U.S. equity markets posted a positive start to 2021, with the S&P 500 Index breaching the 4,000 level for the first time on its way to a 6.2% return for the first quarter.  The market action had a more frenetic tone in the small cap space, where the Russell 2000 Index ended the quarter with a 12.7% return.  Explosive growth in retail accounts and a skew towards high risk/high reward trades resulted in wide swings across a number of smaller cap companies.  The market’s optimism towards small caps looks like a crowded trade at this point, as the small-cap index has now gained 95% over the past twelve months – one of the largest one-year returns on record.

On a style basis, the rotation from growth to value continued in the quarter.  The improved sentiment towards old economy sectors such as Financials, Energy and Industrials is largely based on the market’s expectation for a sharp earnings recovery as the economy strengthens in the coming quarters.  Banks and related financials received an additional tailwind in the form of a steepening yield curve, which conversely weighed on growth stocks. Just as an uptick in rates is more damaging to long-duration bonds, rising rates are negative for long-duration growth stocks, whose cash flows are typically further out in the future.

Inflation and Steepening Yields – False Dawn or Beginning of a Trend?

One supporting catalyst for the gain in equities over the past ten years has been the ‘TINA’ backdrop; i.e., ‘there is no alternative’ to stocks.  In response to the low yield environment that has been in place since the 2008-09 financial crisis, investors have moved out on the risk curve in the pursuit of higher returns – from money market instruments and bonds into public equities and alternative assets.  Given the year-to-date move in the U.S. 10-Year Treasury from 0.9% to the 1.70% level, is this TINA relationship poised to change?  While still low in absolute terms, fixed income is beginning to offer an investment alternative to stocks, particularly in light of the lower equity return assumptions that many strategists are forecasting.

The big question over the next 12-24 months is how will central banks (and markets) respond should we get an inflationary bulge resulting from pent-up demand, immense liquidity, supply chain challenges and other fundamental changes in the economy?  Historically, the Federal Reserve used interest rates as a governor in an attempt to keep the economy from overheating.  Yet the Fed appears comfortable staying pat on rates in the event of an upward pressure on prices, stating that the resulting effect on inflation will be ‘neither particularly large nor persistent’.  Given the recently announced $2 trillion infrastructure initiative coming on the heels of a $1.9 trillion fiscal stimulus plan, the path of least resistance for yields is almost certainly higher.  That said, the pace of the advance will be key; i.e., the markets can likely digest a slow and steady move higher in yields, while a rapid steepening in yields would almost certainly trigger a more volatile response in equities.  If necessary, the Fed could mimic Japan and Australia by taking more explicit action to control yields in the form of yield curve control.  That said, deploying such an unconventional tactic with equity markets at all-time highs may be difficult to justify.  The bigger takeaway is that inflation expectations are rising for the right reason – growth expectations are improving, and interest rates (the dependent variable) are also rising as conditions improve. 

As opposed to making inflation and interest rate forecasts, the more relevant considerations in Cambiar’s analysis are the potential impacts to our companies’ margin/earnings outlooks should cost pressures arise.  One industry that is experiencing shortages in raw materials is semiconductors.  This is a notable development; unlike ketchup (another key shortage for consumers of this condiment), semis are an increasingly essential component to a range of end markets.  The current bottleneck is affecting production of PCs, gaming consoles, smartphones, and cars – at a time where demand is surging.  The increase in lead times will likely lead to higher prices for consumers, as well as missed revenue opportunities at the corporate level.  Cambiar continues to focus on companies that possess a defensible margin structure (vs. competing on price), and can offset potential increases in materials or labor costs via pricing power and/or continued productivity improvements.

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