It is astonishing to see the market narrative shift in the space of only a few months from “inflation is coming” to a growth scare. In late March, the 10-year Treasury yield topped at over 1.7% and the 2s10s yield curve was steepening. Today, the 10-year has decisively broken support and the yield curve is flattening, indicating fears of slowing economic growth.
In late May, I forecasted bond market price strength and called for a counter-trend rally in growth stocks (see What a bond market rally could mean for your investments
) but the latest move in both yields and growth appear exhaustive. As evidence of the change in psychology, Bloomberg
reported that put option premiums over calls on the 10-Year Treasury Note have vanished. Traders are now paying more for call options than put options.
Here are seven reasons why investors should fade the growth scare.
Lack of cross-asset confirmation
The bearish scenario, which is becoming the consensus one, would see a stalling in economic growth and momentum, causing the Fed to take a more dovish tone, Treasury yields to pull back, the yield curve flattens, put upward pressure on the USD, which would be negative for commodity prices. Growth stocks would regain market leadership as investors pile into growth stocks when growth becomes scarcer, and value stocks lag owing to their high cyclical exposure.
While investors have bought growth stocks because of the perception that growth is becoming scarce, many other cross-asset signals have not confirmed the growth slowdown. While the 10-year Treasury yield has broken technical support, the USD Index is still trading below a key resistance level. If the global economy is indeed slowing, the USD would be an important safe haven asset that should be rallying hard.
Commodity prices are also not signaling a major deceleration in growth. Commodities remain in an uptrend and they are holding above their 50 and 200 dma. In addition, the cyclically sensitive and base metals to gold ratio remains firm and exhibiting a positive divergence against the 10-year Treasury yield.
Value poised for a comeback
Another cross-asset signal can be found in equity style performance. The relative performance of growth stocks, as measured by the NASDAQ 100 to S&P 500 ratio, is correlated to bond yields. That’s because growth stocks are high duration assets that are more sensitive to changes in interest rates. Indeed, growth stocks have rallied on a relative basis as bond yields have fallen (inverted scale).
The relative performance of value to growth has gone global. Not only are value stocks lagging in the US, but internationally as well. A closer look at the Russell 1000 Value to Growth ratio shows a positive RSI divergence in favor of value. As well, the relative breadth of value to growth may also be bottoming.
A value hiccup in an uptrend
Jason Goepfert of SentimenTrader
believes the “Pounding of Value Stocks May Be Nearing an End”. The setback experienced by value stocks is occurring in the context of a relative uptrend, as defined by a rising 200 dma.
One difference with the recent losses is context – it’s happening in an uptrend. Unlike the large rolling 1-month losses during much of 2020, the 200-day average of the Value/Growth Ratio is rising.
If we focus on large declines in the ratio only within uptrends, we can see that losses this large have typically resulted in the trend reasserting itself rather than sliding into another long-term downtrend. The ratio was extremely volatile in the 1930s, so many of the precedents were triggered then.
Growth stocks are highly extended
I recently pointed out (see U-S-A! U-S-A! But for how long?
) that investors have piled into US equities as a safe haven in the current growth scare and the relative performance of US equities are highly correlated to the growth/value ratio. The relative performance of the S&P 500 is highly extended, though it staged an upside breakout through relative resistance.
observed that NASDAQ sentiment is at a crowded long condition: “Timers my firm monitors who focus on the Nasdaq in particular are, on average, more bullish now than on 94% of all trading days since 2000. (That’s according to my firm’s Hulbert Nasdaq Newsletter Stock Sentiment Index, or HNNSI.)”
One anomaly to the growth leadership is the lagging performance of speculative growth stocks. Even as the relative performance of the NASDAQ 100 rose, the ARK Innovation ETF (ARKK) weakened both on an absolute and relative to the S&P 500.
Earnings Revisions Are Strong
As we approach Q2 earnings reporting season, EPS estimates are also rising strongly. There are no signs of slowdown or deceleration.
Q2 earnings seasons may be a challenge because forecast growth rates are very high owing to low base effects. However, companies have historically managed expectations well so that they have beaten estimates.
In addition, FactSet
also pointed out that forward guidance is extremely strong. The risk of a disappointing earnings season should be fairly low.
For Q2 2021, 37 S&P 500 companies have issued negative EPS guidance and 66 S&P 500 companies have issued positive EPS guidance. If 66 is the final number, it will mark the highest number of S&P 500 companies issuing positive EPS guidance since FactSet began tracking guidance in 2006
Delta and Lambda: Under control
One of the reasons advanced for a growth scare is the rising prevalence of different COVID-19 variants which could lead to renewed lockdowns that put the brakes on a recovery. Joe Wiesenthal
documented the UK experience with the Delta variant, which has ripped through that country. The red line is the five-day moving average of new COVID cases, while the green line is the five-day moving average of COVID deaths. The UK is one of the most vaccinated countries in the developed world. Vaccines work to mitigate the effects of the pandemic.
As well, concerns over a new Lambda variant is beginning to appear. An article in MedPage Today
Yet another SARS-CoV-2 variant is making headlines, but experts reassure that early evidence suggests it can’t substantially evade vaccines — though it does have potential to become a variant of concern, one expert said.
The Lambda (C.37) variant, first identified in Peru in December 2020, now accounts for the majority of infections there, and is on the rise in other South American countries, including Argentina, Ecuador, Chile, and Brazil.
MedPage Today interviewed researcher Nathaniel Landau, PhD, a virologist at NYU Grossman School of Medicine, who found the new mutation appears to increase viral transmissibility and it is more resistant to current vaccines:
The novel mutations in spike may contribute to increased transmissibility, and could result in greater reinfection rates or reduced vaccine efficacy, the researchers reported. Their analysis showed that Pfizer serum samples were about 3-fold more resistant to neutralization, and Moderna samples were about 2.3-fold more resistant. Convalescent plasma was about 3.3-fold more resistant, while Regeneron’s monoclonal antibody combination had no loss of antibody titer, the group said.
Alarming? Well, not really.
“The typical titer for someone who is vaccinated is 1:2,000,” Landau told MedPage Today. “You can take that down to 1:500 and it will still kill the virus. … Natural infection titers tend to be 1:200, on average, and that’s still protective.”
“We’ve done this for Alpha, Beta, Gamma, Delta, and now Lambda,” Landau added. “The results we see are very similar for all these variants. We’re primarily looking at the mRNA vaccines, and vaccine-elicited antibodies do a good job of neutralizing all the variants.”
Bottom line: As long as there is progress in vaccinations, worries about another pandemic-induced slowdown are overblown.
Here comes the PBoC
Lastly, any growth deceleration will invite a policy response. There are already signs of a growth slowdown in China. Reuters
reported that a former PBoC official said he expects the central bank to engage in monetary stimulus in H2.
Sheng Songcheng, former head of the statistics department at the People’s Bank of China (PBOC), said China should “reasonably and appropriately” lower interest rate levels in the second half of this year as pace of economic growth might ease to 5-6% against the backdrop of fading low base effect.
Subsequent to the publication of that story, Bloomberg reported that the PBoC announced a surprise cut to banking reserve requirements.
The People’s Bank of China will reduce the reserve requirement ratio by 0.5 percentage point for most banks, according to a statement published Friday. That will unleash about 1 trillion yuan (US$154 billion) of long-term liquidity into the economy, the central bank said.
The cut will be effective on July 15, according to the statement.
Monetary accommodation is on the way.
Why are bond yields falling?
Under normal circumstances, falling bond yields is a signal that the market believes the economy is about to slow. If the fears of a growth scare are overblown, why are yields falling?
The market’s confusion can mainly be attributable to a misinterpretation of the apparent hawkish pivot from the June FOMC statement and dot plot. As a reminder, seven Fed officials saw rate hikes in 2022, compared to four at the March FOMC meeting; 13 saw rate hikes in 2023, compared to seven at the June meeting.
The misinterpretation stems from the mixed message owing to the divide that’s appearing at the Fed between the inflation hawks, who are mainly Regional Fed Presidents, and the doves, who are mainly members of the Board of Governors. The minutes of the June FOMC meeting
tells the story [emphasis added]:
In their discussions on inflation, participants stated that they had expected inflation to move above 2 percent in the near term, in part as the drop in prices from early in the pandemic fell out of the calculation and past increases in oil prices passed through to consumer energy prices…Most participants observed that the largest contributors to the rise in measured inflation were sectors affected by supply bottlenecks or sectors where price levels were rebounding from levels depressed by the pandemic. Looking ahead, participants generally expected inflation to ease as the effect of these transitory factors dissipated, but several participants remarked that they anticipated that supply chain limitations and input shortages would put upward pressure on prices into next year.
In their comments on longer-term inflation expectations, a number of participants noted that, despite increases earlier this year, measures of longer-term inflation expectations had remained in ranges that were broadly consistent with the Committee’s longer-run inflation goal. Others noted that it was this year’s increases that had brought these measures to levels that were broadly consistent with the Committee’s longer-run inflation goal.
Moreover, there was broad disagreement about inflation risk:
In discussing the uncertainty and risks associated with the economic outlook…Although they generally saw the risks to the outlook for economic activity as broadly balanced, a substantial majority of participants judged that the risks to their inflation projections were tilted to the upside because of concerns that supply disruptions and labor shortages might linger for longer and might have larger or more persistent effects on prices and wages than they currently assumed. Several participants expressed concern that longer-term inflation expectations might rise to inappropriate levels if elevated inflation readings persisted. Several other participants cautioned that downside risks to inflation remained because temporary price pressures might unwind faster than currently anticipated and because the forces that held down inflation and inflation expectations during the previous economic expansion had not gone away or might reinforce the effect of the unwinding of temporary price pressures.
Confusion at the FOMC and its communication policy has led to confusion in the markets.
In addition, when I issued the call to buy bonds in May, bond market sentiment and positioning was at a bearish extreme. Long bond sentiment has now surged to a bullish extreme.
In conclusion, I called for a bond and growth stock market rally in late May and those trades are on their last legs. The market is currently overreacting to a growth scare. Investors have piled into safe haven assets, such as US equities and growth stocks while broad equity market levels have not suffered much of a setback. Equity investors should rotate back into value and cyclical stocks in anticipation of better performance ahead.