Constructive value and reflation green shoots

The economic winds are shifting and it may be time for investors to trim their sails.

A value revival

A detailed review of the major value and reflation-sensitive sectors reveals a broad-based recovery. Financial stocks staged an upside breakout from a saucer-shaped bottom. The relative performance of this sector is correlated with the yield curve and a steepening yield curve improves banking profitability because they borrow short and lend long. Relative market internals (bottom two panels) improved sharply in the last week, triggered by the strong July Jobs Report.

Industrial stocks represent a value and reflation-sensitive sector. These stocks are testing resistance after tracing out a saucer bottom. Relative breadth has been either improving (% Bullish) or already strong (% above 50 dma).

Material stocks are also showing the familiar pattern of a saucer-shaped bottom while approaching technical resistance. Relative breadth is showing signs of strength.

Consumer discretionary stocks are a mix of growth and value. The largest weights in the sector are Amazon and Tesla, which have growth characteristics, while the rest of the sector is more reflation and cyclically sensitive. The sector has been on a well-defined uptrend owing to the strength of its growth components. However, the relative performance of the equal-weighted consumer discretionary sector (red dotted line) has been moving sideways. Relative breadth has shown signs of improvement, indicating underlying strength of reflation and cyclical factors.

Energy is the weakest of the value and reflation sectors. It is testing a relative support zone and relative breadth indicators remain weak.

In short, most value and reflation sectors are showing strong relative internals. This could be the start of a value and reflation rally. The bullish trigger for the rotation might be an upside breakout by small-cap stocks, which have been range-bound for most of 2021. The relative performance of small to large-caps is small-cap bullish, supportive by a positive RSI divergence and positive relative internals (bottom panel).

Also keep an eye on the 10-year Treasury yield, which is correlated to the cyclically sensitive base metals/gold ratio. The combination of a rising 10-year yield and a steepening yield curve is a signal that the bond market is buying into the reflation narrative.

The Fed’s response

As the signs of a continued recovery trickle in, a Fed decision to taper its QE purchases appears to be baked-in. Fedspeak from a range of doves and hawks are all pointing in the same direction, though with some important differences in nuance.

The Financial Times reported that Mary Daly, President of the San Francisco Fed and an important dove, expressed confidence that the robust recovery in household and business activity would continue to gather momentum as more people returned to work and consumer spending remained buoyant, setting the stage for a policy pivot in the coming months. She added: “Talking about potentially tapering those later this year or early next year is where I’m at.”

Robert Kaplan, President of the Dallas Fed and a hawk, indicated in a Bloomberg podcast he is supportive of immediate tapering, but with an important difference. 

Tapering could help take some of the pressure off the need to raise interest rates in the future, according to the Dallas Fed president. “Adjusting these purchases sooner might actually allow us to be more patient on the Fed funds rate down the road,” he says. It’s a nice reminder that tightening monetary policy doesn’t have to be a monolithic or even linear activity. 

As we approach the Fed’s annual Jackson Hole conference, investors can expect an outline of a decision framework on a QE taper. An announcement of an actual taper should follow shortly afterward. So far, the markets have not been unsettled by the prospect of a taper, which is supportive of further equity market gains.
 

 

Key risks

The stakes are high if value and reflation stocks don’t recover. Marketwatch reported that Barry Bannister and Thomas Carroll, strategists at Stifel, observed that the cyclical vs. defensive ratio had rolled over. The Stifel team is calling for a summer top for the stock market, followed by weakness for the remainder of the year.
 

 

While Google’s mobility survey of retail and recreational activity shows that most developed markets have shrugged off the effects of the Delta variant…
 

 

…much of Asia has been hard hit. Asian manufacturing PMIs are tanking.
 

 

Even worse, a COVID outbreak in China has created congestion off China’s top two container ports. The port of Ningbo shut down a container terminal when a COVID-19 case was detected this week.  The Meidong terminal suspended all operations since early Wednesday, while other terminals in Ningbo imposed restrictions limiting the number of people and cargo entering port areas. These shutdowns represent about one-quarter of the capacity of the world third largest port and these kinds of supply chain disruptions have the potential to bring global trade to a sudden stop and stall the growth recovery.
 

 

As well, a political storm is brewing in Washington despite the passage of the bipartisan $1 trillion Infrastructure Bill in the Senate, which now goes to the House for consideration. House Speaker Nancy Pelosi has vowed to pass both the Infrastructure Bill and a separate $3.5 trillion budget at the same time, assuming there are no defections among Democrats. The budget is expected to include a corporate tax increase and corporate minimum tax. So far, Q2 earnings season results have been very strong and forward 12-month EPS estimates have risen, but Street analysts have not begun to factor in the possibility of a tax increase. The 2017 Trump tax cut had been well telegraphed in mid-2017, but the market did not respond until late 2017.
 

 

A detailed analysis of changes in quarterly EPS estimates shows the market’s vulnerability. Estimate revisions for the remainder of 2021 are roughly flat, but they are rising strongly in 2022, which is most likely to be affected by any changes in the tax code. While some top-down strategists have tried to estimate the effects of a tax increase, company analysts have not revised their estimates because they cannot make changes without knowing the exact details of the legislation.
 

As well, the debt ceiling looms, and the money market is starting to get nervous as the debt-ceiling battle will go down to the wire. Treasury bills maturing in October and November have cheapened relative to the rest of the short-end curve. The risks of a disruptive 2011-style budget and debt ceiling fight are rising.
 

In conclusion, a review of market internals shows that the value and reflation trade is gaining ground. If this trend continues, it would translate into a bullish intermediate-term outlook for equities. However, investors have to be aware of the supply chain disruption risks from the Delta variant, the chances of a political storm in Washington, and the possible negative effects to earnings from a possible corporate tax increase.