Weekly Investment Commentary: COVID-19, growth fears make markets defensive
Weekly market update highlights
- Last week’s strong retail sales and industrial production data underscored strength in the robust economy, reinforcing consumer strength and possible easing of supply chains.
- We continue to side with the Fed as employment and economic data continue to look promising; however, the impending chairman nomination may briefly inject volatility into equity markets.
- Concern for long-term economic growth was elevated last week, causing U.S. Treasury yields to fall and value stocks to underperform; we expect economic growth to reaccelerate into 2022.
Last week’s equity market activity reflected rapidly growing concern over possible economic restrictions associated with the latest wave of COVID-19, as growth and defensive stocks outperformed. Among broad-based indexes, the tech-heavy NASDAQ added 1.3% and the S&P 500 gained 0.4%, while the more cyclically oriented DJIA fell -0.4%. Outside the U.S., the MSCI EAFE, EM and ACWI ex-USA indexes lost between -0.8% and -1.3%, with developed markets faring better than EM.
Market drivers & risks
- Supply chains and earnings continue to go hand-in-hand, as we see our thesis for margin control play out in real time.
- We have consistently maintained that firms with pricing power to defend/grow margins and overcome inflation, as well as business models capable of weathering the supply chain storm, will be rewarded by investors. Last week several big retailers released 3Q results that showed they had intentionally compressed margins, choosing not to pass higher input costs on to customers in an effort to build brand loyalty ahead of what is expected to be a very robust holiday shopping season. We believe this plan may pay off as long as inventory builds are strong and further COVID-19-related restrictions can be avoided.
- Economic data remains solid, with last week’s releases of October industrial production and retail sales both beating expectations.
- The duration of the current cycle will be predicated largely on how long economic growth can outpace inflation. At the same time, however, the longer the economic data stays strong, the more wary of inflation the equity markets will become. If the perception of an overheating economy begins to dominate, the Fed may be forced to change its messaging on the pace and/or timing of policy tightening. That said, we’re still optimistic that supply chain pressures will subside and economic growth will continue in 2022.
- The recent pullback in oil prices is being driven by factors that are unlikely to last.
- The West Texas Intermediate crude benchmark has tumbled roughly 10% from October’s highs, to $76 per barrel at the end of last week. Much of this decline has been driven by the Biden administration’s deployment of strategic reserves to battle rising prices, a course of action the Chinese government is expected to take as well. While this incremental boost in supply will provide some near-term relief, we expect burgeoning demand in 2022 to surpass 2019’s pre-pandemic levels as producers exhibit greater discipline when it comes to adding capacity. Though we don’t expect oil prices to rise sustainably higher from October’s peak, we believe current levels are artificially low.
Economic week in review
- Results were driven by growing fears over the possible reinstatement of economic restrictions as growth and defensive stocks were the relative outperformers. From a sector perspective, technology (+2.4%) and utilities (+1.0%) were among the best performing sectors. Financials (-3.6%) and energy (-4.2%) fell the most on a pullback in rates and oil prices, respectively. Consumer discretionary was the biggest winner last week, adding nearly 4% thanks in part to strong earnings results from home improvement retailers.
- Globally, COVID-19 trends have taken a turn for the worse, with headlines shifting focus away from policy and inflation and toward lockdowns and mandated vaccinations. In the U.S., 30 states are now showing worsening trends in cases and hospitalizations, prompting growing concerns about another round of possible economic restrictions. Last week’s worrisome developments came as the FDA authorized booster shots (Pfizer/BioNTech & Moderna) for all adults, and as anticipation grows for approval of effective oral treatments by year-end.
“The next few months could remain challenging, with continued high volatility and possible near-term market selloffs.”
Risks to our outlook
COVID-19 cases and hospitalizations are on the rise in many countries. Although a renewed wave of infections has been anticipated, the fear of economic restrictions (as enacted last week in Austria) will certainly weigh on equity markets.
The Fed will be under intense scrutiny as it tiptoes toward contractionary policy. With markets so accustomed to quantitative easing and low rates, volatility is likely to rise as investors grow leery of a misstep in timing or magnitude.
Volatility may begin to spike in the coming weeks as the December 15 deadline for raising the U.S. debt ceiling may now coincide with finalizing a potential “soft” infrastructure spending package.
Though it appears U.S. corporate tax rate hikes may ultimately be avoided, markets still must assess the expected impacts of potential increases in other U.S. tax rates, including a minimum tax on U.S. companies’ foreign income.
In the U.S., reflation and expectations for higher yields could bolster returns for small caps and financials, as well as companies with pricing power and reopening tailwinds. Supportive monetary policy and the prospect of stronger relative earnings growth could boost certain stocks in cyclically oriented sectors in developed non-U.S. markets, particularly in Europe and select emerging markets, ex-China. Select growth companies well positioned for reopening, such as front-office software leaders, also look attractive. Our long-term approach tilts toward cyclicals and value stocks that exhibit strong earnings growth and pricing power.
In focus: Tailwinds for BEVs.
While battery electric vehicles (BEVs) are by no means new to the automotive lexicon, they remain a small percentage of cars on the road. Still, BEVs are well on their way to becoming mainstream, as global economies from the U.S. to the EU to China are committing to sustainability across the auto industry. In fact, virtually all major traditional car manufacturers have begun to pledge a transition from fossil fuel-powered vehicles to BEVs over the next two decades for significant portions of their fleets.
From a user perspective, BEVs offer several advantages, from better performance and internet connectivity to obvious environmental benefits. As a result, large volume buyers such as car rental and shipping/logistic companies are already shifting orders away from standard internal combustion engines (ICEs) to their BEV counterparts. Looking further out, the impact of these purchases will be felt across used car markets, ultimately reducing the value of pre-owned ICEs.
The near-term outlook for BEV-related equities may be hampered by extended valuations, as well as the rising rate environment. Longer-term, the prospects for BEV makers are bright, as the number of entrants to the market increases and the costs to consumers become more competitive with existing ICE price tags — something we expect to see over the next 3 to 5 years. Additionally, investors may look to benefit from exposure to BEV component manufacturers given that BEVs require twice as many of their inputs as do their ICE counterparts.
All market data from Bloomberg, Morningstar and FactSet
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