We believe there is a disconnect between economic activity, the equity market, the bond market and what to expect in the future.
The economy is strong. GDP grew at 6.4% in the first quarter of 2021. Whether growth has peaked or not is irrelevant, we expect a strong follow through into the third and fourth quarters. The consumer is sitting on a lot of spending power. Restaurants are reopening and football season is close. The problem, however, is that Covid cases are increasing in parts of the country, and the Delta variant appears to be spreading. An increase in pandemic-like conditions could put a damper on the economy if large in person gatherings are restricted, including school and college, concerts, sporting events, conventions, and conferences.
The Department of Labor released seasonally adjusted initial jobless claims at 360,000 last week, the lowest level since March 14, 2020 before the pandemic shut down the economy. In addition, retail sales increased 0.6% last month which supports strong momentum in the consumer sector.
We are at the beginning of earnings season and expect solid earnings this quarter. So does the market. The S&P 500 is trading at 4500, near record highs. Valuations are high as well. The Price/Earnings ratio of the S&P 500 is near 24.5 times forward earnings. Normally, we would expect 18 times earnings. The equity market is discounting three to four percent revenue growth and sustainable margins, which will be difficult in the face of increasing labor and input costs.
While the equity market is pricing in a lot of good news, the bond market appears to be discounting a slowing economy and falling inflation. The yield on the 10 year US Treasury has declined from 1.55% to 1.27% over the past month. At the same time, the rate of inflation, measured by the CPI has increased to 5% over the past trailing twelve months. At the same time, risk premia in the credit sectors have declined sharply as credit spreads narrowed to historically tight levels. It is counterintuitive to have yields foreshadow economic slowing and credit spreads tighten to historic levels.
The answers lie in the massive government intervention through monetary policy and fiscal initiatives, which are distorting valuations on assets.
Back in the 1980’s, the Federal Reserve targeted the supply of money in the system in an effort to meet its dual mandate of price stability and full employment. Every Thursday afternoon, the monetary aggregates were released with a focus on M1 and M2. In the mid-1990’s the Fed shifted to targeting the Fed Funds rate. Today, with interest rates near zero, one of the Fed’s most powerful tools is its balance sheet. Through quantitative easing, the Fed buys bonds in the open market and can impact the level and shape of the yield curve. The other tool the Fed implements is its communication to the market. Statements from the Federal Reserve chairman has helped to reduce volatility in the market since the Fed shifted its communication policy.
Leading up to the pandemic in late 2019, the economy was slowing and the Fed struggled to push inflation above 2%. Now, inflation has accelerated to a rate of 5% growth, and the Fed has been saying that they believe inflation is transitory and will begin to fall. However, last week, Fed Chairman Powell testified to the Senate Bank Committee saying “This is a shock going through the system associated with reopening the economy, and it has driven inflation well above 2%. And, of course, we’re not comfortable with that.”
We expect the Fed is beginning to shift its narrative to allow for the reduction in monetary support and is getting set up to reduce its asset purchase program.
The S&P fell -1% from highs last week, ending at 4327. Year-to-date the index is up 15.20%. The Nasdaq fell 2%, bringing year to date performance down to 12%. Finally, the DOW also fell about -0.50% for the week. The S&P experienced its first weekly drop in over a month as the week brought in the beginning of second quarter earnings. Banks that reported included JP Morgan, Goldman Sachs, Morgan Stanley, and Bank of America.
JP Morgan [JPM]
JP Morgan reported earnings of $3.78 vs. $3.21 per share. Revenue came in at $31.4 billion, beating estimates by $1.5 billion. Trading revenue fell -30%, mostly caused by the fall in fixed income revenue. Equities trading generated $2.7 billion in revenue, which beat estimates. Investment banking also performed well, bringing in $3.4 billion in revenue. JPM shares are up 24% this year, generally in line with the banking sector and outperforming the S&P by over 7% for the year.
Goldman Sachs [GS]
Earnings for Goldman were $15.02 per share vs. $10.24 expected. Revenue was $15.39 billion which beat estimates by over $3 billion. Investment banking helped lead the beats, with its second highest revenue quarter ever, given the surge in the IPO market. Trading revenue was $4.90 billion, which was much lower than the previous quarter, but still above expectations. Goldman has been the best performing bank this year, rising 40% this year.
Morgan Stanley [MS]
Morgan Stanley reported EPS of $1.85 vs. consensus of $1.66. Revenue was $14.8 billion vs. the $13.98 billion estimate. Investment banking revenue was strong like Goldman Sachs, and increased to $2.38 billion from $2.05 billion last year. Equity net revenue was $2.83 billion, up from $2.63 billion last year. Fixed income revenue dropped to $1.68 billion from $3.04 billion. Wealth management revenue was $6.1 billion, up from $4.7 billion. Large increase here is helped by their E-Trade acquisition last year. Investment management revenue was also helped by their purchase of Eaton Vance. The stock was flat on the earnings release and up 33% year to date.
Bank of America [BAC]
Bank of America reported earnings of $1.03, which beat the 77-cent estimate. Revenue dropped -4% year over year and also missed estimates for the quarter. Total revenue was $21.6 billion. Like the other banks, trading revenue came in lower than last quarter. However, it was much lower than expected as well. Fixed income revenue was $1.97 billion, which was almost $1 billion short of estimates. Shares of the company fell -3%. The bank has risen 25% for the year.
Next week earnings calendar includes:
Monday: International Business Machines
Tuesday: Chipotle Mexican Grill, Netflix Inc
Wednesday: Coca-Cola, Johnson & Johnson, Verizon, Microsoft, Tesla
Thursday: AT&T, Domino’s Pizza, Southwest Airlines, Twitter Inc
Interest rates took another leg down over the past week, with the 30-year U.S. Treasury falling below 1.90%. However, interest rates are still generally higher year-to-date, and therefore, investment grade fixed income has had a difficult 2021.
Long-end Treasuries have had a total return decline of over -10% and corporate bonds are negative -2% for the year. The one bright spot across fixed income is high yield. The Bloomberg Barclays High Yield Index is up nearly 5% for the year, and bank loans are up 3%. These returns are still quite minimal given the amount of risk an investor is taking by investing into high yield, especially at current spreads. Investors chasing yield at the cost of duration or credit quality are taking increased risk as interest rates return to historically low levels. The runway for returns driven by either declining rates or tightening spreads is becoming increasingly shorter. We continue to prefer the up in quality trade. Whether that means a higher allocation to AA rated securities in an investment grade portfolio, or remaining in BB rated securities across high yield portfolios, we believe investors are not adequately compensated for the risks possible across fixed income in this current market.
This report is published solely for informational purposes and is not to be construed as specific tax, legal or investment advice. Views should not be considered a recommendation to buy or sell nor should they be relied upon as investment advice. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Information contained in this report is current as of the date of publication and has been obtained from third party sources believed to be reliable. WCM does not warrant or make any representation regarding the use or results of the information contained herein in terms of its correctness, accuracy, timeliness, reliability, or otherwise, and does not accept any responsibility for any loss or damage that results from its use. You should assume that Winthrop Capital Management has a financial interest in one or more of the positions discussed. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Winthrop Capital Management has no obligation to provide recipients hereof with updates or changes to such data.
© 2021 Winthrop Capital Management
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