The Monthly View – September 2020

After plunging alongside the rest of the stock market in March, tech stocks have strongly outperformed over the past months. The tech-heavy Nasdaq 100 is up 21% since the start of the year. The “Awesome 8” stocks (Amazon, Apple, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla) have gained a staggering 59% on a market cap-weighted basis. Meanwhile, the median US stock has lost 14% this year, which creates a huge divergence in the market.

Even after last Thursday’s correction in technology stocks, tech stocks are only back to mid-August levels. Source: Bloomberg

Many tech companies also trade on long-term growth prospects, which means that changes in discount rates have a disproportionately greater impact on the present value of their cash flows than for slower growing companies. All this means that tech stocks tend to outperform in environments where inflation and interest rates are falling. We thought there was a real possibility the market could correct through summer. This view did not materialize for several reasons.

The S&P 500 All Time High

The S&P 500 recent all-time high ignores a long list of tactical indicators that flag an elevated risk of correction. Also, because the S&P 500 Index is propelled by the performance of the tech giants. The strength of the US equity market is a testament to the power of policy stimulus, the perceived invincibility of tech titans and the hopes that the powerful economic recovery will continue.
Although we expect equities to climb in the coming year, higher bond yields could transfer the market leadership from tech and growth stocks to more traditional stocks. While these shifts usually do not spell the end of bull runs, often they generate periods of volatility, especially when the leaders account for 40% of market capitalization.

We underestimated the impact of the weaker dollar, which has benefitted the equity bull market. When expressed in Euros, the S&P 500 has been flat since June 5. Relative to gold, the S&P 500 is down by 9% since June 8, which further highlights how equities have been supported by a weak U.S. dollar and a plentiful money supply. Source: Bloomberg

Meanwhile, the S&P 500 has outperformed the EURO STOXX 50 Index by 7.8% since June 5; however, when we factor in the effect of the strong euro, US equities have steadily underperformed the Eurozone benchmark since early May. Source: Bloomberg

Low bond yields have also supported U.S. equities. Near-zero interest rates have allowed the valuation of growth stocks to hit extraordinary levels. The NASDAQ trades at 32-times 2020 earnings and 27-times forward earnings. In the most extreme cases, the five tech stocks that have accounted for 31.7% of market gains since March 23 (Apple, Amazon, Microsoft, Alphabet and Facebook) trade on average at 40-times 2020 earnings and 32-times 2021 earnings. Source: BCA Research

Retail investors seem to continue to serve as the primary source of support for US equity markets. This is important, since continued investor optimism throughout August can be largely contributed to large demand for call options on the big tech stocks (Amazon, Apple, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla). Source: Vanda Research

The Robinhood investor base ongoing influence on equity markets has been made possible by two factors in particular: the continued absence of institutional investor activity, and this younger investor base’s willingness to use leverage. Institutional investors are still holding relatively large cash positions, which could also limit how far the market could potentially correct.

The Influence of COVID on Tech

COVID-19 has clearly had a positive influence on tech stocks. While spending on restaurant, entertainment and retail collapsed during the pandemic, outlays surged on Amazon, Apple products, Netflix subscriptions, etc. Source: Bloomberg
At the apex of the crisis, online retail sales expanded by 26.3% annually in the US, while bricks-and-mortar sales contracted by an unprecedented -17.7%. Meanwhile, global shipments of personal computers and servers are expanding by 11.2% and 21.5% annually, respectively. Therefore, the largest sector of the S&P 500 is outperforming relative to the rest of the market. As long as investors continue to expect COVID-19 to affect consumer behavior, they will pay a premium for tech stocks that benefit from the pandemic. Source: Bloomberg

Looking further out, the rapid growth in tech earnings could decelerate as many of today’s marquee tech companies struggle to expand market share. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. Source: BCA Research

New opportunities for growth will undoubtedly arise, but there is no guarantee that today’s leaders will be able to take advantage of them. History is littered with tech companies that failed to keep up with a changing world: RCA, Kodak, Polaroid, Atari, Commodore, Novell, Digital, Sinclair, Wang, Iomega, Corel, Netscape, Altavista, AOL, Compaq, Sun, Lucent, 3Com, Nokia, and RIM were all once major players in their respective industries.

Overall the outlook for stocks is positive, but near-term risks have not disappeared. On the contrary, the U.S. election season is heating up and geopolitical tensions are rising in different parts of the world. So far, these risks have not derailed the market rally but watch for higher bond yields as the potential trigger for a short-term correction.

Overall, the key positive driver for markets, monetary policy, remains extraordinarily accommodative. Even when we account for the S&P 500’s elevated valuation, the exceptional amount of fiscal and monetary stimulus is working its way into the real economy.

The strength of US housing activity indicators confirms that the Federal Reserve has pulled the right levers to boost domestic economic activity. For example, the NAHB Housing Market Index has reached a 22-year record, while building permits in July grew at their fastest monthly rate in 30 years, and the Mortgage Applications Index for purchases rocketed to a 11-year high in August. In other words, the US economy continues to heal. Source: BCA Research

However, for stocks to climb further on a cyclical basis, the market will need more than a few tech giants leading the charge. Hence, earnings expectations for the rest of the market must also start to improve.

Fixed Income

It is likely that bond yields will start to move higher. Inflation expectations continue to rise, which will eventually push up nominal bond yields as well.
Fed Chairman Jay Powell recently announced that the Fed will target average inflation, which is effectively the same as saying that the Fed will keep interest rates low for a long time and will let inflation run up. But this will put upwards pressure on the longer dated Treasury yields.

Inflation momentum confirms the risks to bonds. The peak of the deflationary shock has already passed. In July, core CPI excluding housing costs rose by 0.84% month-on-month, which was the highest reading since 1981 when the Fed was combating the most violent inflation outbreak in generations. Source: BCA Research

The upturn in core producer prices also warns that the annual inflation rate of core CPI should accelerate meaningfully in 2021. The dollar’s weakness is another inflationary force. Import prices from China have already bottomed, which points to an escalation in goods inflation in the coming months. Rising natural resources prices are inflationary, but they also indicate that the global economy is strengthening, which should put upward pressure on real interest rates.

Strength in the housing sector also confirms that government bond yields have upside. As we highlighted above, a robust housing market is an important validation that monetary policy is very accommodative.

By definition, the objective of loose policy is to boost future economic activity and eradicate deflationary pressures. The slowdown of COVID-19 also suggests that economic activity has scope to accelerate. Moreover, the House of Representatives reconvened to address the problems plaguing the US Postal Service ahead of the November elections. This early return to work gives Washington another opportunity to negotiate the stimulus bill that it failed to pass earlier this month.

We still expect such a bill to ultimately become law because both Democrats and Republicans have too much to lose in November if the economy relapses in response of political paralysis. Declining infections and increased government support will bolster aggregate economic demand and put upward pressure on rates.

Precious Metals & Commodities

The negative US balance-of-payment dynamics, coupled with increasing inflation risks, will continue to weigh on the dollar, especially as various large emerging countries try to diversify their reserves and payment systems away from the dollar. Meanwhile, a declining dollar, expanding global growth, monetary debasement, populism, inflation and a lack of investment in supply, all will accentuate the appeal of real assets.

We think this will not only benefit the gold price but several precious metals and commodities. Especially commodities with limited supply. This could also manifest itself in a further rise in the price of Bitcoin.

To profit from this emerging trend we have constructed a thematic portfolio that focuses mostly on a combination of precious metals that we believe could perform well in the current macro climate. Commodities have different risks and characteristics versus traditional stock and bond allocations and are not suitable for all investors.

This basket is best suited to investors who are comfortable with the volatility and risks associated with commodities and want to manage inflation risk. We diversify the portfolio with Bitcoin and base commodities through Exchange Traded Funds (ETFs), that provide daily liquidity on a regulated market.