Market Optics: Data-Driven Insights Guiding Us Forward

This episode focuses on unpacking data insights in an effort to understand what it’s informing from a macroeconomic, fixed income, and equity markets perspective. Providing these insights are Brian Jacobsen, Senior Investment Strategist with the Multi-Asset Solutions team; John Krueger, Head of Platform Equity & Portfolio Specialists; and Danny Sarnowski, Portfolio Specialist on our Global Fixed Income team.

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Brandon Brouillard: I’m Brandon Brouillard and you’re listening to On the Trading Desk®.

For today’s conversation, we’ll be discussing our flagship chart book, Market Optics. Throughout this discussion, we’ll unpack insights gleaned from Market Optics and what it’s informing from a macroeconomic, fixed income, and equity markets perspective.

The purpose of this chart book is to help investors visualize data in order to power their investment ideas and decision-making as they look to invest. For reference, Market Optics can be found on our website under the Insights tab or requested from your financial professional, if you work with one.

Now I’m excited for our guests and joining me for this conversation are Brian Jacobsen, Senior Investment Strategist with the Multi-Asset Solutions team; John Krueger, Head of Platform Equity & Portfolio Specialists; and Danny Sarnowski, Portfolio Specialist on our Global Fixed Income team. Welcome back to the program, gentlemen.

Brian Jacobsen: Thanks for having us.

John Krueger: Yeah, thanks, Brandon.

Danny Sarnowski: Yeah, thanks. Looking forward to the conversation.

Brandon: Sounds great. Well, Brian, let’s start with a macro view and jump into a discussion around the global economy. What’s the consensus view on growth and inflation and are there any surprises we should watch for?

Brian: There is really an interesting dynamic developing. If you think back to November 2020 where we obviously had the presidential election, but then we also had the announcements from some pharmaceutical companies about how effective their vaccines were and a lot of people got excited about the prospect of a globally synchronized economic recovery.

But now, if you fast-forward to today, it’s pretty clear to me that the pattern of economic recovery has pretty much followed the pace of vaccinations in the different countries. You have places like the United States and the United Kingdom roaring ahead, China also doing quite well. And then Europe, they were kind of lagging behind, but now they’re beginning to play some catch-up. Then, you have other areas like, say, Japan being apparently way behind the curve. And also, let’s not forget about many of the emerging markets who seem to be sort of suffering under some of these variants of the coronavirus.

But yet, all countries have been experiencing to various degrees these inflationary pressures, and a lot of that is associated with demand being very strong in places like the United States and China and the United Kingdom, but supply still being constrained.

Some countries like New Zealand, Korea, Brazil, Russia, Mexico, their central banks have already started hiking rates or plan on hiking soon. But others, like the U.S. and then the Eurozone, they have hiking way off on the horizon. And so this diverse economic growth context with a mix of central bank policy responses could be a recipe for some pretty interesting tactical opportunities, in our opinion.

Brandon: That’s great perspective, Brian. And so it seems as though the world is opening back up and that we’re shifting into a full blown recovery phase. How does this impact the global economy from both a monetary and fiscal policy perspective?

Brian: I think that really what it means is policy divergences are beginning to increase.

Central banks like in New Zealand and Korea, they’re trying to prepare markets for the day when those banks are set to hike rates, which could be this year or this summer already.

Other central banks, like the European Central Bank, they seem to be doubling down on their commitment to keep rates low, if not, possibly lower.

The difference is partially due to how confident the central bankers are in the growth and inflation outlook, but it also seems partially due to those bankers’ concerns, or maybe lack of concern, about currencies and capital flows.

The Federal Reserve (The Fed) seems to fall in the camp with the European Central Bank where it’s in no real hurry to hike. Now it might be tiptoeing towards tapering its asset purchase programs, but I think a key lesson to remember from the financial crisis is that removing emergency measures, whether it’s monetary policy or even fiscal policy, it does not have to be disruptive to growth or markets if the measures are removed at a measured pace and removing them going into economic strength as opposed to economic weakness.

Brandon: And so kind of piggybacking on that, this pandemic has ultimately led to even higher levels of debt, but it’s also put a fair amount of cash into the pockets of consumers along the way. So how does this influence consumer demand in the next leg of the recovery, and who’s likely to shoulder the majority of the tax burden associated with this debt incurred during the crisis?

Brian: Yeah, I mean as far as the last question about who’s going to shoulder the burden of the debt, it’s the future generations, really, or future taxpayers that oftentimes end up paying for the debt.

But if you think about when the pandemic hit, the fiscal policy response was almost uniformly across countries big and bold. The U.S. showed that despite high budget deficits, there was plenty of appetite still for more government debt. And the pandemic itself, it probably caught a lot of businesses off-guard.

You know, the traditional crisis playbook said that businesses should plan on reduced sales. But because of these relief and stimulus payments, incomes rose, when you include government transfer payments, and consumer spending surged.

Now some of those programs are sunsetting, so they’re kind of going away, but consumers have accumulated a lot of savings, and we could see consumer spending stay buoyant as individuals transition back into the labor force.

So in terms of paying for all this then, if post-wartime fiscal policies are any historical guide, it’s probably going to be a combination of things. It’s rarely, if ever, just one thing that ends up paying for it. It’s likely going to be a combination of central banks keeping government financing costs abnormally low. There could be a slight bending of the government spending curve. It could also be a little faster economic growth and probably, eventually, higher taxes.

But I’m not too worried about it, at least over the intermediate term, and we always have to define then, well, what you mean by the intermediate term? So I’m talking about over the next, say, like three years here. You know, the bills will come due, but not all at once and a lot of the pain and the payment will likely take place over a long period of time.

Brandon: Well, thanks for the color there, Brian. And so this is a good time, I think, to segue into fixed income. So Danny, I’d like to ask you about interest rates around the world. What’s going on?

Danny: What is going on, for sure? Well, you know, we saw global sovereign yields in the second quarter modestly fall. And we saw yield curves flatten.

On a global level, the U.S. continues to offer a higher yield for sovereign debt than many countries in Europe and around the world. But similarly, rates here also moderated in the second quarter.

Now remember, Treasury yields had risen from last August through the first quarter of this year and in that period, the 10-year Treasury, for example, rose nearly 100 basis points, so a conviction move higher.

And that rise was powered by a lot of optimism in the markets, right? We had the initial onset of the vaccine efforts, the resolution of the elections in the U.S., the promise of vast amounts of fiscal stimulus, signs of significant growth as economies around the country opened, and consumers flush with cash felt safer spending.

We also had initial data sets showing that inflation across several measures rose materially and would likely continue to rise due to the growth I just mentioned and due to distortions in supply chains and the employment market.

But, by contrast, the second quarter seems to have closed with a whole lot more pessimism, right? The vaccine effort, which has continued, has certainly slowed down. COVID-19 case counts have risen as several variants of the virus are proving to be more contagious. The fiscal situation has slowed down as gridlock has once again raised its head and left Congress not doing a whole lot. And while growth continues to come in high, many in the marketplace seem to have agreed with the Federal Reserve that inflation will be higher, but also transitory, meaning that it will just abate after a period.

And all this has led U.S. Treasury yields to decline across much of the curve in the second quarter and for the curve to flatten as a result.

Now we tend to think this is a bit overdone. We had expected rates to rise in a, call it, a two steps forward, one step back sort of fashion and that’s largely what’s played out, but yields today are back to pre-vaccine levels. We just think that’s a bit too grim.

And so while growth may moderate from the very high trajectory it has been on recently, it’s likely to stay elevated relative to the pre-COVID levels. And similarly, inflation will probably moderate in the next few months, but dropping from a, call it, a 5% inflation rate to 2.5% or 3% inflation, that’s still quite a bit more inflation than we’ve had prior to the pandemic and for a long time.

So we do think that all these things will come together. We’ll see some more volatility, but it wouldn’t surprise us to see U.S. Treasury yields higher over the next couple of quarters and certainly by year-end.

Brandon: Interesting. So rates today are low, could stay that way, but could also migrate higher. So what opportunities persist within the credit market and how do spreads look relative to historical averages?

Danny: Yeah, that’s a great question. Spreads have remained extremely tight. In just the last quarter, investment-grade credit here in the U.S. and high-yield bonds have set new post-Great Financial Crisis tights, and that means that the amount of additional compensation that investors are earning for bearing credit risk today is at the lowest point in about 14 years across a huge swath of the domestic fixed income markets.

Now the backdrop, you heard it from Brian, fundamentals are relatively strong, corporations loaded up a lot of cash last year by issuing debt as the pandemic began, and the consumer, from a financial standpoint, is actually very healthy and has gotten right back to spending. So there’s reason to be constructive on growth.

The technicals are also very strong, as investors all over the world look for yield and continue to find some of it in corporate and high-yield credit, but it leads to valuations that are a little worrying, right? They’re just extremely high and don’t leave much in the way of upside. So we think this means investors really should be considering the downside risk of every bond they own today, right?

There can be continued upside and spreads can trade sideways for a long time and that gives credit the opportunity to spin off carry, which adds to total returns. But the downside risks have grown and the cost of being wrong on any given credit, we think, is just higher. And so this is a good time to look at where credit has outperformed the most, maybe trim a little bit there, trim some of those winners and look for other opportunities to earn carry.

Structured product or, that is, securitized sectors offer a very diversified set of markets and subsectors in which to invest and which have many different touch points supported by the consumer. Asset-backed securities or mortgage-backed securities, for example, offer the opportunities to benefit from healthy consumer balance sheets.

Brandon: Well, that’s great perspective. And on the taxable side, it seems that a multi-sector approach is a strong one to consider, given today’s yield and spread environment. But what about on the tax-free side? Munis have enjoyed fairly strong demand for the last couple of years, so what’s next for this market?

Danny: I’d say that municipals have seen more than fairly strong demand. They’ve had incredibly strong demand. In fact, the average weekly inflows here for the first half of 2021 are more than double the average weekly inflows for the second half of last year and that was an incredibly strong period of inflows.

The first half of 2021 has seen enough inflows into municipal bond mutual funds and ETFs (exchange-traded funds) to stand as the third-highest year of all time for the asset class, and we still have half the year remaining. This has just caused bond prices to rise and yields to fall. And as a result, municipal-to-Treasury yield ratios have fallen in 2021 and they remain extremely low by any historical measure. So municipals are just extremely rich relative to Treasuries and this is across all areas in municipals and across the credit quality spectrum.

High-yield municipals have outperformed higher-rated municipal bonds for 11 months straight. And every new deal seems to come multiple times oversubscribed. And municipal bonds are trading in very tight ranges, regardless of credit fundamentals of the underlying issuers. So you’ve got airports sort of all trading in a range. You’ve got hospitals trading in these tight bands and so on. And so we all know that these issuers are not all created equal and that at some point, credit selection is going to matter and we think it’s going to be critical to the long-term success of municipal investors.

So this is another spot, like we just talked about with credit, where research is really, really critical because everything is fairly expensive right now and so that cost of being wrong just gets higher and higher and higher. So again, fundamentals actually pretty good, technicals very strong, but valuations are certainly stretched across much of the tax-free fixed income markets here in the U.S.

Brandon: Well, thanks, Danny. It certainly sounds like there’s opportunity, as you mentioned, for savvy research focused fixed income investors. And so let’s shift the conversation to equities now. John, coming to you. With equity markets continuing to roar and the prospects of a material pullback on investor minds, what can you tell us about relative returns in the equity market?

John: Yeah, thanks, Brandon. The S&P 500 is now up 15.3% year-to-date through June 30 and actually just hit all-time highs actually in last few days. The top-performing style lately has been in growth indices. The peak in the small-cap stocks was way back on March 15 and the highs in value stocks was on May 7, so there’s been a halt in the cyclical trade and a little foundational deterioration within the broad markets. The question is whether this narrow market is signaling something more sinister or whether some of the ebbs and flows is just normal seasonal action. If we look at it through the lens of earnings and interest rates, we just think this is normal seasonal action.

Brandon: Thanks for the perspective and with earnings season well underway, what are valuations suggesting throughout the cap spectrum and across equity styles?

John: Yeah, if we take a look at underlying earnings—and we’re still in the early innings of Q2 reporting season—but 25% of S&P 500 companies have reported to date, and earnings continue to exceed expectations and by a higher-than-usual percentage.

Overall earnings are now expected to grow 76% year-over-year. That’s the best rate since 2009. 85% of companies are beating numbers by analyst estimates and we’re seeing these companies now guide higher.

Third quarter earnings estimates are now expected to grow 27%, which is up from 20% on April 1. Q4 earnings are now expected to grow up 20% and that was just 13% on April 1, so again, everything continues to move in the right direction.

Second, these higher earnings help ease some of the pressures and concerns around valuation multiples. Strategists have been slowly raising overall estimates on the S&P 500. It’s really on track to earn somewhere around $195-$200 on the S&P 500 for the full year 2021, and we’re closing in $220 for 2022. With the S&P 500 at 4300 at the end of second quarter, the broad market’s trading at about 21.5 times 2021 numbers, 19 times 2022 earnings. So these are lofty multiples, but these aren’t egregious.

In fact, let me put a finer point on this. Last quarter, I mentioned, the difference in the earnings yield on the S&P 500 versus the yield on the 10-year U.S. Treasury was about 280 basis points. Even though the market has continued to hit new all-time highs, the earnings yield spread has actually increased to more than 310 basis points due to the improved earnings and then falling interest rates.

Brandon: Thanks for that insight, John. And really, it kind of leads to the question of what’s driving companies’ earnings and cash flows and what does this mean for equity investors?

John: It’s really led by strong profit and free cash flow margins. We’re seeing a lot of companies take out costs in their operations over the short run when you think about reduced travel and expense budgets during COVID. But these businesses have also invested heavily in technology over the past 12 to 15 months and that’s leading to productivity gains, things like the reduced real estate footprint, or videoconferencing capabilities using Zoom and Microsoft Teams, online ordering and point-of-sale payment systems at stores and restaurants. These are just to name a few things. But all of these items are helping companies maintain and boost their margins.

In addition, we continue to hear anecdotal evidence of management teams experiencing significant input cost inflation, but actually finally have pricing power to pass along some of that inflation to their customers. For many companies, it’s been a long time since it had that pricing power to take advantage of it and the early data that we’re hearing from companies’ reportings is still confirming that margin story, right? The historical range of profit margins for the S&P 500 is generally between 9% and 11% over time. But Q1 profit margins were at 13% and currently are running 12.8% in Q2, so again, really healthy numbers.

Brandon: Well, thanks for sharing that. And so as we move into the final minutes of the program, I wondered if each of you could share any last thoughts with our listeners? And John, let’s stay with you and have you lead off this section.

John: Yeah, thanks, Brandon. And again, we want to acknowledge there’s always things to be concerned about. Possible Fed tapering later this year and, as Danny mentioned, Washington political leaders provide us no shortage of concerns as they move forward to tricky negotiations over a $1 trillion infrastructure bill or $3.5 trillion dollars spending bill with corporate and personal tax hikes. And of course, now we’re starting to hear discussions or concerns around debt ceiling negotiations.

But from our view—and the market might be a little overdue for some short-term consolidation—but overall, company fundamentals continue to look strong. Valuations aren’t egregious in the face of the current interest rate environment. Small-cap value in international positions look particularly attractive. And so we’re pretty constructive about the equity markets over the medium-term.

Brandon: Thanks for that. And Danny, do you have last thoughts that you’d like to leave our listeners with around bond markets?

Danny: Sure, I think the reasons for which investors choose fixed income or bonds—and that’s diversification, income generation, and liability matching—are all still available through fixed income, even in this market.

But as I mentioned earlier, there’s nothing easy, there’s nothing cheap, there’s nothing obvious. And so this is one of those points in the cycle where the credit research and discipline around valuation really matter and that careful consideration of total return is going to be vital to success over the next several months and quarters.

We think being mindful of not overreaching for risk or yield or stretching at this point is going to be really what makes it for investors from here. And so that’s where our teams are focused on. We’re always focused on careful credit work, but really being mindful of and disciplined around valuations in these tight, tight bond markets.

Brandon: Sounds great. And finally, Brian, to wrap it up, what would you say to our listeners?

Brian: I think that there’s always some fear out there and there’s always some optimism out there.

And I think that the fears about peak inflation may be peaking. Some of the optimism about growth may be peaking, as well, unfortunately.

But even though we’re probably seeing growth begin to moderate a little bit here in the United States, that doesn’t mean that we can’t have strong growth going forward. We’re still very constructive on the global growth outlook, though some of the growth surge, maybe it could rotate from the early leaders in the U.S. and China to the fast followers in Europe. Growth going from great to good isn’t bad as long as the inflationary impulse that we’ve been living through begins to fade as we think that it will.

And there are a lot of divergences developing, but the trend, we think, is still favorable for equities and credit risk. Different countries are reopening at different rates. Different central banks are hiking or holding, depending upon the unique circumstances of each country. And we think that this creates really interesting relative value opportunities if you cast a wide net in your search for opportunities.

Brandon: Perfect. Well, Danny, Brian, and John, thanks so much for the insights you shared with us today. This has been an informative and enjoyable discussion certainly here. So thank you all again for making the time.

Danny: Thanks for having us, Brandon.

Brian: Thanks for having us.

John: Yeah, thanks, Brandon.

Brandon: Well, that wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from our investment team, you can find them at our website or our Advantage Voice® blog.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you may subscribe to the podcast on iTunes, Stitcher, Overcast, Google Podcasts, and Spotify. Thanks for listening. I’m Brandon Brouillard and we’ll catch you next time.

Originally Posted on July 30, 2021 – Market Optics: Data-Driven Insights Guiding Us Forward


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