Interest rate hikes and Greece got some much-needed company in the headlines last week, as the financial sector joined the two on Wall Street’s most-talked-about subject lists. While the S&P 500 ended the week pretty much flat and quiet, the financial sector ended higher by over 1%. Investors are taking note of the sector’s status as possibly the biggest beneficiary of higher interest rates. Decent data from the Job Openings and Labor Turnover (JOLT) report, a higher-than-expected rise in consumer spending from the Retail Sales report last week, increasing signs of inflation, wage growth, labor market tightening and solid job gains last month are all pointing to an economy that should soon satisfy the Fed’s requirements for higher interest rates in the coming future.
In our opinion, a highlight worth noting is that while staring at the upcoming disappearance of easy money, investor sentiment seems to have remained orderly and without turmoil so far – with the exception of some treasury yield spikes during recent news releases. Market sectors are reacting as expected, with utilities down, consumer-oriented stocks up, and companies continue to utilize debt to issue buybacks, conduct M&A activity and consolidate. Wall Street’s gurus, meanwhile, are, in general, promoting active management during volatility, advising selectivity, and have been pretty vocal in their projections of an upcoming correction. We agree with all of the above – but importantly, not because of weak fundamentals, but instead, merely the need to cleanse what has been an extremely unusual, polarizing, long-running bull market for the past 6 years in a sluggish global growth environment.
The pullbacks in emerging markets including India (off 10% since its recent highs), Indonesia, Mexico, and certain currencies even though there have been no fundamental changes there is basically evidence of the reallocation of money back to the US due to the attraction of higher rates, in our opinion. Europe and Japan are on the mend as well, and other than Greece, the picture looks not-too-bad – including investor sentiment towards the regions. In the US, consumer discretionary stocks, information technology stocks, and financials are looking good; Ari Wald, Oppenheimer’s head of technical analysis, recently stated on CNBC that ‘[these sectors] are the right leadership’, and that ‘it is a sign that investors are embracing risk’. So, one may feel pretty good reading all this. The prudent thing to do next would be to highlight the risks – and here are the two we felt were worthy of attention this week:
Greece: With debt negotiations appearing to have collapsed over the weekend, the country finds itself at a major crossroad. As we mentioned in our May 31st column, a binary approach would provide opposite outcomes for stocks. Ripping the bandaid off is probably the right approach, as dragging the drama on by kicking the can down the road is just not working; note that Germany has corrected over 10% in the past month – primarily on Greek fears. A conversation earlier this week highlighted a potential solution – let Greece go back to the Drachma, rebuild the economy on their own terms over the next, say, 5 years, and provide light at the end of the tunnel by allowing it to re-enter the monetary reunion at the end, with certain conditions. Sure, you can find some flaws with this approach – but at this point, no direction is perfect. The situation is affecting the entire globe, and the unstable footing was undoubtedly one of the reasons the IMF and the World Bank both warned the Fed against raising rates in 2015 recently. It’ll be interesting to see whether the Fed decides to heed their warnings – effectively transforming it into the World Fed, or whether it sticks to its guns and moves ahead with raising interest rates (doing exactly what the market is looking for it to do).
China: We highlighted our concern in our May 4th column initially, and felt it was worth revisiting. Stocks here have zoomed up way too quickly here. If the world’s 2nd largest economy’s market effectively doubles in a year while GDP growth slows down, something’s disconnected. And then, looking into the details – retail money, rather than institutional, is driving the trend, and with behavior similar to the dot com bubble sentiment stateside (investing on momentum rather than fundamentals), it’s a bit concerning. Some of Wall Street is joining us on the sidelines – according to Credit Suisse, ‘margins, profitability and value creation continue declining as productivity growth lags real wage growth and product selling prices are eroded’. The company’s model calls for a 23% overbought state (15% in US$ terms), as highlighted by CNBC. What makes this situation interesting, though, is the government’s backing of the rally. ‘Don’t fight the Fed’ is a given statement in the US. Fighting the Peoples’ Bank of China, in that case, is an absolute no-go, and given Chinese inflation data remains weak (consumer prices rose 1.2% YoY in May, and producer prices fell 4.6%) – there’s plenty of room for further easing, as the WSJ noted recently. If there’s one thing we can bet based upon everywhere else, it’s that easing helps the markets. So, it’s worth keeping an eye on this market to see how the international region reacts to China’s market boom.
What it means for you: The world’s markets find themselves in a pretty fascinating situation. Fundamentals are improving, policies are changing, and the interconnected nature of the global economy will play a major role in asset and regional returns in the coming months. For a tactical play, rotating into financials, technology, and select sectors that may benefit with rising rates and an improving domestic economy may work. If you want to protect your gains, a neutral strategy like buying the sectors above while shorting the S&P 500 is an option. You could, of course, just buy the broad market index funds such as SPY and VXUS, and sit back for the long term, as Wall Street has shown to reward its loyalists over time. In any case, it’s good to stay alert. Next week, we’ll have a special report from Germany on the state of the EU. Until then, keep looking into the details to stay on top of your investments on Wall Street.
