October 5, 2020
Rotation? The pullback in the S&P 500 (SPX) and NASDAQ 100 (NDX) started on 9/3 after CIEN issued unusually bad guidance. Since that day, the NDX has underperformed the SPX by ~300bps and the S&P 500 Value Index (SVX) by ~550bps. Bond yields broke higher on 9/4 with the 10-year Treasury yield rising to 0.718%, but drifted gently lower until last Wednesday. No one really noticed until Friday when higher yields and curve steepening resulted in more stark outperformance in cyclical/value sectors like Financials, Materials and Industrials. Increased expectations for pre-election fiscal stimulus are partially responsible for the move but so is the increased possibility of a Democrat sweep following Trump’s hospitalization that capped a bad week for him politically. A Biden presidency and Democrat control of the House and Senate is supposed to lead to a massive increase in fiscal spending, which would mean higher bonds yields and curve steepening to a point. Higher bond yields and curve steepening associated with increased odds of Democrat sweep plus positive vaccine news later this month could finally lead to a rotation into value sectors. To date, the outperformance in value sectors looks like a commitment of new capital rather than a true rotation where Tech becomes a source of funds.
Fiscal stimulus: Record Q3 GDP growth of ~35% is expected to downshift to something like ~6.5% in Q4. The $3T Cares Act was powerful stimulus, but a very low multiplier and record Q2 US household savings rate suggests some of the stimulus has yet to be utilized. A good amount of that ~35% Q3 GDP growth came from pent up consumer demand that should begin to fade this quarter. GDP growth of ~6.5% in Q4 and estimates for ~4.5% in Q1’21 aren’t weak, but they still leave you short of pre-pandemic levels in GDP, employment, profits and inflation. While near-term fiscal relief in the $1T-$2T range is probably required to get back to those levels, massive fiscal stimulus beyond those levels could prove counterproductive. Higher yields aren’t a bad thing as long as the curve is steepening. What you don’t want to see is higher bond yields and curve flattening, which could result from larger deficit figures. The 2020 fiscal deficit will probably wind up being ~12% of GDP and expected to decelerate to ~8% next year as temporary fiscal stimulus measures fall off. That number doesn’t assume higher tax rates (lower GDP) and large-scale increases in fiscal spending that could result from a Democrat sweep. Equities prefer a balance of power in Washington.
Here now: While it’s important to understand the implications of the aforementioned scenarios, it’s also important not to get too far ahead of markets. At the moment, we still see the outperformance in cyclical/value sectors as part of a broadening rally that will lead to a test the September 2 high of ~3581.