The past week was defined by markets struggling at the high end of our anticipated range with continued bouts of factor volatility beneath the surface. The interplay between reopening optimism (with the associated 2nd derivative improvement in higher frequency data) and policy support offset by the reality of diminished aggregate demand and valuation impediments continues. The frustration has manifested in the continued episodic fits and starts of key “reflation” elements where the countertrend recovery moves have dramatically disconnected with the absolute state of the world and pulled underweights higher.
As we noted last week, we view the counter trend movement in cyclical sectors as quite late inning and believe that this emerging pocket of market downside will be lead by “old economy” weakness while key structural relative strength trends will be driven by the denominator (i.e. QQQ modestly lower, QQQ/SPY higher).
Our wide range view is unchanged and we see the confluence of technical and valuation resistance that emerged towards the end of April around the 2930 level as defining the high end of the risk range for some time. On the downside, our focus is initially on the 2650-2640 area though we acknowledge there is risk to an overshoot of those levels. Should we see risk overshoot on the downside, we would look to engage more aggressively (continuing to favor key structural trends) as the policy response will keep deep left tail outcomes from emerging.
A few observations from this past week
- Credit has been softening – HY spreads closed the week wider while CDS in both IG and HY were higher WoW. HY protection registered the most elevated reading since the 4/9 Fed lending update
- Inflation expectations have lost upside impulse – Breakeven complex saw flat to slightly lower action WoW despite continued recovery in prompt crude. 5y5y closed at the lowest levels since 3/20 at ~1.41%. Copper/Gold is flirting with mid-April lows and has yet to register downside extremes.
- The Dollar exhibited broad strength – Dollar indices closed higher and weakness was evident in the majority of both developed market and emerging market crosses (the Turkish Lira the one exception). Basis markets for both EUR and JPY have moved back into negative territory and are well off early April levels suggesting dollar liquidity is tightening again.
- Despite late week factor noise, relative trends are beginning to assert themselves – We saw new highs in “Growth/Value” (IWF/IWD), QQQ/SPY, “Momentum” (MTUM/SPY) and key subsectors (XLK/SPY, IGV/SPY) at/near new highs as well. Conversely, we saw deterioration across cyclicals with new relative lows in financials (XLF), industrials (XLI), and transports (IYT) while energy (XLE and XOP) is beginning to fail at intermediate resistance.
Near term, the outlook is for downside of ~8% (cash SPX to 2650-2640) which will be led by cyclical underperformance. The post-April landscape remains one we are quite familiar with, a low growth/low inflation world dominated by outsized monetary policy. We know the expression of such a world well with US outperformance, “Growth”, and “Size” continuing to dominate the performance landscape. It is these areas that will present opportunity as we move to the low end of our anticipated range.
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