- Large-cap Growth stocks outperformed over the month of July, while small and micro caps lagged.
- 10-Year Treasury Note yields continued to fall, helping growth stocks.
- COVID cases surged as the Delta variant took hold across the country.
- Inflation figures continued to rise – causing the IMF to warn of potential longer-lasting and unintended consequences.
Stocks once again hit record highs during the month of July despite a resurgence of COVID-19 cases throughout the country as the Delta variant became the dominant strain. Inflation also continued to climb ever higher, but the reported figures haven’t caused the central bank to change course just yet. Finally, nearly 60% of S&P 500 companies reported earnings during the month, with a record 88% beating earnings expectations and 84% reporting positive top-line results.
The Federal Reserve noted that the U.S. economic recovery remains on track despite the rise in coronavirus infections. Fed Chair Jerome Powell described the job market as still having “some ground to cover” before it would be appropriate to withdraw some economic support, which has been in place since the beginning of the pandemic. While the IMF mostly agrees with the Federal Reserve’s stance that higher inflation is the result of “transitory factors,” they did warn that uncertainty remains high, and the risk that transitory pressures could become more persistent may force central banks to take preemptive actions to fight it.
On the COVID front, the U.S. saw a resurgence of the virus comparable to what has been observed in the U.K. The U.K. similarly saw an unexpected surge as the Delta variant spread but has since seen infection counts drop nearly as quickly as they went up. While state and local officials debate the merits of re-instituting mask mandates and the effectiveness of vaccines, former FDA commissioner Dr. Scott Gottlieb noted, “The original premise behind these vaccines is that they would substantially reduce the risk of death and severe disease and hospitalizations. That premise is still fully intact.” He also highlighted, “Of 163 million Americans fully vaccinated as of July 26; there have been 6,239 hospitalizations, including 1,263 deaths in people diagnosed with SARS-CoV-2 infection. In about 25% of cases, patients were asymptomatic, or diagnosis appeared secondary to primary cause of the event.” Markets appear to agree with the assessment that the resurgence of the virus, and in particular the prevalence of the highly contagious Delta variant, don’t pose much of a threat to the broader economy as investors don’t expect new lockdown measures to be put in place.
CPI Inflation – YoY and MoM
Healthcare led all sectors to start 3Q21 (+4.9%), followed closely by REITs (+4.4%), Utilities (+4.3%), Technology (+3.9%), and Communications companies (+3.6%). Staples and Basic Materials also climbed during the month, finishing up by 2.6% and 2.0%, respectively, while Industrials and Consumer Discretionary stocks finished up under 1%.
Financials cooled off to start the quarter, closing the month down 0.4%, while Energy stocks were slammed mid-month as COVID fears resurfaced, finishing lower by 8.3%. It should be noted, though, that Energy stocks did begin to recover to close out the month and remain the market leaders on a YTD basis, gaining over 33.6%.
As we pass the halfway point of the second-quarter earnings season with just over 60% of S&P 500 companies reporting, we have so far seen positive earnings surprises in 88%, with an average beat of ~17%. These figures top the five-year average of 75% and 7.8%, respectively. If positive earnings surprises finish the reporting period above 88%, it will be the highest percentage of S&P 500 companies reporting positive EPS surprises since FactSet began tracking the metric in 2008.
Consumer Discretionary has again seen the strongest earnings beats, with an average beat of 31%, followed by Financials with 29%. In terms of sales, over 84% of companies have reported a positive revenue surprise versus the 5-year average of 65%. Revenues are currently tracking 4.6% above estimates. Earnings growth is also positive, with 90% of companies reporting growing revenues, with an average growth of 27%.
The forward 12-month PE for the S&P 500 is 21.6, which is above the five and 10-year averages.
In terms of price action following earnings prints, Energy stocks have seen the biggest two-day move relative to earnings surprise. On average, energy names are climbing just over 2.6% on an average earnings surprise of 12.5%, while Consumer Staples have fallen ~1.6% on an average surprise of 8%.
Rates & Commodities:
Even as inflation rose, 10-year bond yields continued to trend lower to start 3Q21. There seem to be two schools of thought as to what exactly is driving yields lower given the current economic backdrop. The first believes that the Fed will be quicker to tighten monetary policy, potentially by 2023, which would curb inflation and likely keep yields anchored around current levels. A second theory points to investors lowering expectations of future economic growth, which already came in weaker than expected at the end of the month. Annualized Real GDP rose 6.5% in the second quarter, 1.9% below consensus estimates. If most investors begin to fall into the second bucket, one could expect to see the broader stock market begin to soften as well, so it appears as though the first theory seems to be holding stronger at the moment. Gold saw small gains over the month but has been consistently trending lower since it hit all-time highs in early August 2020.
10y Government Bond Rates
As lumber futures settled after an epic surge higher and subsequent crash lower, we continue to see an increase in existing home prices across the country. The Case-Schiller 20-city Composite once again registered new highs after climbing over 1.81% on an MoM basis and 17.0% on a YoY basis as of May 31 (reported in July). Given the delayed nature of the Case-Schiller index, it will be interesting to see if housing prices start to fall now that lumber prices have collapsed back to more normal levels.
After trading mostly sideways/lower during the summer, Bitcoin began to move sharply higher to close out July. The $40,000 has been a key psychological resistance point for the cryptocurrency, so it will be interesting to see if the recent gains can hold for another sharp move higher. Ethereum also saw gains to start out the third quarter, hitting just below $2,500 before breaking out at the start of August. Per Coin Metrics & Goldman Sachs Global Investment Research, Ethereum has experienced the most network growth since 2018. It is becoming more and more recognized for cryptocurrencies to be valued by their underlying distributed networks, similar to how social media company valuations can be derived from monthly active users. Based on some of these metrics, Bitcoin’s market cap has risen higher than its network growth, while Ethereum has seen less appreciation when compared to its network growth.
For what seems to be the consistent theme for 2021, markets will continue to focus on the big three of earnings, COVID, and the Fed/inflation, but there is also a potentially major foreign disruption on the horizon. Even as Chinese technology stocks sold off as Beijing continued to crack down on private enterprises, another worry remained property giant China Evergrande.
Three years ago, China Evergrande was the largest property developer in the world, but its massive debt-fueled growth has caught up to the company, which has seen its bonds due in 2025 trading at less than 45 cents on the dollar, and the 2022’s trading at around 56 cents on the dollar. According to Bloomberg, three banks with a combined $7.1 billion of exposure to Evergrande decided not to renew some loans when they mature this year, while at least four major Hong Kong banks stopped extending mortgages for two Evergrande apartment complexes in development over concerns the development wouldn’t be completed due to funding concerns.
It has been reported, though, that the banks subsequently reconsidered after the Hong Kong Monetary Authority questioned the moves. If China Evergrande is unable to refinance or repay its debts, the Chinese government could be forced to step in to save the company as the downstream effects of bankruptcy could be jarring to the entire economy. If the government doesn’t step in to save the company from bankruptcy, essentially breaking the implicit guarantee of state-owned enterprises’ solvency, there could be a substantial repricing of risk.
This doesn’t necessarily mean there will be any substantial impact on the U.S. economy, but it is worth monitoring given the importance of the Chinese consumer in the global economy.
Another concern raised by the crackdown on tech companies was whether Chinese regulators might seek to exert even more control over large Chinese companies. Stricter cybersecurity regulations highlighted just low little recourse U.S. investors have if authorities stop tolerating the “variable interest equity” structure that has allowed U.S. investment in Chinese companies despite prohibitions against it. The SEC even temporarily halted approvals of new Chinese IPOs as it seeks more disclosures about the risks to U.S. investors. Chinese regulators have since called for talks with American authorities. The Chinese likely do not want to lose access to American capital, so will probably seek to reassure U.S. investors, but the recent selloffs in Chinese stocks and U.S.-listed ADRs show some investors are reassessing risks to owning Chinese stocks.
Evergrande bond prices
Stocks remain near the record highs set by most indexes on Monday, 7/23. Covid concerns could put a dent in share prices, and the current trend in interest rates is also a warning sign. But a lot has been thrown at stocks, and they keep chugging higher. Strong earnings, low rates and fed support mean the path of least resistance has been higher.
Looking forward, August is one of only two months where the S&P 500 has averaged a negative return since 2010 (May is the other) and is also one of only two months (January) with more negative results (6) than positive, so the ride for individual stocks and sectors might be bumpy.
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