted market capitalization in each market. The index is built using MSCI’s Global Investable Market Index (GIMI) methodology, which is designed to take into account variations reflecting conditions across regions, market cap sizes, sectors, style segments and combinations. (Source: MSCI)
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. (Source: Russell)
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. (Source: Russell)
The Standard & Poor’s 500® is a market value weighted index that includes the 500 leading U.S. based companies and captures approximately 80% coverage of available market capitalization. (Source: S&P Global)
The Dow Jones Industrial Average™ was introduced in May 1896, is a price-weighted measure of 30 U.S. blue-chip companies. (Source: S&P Global)
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. (Source: Russell)
The MSCI All Country World Ex U.S. Index is market-capitalization-weighted index maintained by Morgan Stanley Capital International and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets. (Source: MSCI)
The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries. (Source: MSCI)
The MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets countries. With 1,397 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. (Source: MSCI)
The Barclays U.S. Universal Index is an unmanaged index comprising U.S. dollar-denominated, taxable bonds that are rated investment grade or below investment grade. (Source: Barclay’s)
The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). (Source: Barclay’s)
The BofA ML U.S. High Yield Master II Index tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. domestic market. (Source: BofA Merrill Lynch)
The Bloomberg Commodity Index is a broadly diversified commodity price index distributed by Bloomberg Indexes. It tracks the price of furutes contracts on physical commodities on the commodity markets. (Source: Wikipedia)
The Alerian MLP Infrastructure Index is a composite of energy infrastructure Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index has 25 constituents that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. (Source: Alerian)
The S&P GSCI Gold Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark tracking the COMEX gold future. The index is designed to be tradable, readily accessible to market participants, and cost efficient to implement. (Source: S&P Global)
The BofA ML 3-Month T-Bill Index is an unmanaged index that measures returns of the three-month Treasury Bills. It consists of a single issue purchased at the beginning of each month and held for a full month. (Source: Lido)
The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies falling within four principal strategies: equity hedge, event driven, macro/CTA, and relative value arbitrage. (Source: HFRX)
The Dow Jones Real Estate Index is designed to track the performance of real estate investment trusts (REIT) and other companies that invest directly or indirectly in real estate through development, management, or ownership, including property agencies. (Source: S&P Global)
LA21MUBG03 — March 2021 Market Update