Cyclical sectors still dominating globally on earnings trends
As we discussed in our last commentary, analysts continue to raise earnings estimates broadly as companies keep beating consensus expectations. Expectations of additional fiscal spending and ongoing easy monetary policy along with progress toward re-opening of the economy are key macro drivers, while certain sectors such as Energy and Financials which had been areas of weakness in pre-COVID and immediate post-COVID times are now contributing more positively to the earnings outlook. This is true in the US and also globally.
Analysts still can’t keep up with surging earnings
Earnings reports for Q1 are coming in very hot once again, even after several consecutive quarters of beating consensus expectations. Analysts seem to still be struggling to keep up with the strength in US earnings, and continue to raise their earnings estimates.
To be fair, analysts have never had to deal with the level of volatility and uncertainty in the macroeconomy that has been seen in the last year or so. The shock of COVID-19 and associated shutdowns in economic activity, followed by unprecedented levels of fiscal and monetary stimulus, and the record-breaking speed of vaccine development are all extraordinary events that most analysts following individual companies are not traditionally prepared to incorporate into their earnings forecasts. The limitations on travel and uncertainty among company executives themselves are also likely hampering analysts in producing their earnings forecasts.
Tech fundamentals still favor Hardware over Software
While the Technology sector has been less dominant in terms of returns this year than it was last year, it remains the largest sector in the US market by value and the focus of much investor attention.
Our view within the Technology sector for some time now has been to favor hardware-related industries over software-related or services areas, and the latest update of both bottom-up and top-down indicators continues to support this view.
Labor market improving but still shows plenty of slack
In the longer-run, a key measure of inflation pressure is the amount of labor market slack (unemployed or underemployed people), which heavily influences the ability of workers to demand higher wages.
The standard reported unemployment rate data (i.e., the U-3 measure in the US) is useful in measuring labor market slack, but has limitations due (in part) to its definitions of “unemployed” and the “labor force” in the calculation: “unemployed” people as a percentage of the “labor force”. That is, to be counted as “unemployed”, a working-age person must be considered actively looking for a job (when asked if they have sought employment in the last four weeks in the monthly household surveys done by the Bureau of Labor Statistics, BLS). If they are not currently seeking employment for any reason, they are “not in the labor force” and thus do not count in the standard unemployment rate, even if they consider themselves unemployed.
Inflation is steady on the surface, volatile underneath
Inflation expectations have been a topic of growing interest thanks to the extraordinary fiscal and monetary support in place for much of the last year, most recently the huge $1.9 trillion American Rescue Plan that is currently sending checks out to millions of Americans.
All of this new spending by the federal government, along with the economic recovery permitted by the rollout of COVID-19 vaccines, is provoking more discussion about whether demand for goods and services will outpace the economy’s ability to produce them and push prices higher.
S&P 500 earnings have fully recovered, but with wide differences among sectors
The S&P 500 has reported another strong earnings season for Q4, with 79% of companies beating consensus earnings estimates for the quarter. This would be the third highest such reading in Factset’s data since 2008. The beat rate for top-line sales was similarly high at 77%. Aggregate income for the index is about 4% above year-ago levels, indicating that net income on a quarterly basis has fully recovered pre-COVID levels based on Factset’s data.
Reviewing current stock vs bond sentiment
Despite what you might hear or read some places, investor surveys do not show an extreme level of optimism toward US stocks. Bullishness on stocks has in fact declined somewhat recently and is not far from long-term average readings.
Sentiment toward bonds, by contrast, has moved quite sharply and is now approaching extreme bearishness by the standards of recent years. This is not too surprising, given that long-term Treasury bond yields have recently risen to their highest levels since COVID hit early last year. The result has been that investors in long-term (20+ year) Treasury bonds have lost about 13% since the end of November and about 18% since the end of July.
Bond market making some noise
The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.
Recent rally in “junk stocks” is not unusual
Financial headlines have been captivated recently by explosive behavior in certain “meme stocks” that have been the subject of intense speculation by online retail traders as well as some hedge funds. This has been accompanied by a general trend of outperformance by smaller, money-losing, heavily-shorted, and volatile stocks (sometimes referred to as “junk stocks”, similar to risky high-yield “junk bonds”).
Semis vs Software trade now favors Semis
Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.
These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.