Without getting technical, let’s just say that because of its impact on markets and pricing, liquidity measures (whether from the Fed, China, or other central banks) must be monitored.
Much has been reported in the past week about recent Federal Reserve operations, such as increasing interest rates offered on excess bank reserves (IOER), or the soaring volume usage of the overnight Reverse Repurchase Repo (RRP) facility that the central bank maintains with the large banking giants who serve as primary dealers of U.S. Treasury securities. As we discussed above, the result of the Fed’s moves had the effect of reducing some of the liquidity from the financial system, and have signaled we have peaked in terms of “excess” liquidity.
Even though the Fed is not claiming to have changed policy, their actions underneath the surface can give insight into how they could behave when they eventually reverse their extremely accommodative position. Perhaps the central bank is trying to help out money market funds, as some suggest … or perhaps the Fed could be oiling the machinery for the future policy action. We will see. Nonetheless the market participants have been reacting, and it has been driving prices to large swings.
The past few trading days was a case in point. Beginning last Thursday, we saw a large two-day selloff followed by a large two-day snap-back rally as investors and speculators rotated positioning. This summer could include many more episodes of this type of frenetic trading rotation and volatility. We expect to hear good earnings and economic activity reports coming from companies; at the same time, we will also hear about rising costs, supply chain disruptions and inflationary impulses. More debate and more volatility seems likely. Conversely, it seems unlikely that “all boats” will rise in concert. Certain industries, groups, countries, and asset classes are clearly better positioned than others. The changing environment is altering the reward/risk outlook for certain asset classes, so we watch closely and focus on key areas we find attractive.
U.S. Stocks — Be Selective
As we noted above, the slowing pace of liquidity expansion should lead investors to greater discernment and selectivity in their stock purchases. Cyclical and industrial stocks have recently peaked. Consumer stocks are highly correlated with consumer income, which has been benefitted by government payments — which we believe have ended for the time being. For some time, we have been suggesting that investors renew their appreciation for GARP, growth at a reasonable price. We could also add an appreciation for quality at a reasonable price: not just growth, but growth (of earnings or dividends, depending on your orientation) with clarity, consistency, and some measure of predictability, and with a healthy balance sheet as a foundation.
After a period of outperformance for cyclicals, the stock market is looking for new leadership, and there is a cogent argument to be made that it will turn again to technology (the NASDAQ recently hit a new all-time high). If investors do return to tech themes, we suggest that they look for quality tech leaders, and not simply compelling stories, themes, and prospects. The FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Alphabet), which in the initial pandemic rally traded in lockstep, may begin to show more differentiation moving forward.
Europe, Canada, and Japan — Attractive, and Cheaper Than the U.S.
We remain interested in Canadian stocks, since Canada is highly exposed economically to cyclical themes that will benefit as the global pandemic recovery proceeds, and the market trades at a substantial discount to the United States.
Europe may be attractive, particularly European growth equities, as Europe emerges from its pandemic lockdown and reaccelerates. And Japan also remains attractive as a “warrant on global growth” that trades at a significant discount to the U.S.
If the rate of earnings growth begins to slow, that’s expected; but will earnings growth still be good in absolute terms? That will be the key question for stocks moving forward.
Bonds
The bond market is simply no longer a transparent price discovery mechanism, thanks to the distorting activity of massive central bank purchases. (We have joked wryly that April, 2020 marked the “nationalization of the bond market” in the U.S.) In the big picture, we continue to believe that bonds are very highly valued; that inflation will eventually force rates to rise; and that bonds, far from being safe ballast in a portfolio, represent a significant risk.
Oil
We believe oil will move towards $100. Despite the rising popularity of environmental metrics in investing, hydrocarbon energy remains the lifeblood of the now-reviving global economy. We would buy the commodity itself through futures or through a non-levered futures-based ETF; among oil companies, we suggest investors steer towards the oil majors.
Agricultural Commodities
As we noted above, agricultural commodity price action represents an extraordinarily complex interplay of global political, financial, and (especially at this time of year) meteorological factors. Still, we believe that food inflation has legs (a fact which in the past has contributed to instability in global regions with greater food insecurity). Therefore we remain interested not so much in agricultural commodities themselves as in the stocks of agriculture-exposed companies, for example, fertilizers and farm machinery; but since they are cyclicals, only on dips.
Gold and Other Metals
Of course, the taper talk from the Fed hurt gold, as it strengthened prospects for the U.S. dollar. For our part, we view an allocation to gold and to other precious metals as a prudent position given the very real risks the Fed faces in engineering a safe landing as it delicately begins to ratchet back pandemic policy support for the economy. Gold may be hurt by a stronger dollar for a few months, but gold will help portfolios in the event of a monetary or financial “accident.” As and if dollar strength slowly wanes, gold’s performance will improve.
Cryptocurrencies
Decentralized cryptos have been the target of relentless government pressure and criticism for many months; China’s recent crackdown, which finally drove bitcoin decisively below a 50% fall from its all-time high, is just one case in point. We expect further price swings, including some uncomfortable fits and tantrums… as the entire crypto space looks to be entering adolescence. Still, cryptos will remain an inflation hedge for many investors and speculators.
Thanks for listening; we welcome your calls and questions.
