Global Strategy: Global Equities and Fed Peaks — Past and Present
Robert J. Pelosky, Jr.
History offers a new perspective on the "Same Old" IT trade. Historically, the best-performing U.S. sectors over the three months prior to a Fed peak and in the three- and six-month post-peak periods are food & beverages, financials and telecoms (last three cycles).
Historical analysis expanded to encompass global markets. Global sector investment opportunities for Fed-tightening-cycle peaks are similar to those in the U.S.: telecoms, consumer staples and financials, especially insurance.
IT and financials may hold key to outperformance in 2H00. Both are exposed to the trade-off between decelerating U.S. (and global) growth, with positive implications for interest rates, and the potential negative impact of slower EPS growth and deterioration in loan portfolios.
Fed tightening may now be close to peak. Our economics team believes that further Fed tightening lies ahead, but they are no longer convinced that it will happen in August. We provide a sliding calendar scale of possible peaks.
It usually doesn't pay to be too negative around Fed peaks. Based on the last three Fed cycles, U.S. stocks gain 8% in the final three months preceding the last Fed tightening in the cycle (global stocks gain 3%). Accordingly, a month ago we reduced cash and the degree of our underweighting in the U.S. (i.e., increased our position) in our MacroScope model portfolios. (The full report can be accessed through Client Link at msdw.com).
U.S. Technical Strategy: Limited Demand, Heavy Supply
Phil Roth
Markets were consolidating from early June to early July but popped last week, achieving something of a breakout. However, very few stocks accounted for the upside, so this is more of a rotation than a rise in broad net demand. Supply/demand has changed dramatically. Last month was a record June for new equity issuance at $20 billion, despite being usually a slow month. The Fed reported that the supply of stock expanded in 1Q for the first time in three years. And net weekly equity mutual fund buying has been only an estimated $1.5 billion over the past four weeks.
So although investors are willing to believe that the Goldilocks economy has been resurrected, the low cash and heavy supply suggests that we should expect only a rotational rally. And that's what we have seen. Investors sold healthcare in quantity, there was barely any movement in consumer staples and telecom, and tech stocks did very well. So the aggressive money is going back to the hot stocks. While the impact should be limited, it is probably something investors can exploit.
The best-positioned tech stocks appear to be computer services, semiconductor and semiconductor equipment, and instrumentation. The best-positioned cyclical stocks are consumer cyclicals like media, and selected transportation like airfreight. Very few deep cyclicals look attractive. I believe we are facing an interim rally and that stock selection is key.
U.S. Quantitative Strategy: What's in the Markets
Joseph Mezrich
There are two stories being told by the markets, one regarding technology, the other cyclicals. Cyclical stocks have been doing well lately, as the stock market is pricing in a rebound in economic growth to 4.5% at year-end, above the 4% level that Dick Berner is forecasting. For cyclical stocks this represents a shift in investors' focus from current growth to future growth. Meanwhile, markets are pricing in essentially no inflation or rate risk, so a Fed rate hike would be a surprise. The rally in the market thus reflects expectations of strong growth with no interest rate worries.
As for technology, what has been powering Nasdaq has been the reduction in the risk premium. Nasdaq volatility had exploded earlier in the year, and we had expected the index to do well as its volatility declined. We think volatility has further to decline, perhaps for another month or so or maybe until Labor Day. We think the cyclical story will likely be more persistent.
U.S. Economics: Secular versus Cyclical Inflation Factors
Richard Berner
Inflation has both cyclical and secular elements. In my view, the strong secular productivity growth of the past several years has been instrumental in restraining cyclical inflation pressures — so far. Furthermore, I do not expect the trend in productivity growth to abate any time soon. However, financial markets have fully embraced the soft landing scenario, generally focusing on the strong secular productivity growth and ignoring what I see as mounting cyclical inflation risks. Those who have acknowledged the cyclical risks have argued either that the productivity trend is strong enough to mute them or that the Fed has done enough to rebalance supply with demand. In contrast, I expect moderate cyclical inflation risk to gradually overtake the impact of productivity growth, with core inflation increasing to 3% from 2.5% currently, despite the expected slowing of the economy.
At his semiannual Congressional testimony on monetary policy this week, Fed Chairman Greenspan will probably echo those competing themes, noting that the Fed must remain vigilant but giving no sense that action is imminent. Whereas markets have embraced and Fed officials hope for the soft landing scenario, I am looking for more of a "soft takeoff," following the 2Q slowing in growth. Recent retail sales data suggest that the second quarter was not as soft as it seemed and that there is still some vitality in consumer spending. I think GDP will come in somewhat below 4% for the 2Q and then pick up to around 4% in the second half, aided by a boom in exports in response to the vigorous global economy. I also expect a modest pickup in inflation pressure, with actionable consequences for the Fed. The timing of the next Fed move is uncertain, but the outcome is not, in my view. Fed action will be highly dependent on the data flow. While the chances of a rate hike in August have declined somewhat over the past few weeks, they are still higher than what is priced into markets.
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