Deflate — Week of May 17, 2021

As of market close May 14, 2021. Returns in percent.

Deflate

Consolidation and rotation are the name of the game this month. Stocks continue to mope lower or sideways as the euphoria from earnings season wears off. The big indices took back half their losses for the week with a solid rally on Friday. Both the Dow Industrials and S&P 500 had eight or more winners for every one losing stock on Friday. This breadth thrust usually signals a turnaround or pause in a downturn. We are inclined to wait until Tuesday at the earliest for a trend change. That would be 15 days since the tech-heavy NASDAQ started its selling squall, and a typical “mini Bear” correction period. 

May’s negative results to date are in line with history but still leave us a bit deflated. Red numbers flashing on the screen are the equivalent of May showers: a short-term downpour, with the sun just around the corner. Through the first half of the month the NASDAQ Composite index is lower by 3.8% and S&P 500 lower by 0.19%. Bonds are largely unchanged. More about rates in a moment.

Rotate

Regardless of very short-term price action, the big picture is unchanged: the economy continues to heal, stocks are marking earnings higher, inflation is heating up, and rates will likely trend higher. A healing economy has helped value and small company stocks make up ground versus mega-tech growth stocks over the last six months. Whiplash is an understandable ailment for traders in the last two weeks as market strength continues to rotate from tech to risk-off and back to tech again. The resulting market swings can be unsettling; however, we believe the market’s fundamentals are not only intact, but improving. For example, ISM manufacturing new orders continue to hit new highs and inventories are low, a consistent signal for better forward industrial earnings.

Technically the last three weeks’ consolidation has washed out some optimism, and when combined with improved earnings, reset valuations a bit lower. Short-term trends may be lower as markets consolidate, however intermediate, and long-term trends are still positive. The percentage of stocks making new highs and trading above their moving averages are all sharply lower. Most of the recent leaders are below their 21-day moving average and close to the 50-day moving average. These moves clean up overbought conditions and set the table for stocks to resume rallies. 

Inflate

We have written over the past few months that we see rates and inflation moving higher. Last week’s inflation reports saw Consumer Prices vault in April to a 4.2% annual rate and the Producer Price Index to 6.2%. Most economists forecasted a move above 3% for both indices. The magnitude of the jump caught them and markets by surprise. Wednesday’s CPI release pushed stocks down smartly on fears that the Fed would have to raise interest rates sooner than expected. The PPI’s 6.2% rise was driven by sharp increases in transportation costs, food inputs and steel mills. Most of the outsized gain in consumer prices was driven by used cars, gas and hotel rates. Used cars accounted for 10% of the rise. 

We understood that many transit users were switching to cars and thought that trade was about done. Perhaps not. Inventories of new cars are low of course due to shortages of microchips and other parts. Used cars have been snapped up as replacements. We have a team member who purchased a new full-size SUV about a year ago. The dealer contacted him recently about selling it back to him for basically what he paid. Apparently, the dealer can sell this model used for even more than new ones – because there are no new models available. Wow. The Manheim Index for used car prices soared 54% in April over year-ago levels and year over year are 16% higher. April’s used car prices are included in the May CPI calculation. This suggests May’s CPI report will be an eye-opener. Do not forget that big-box retailers are running out of appliances and housing items. 

Yes, these inflation rates are measured against year-ago pandemic falling prices. Supply-chain bottlenecks and inventories are continuing to impact buying patterns. But they also reflect increased demand for goods and services. Some of the increase is pent-up demand from Netflix bingeing and Peloton spinning. We would note that demand patterns and consumer spending have changed for several years after major crises. Prior virus epidemics, 9/11 and the Great Depression all altered buying habits. Consumers tend to accelerate purchases when they fear inflation. The Reuters/University of Michigan inflation expectations index for one-year inflation is now 4.6%. This is its highest level since 2008, and the index has a good forecasting track record. We believe inflation will remain elevated through the end of the year along with consumer spending. 

Cresting

Reviewing April data this last week, the April jobs report remains fresh on our minds. Private payrolls grew by 1.1 million jobs, but the headline hiring number was a seasonally adjusted 266,000. The April Retail Sales report showed a similar pattern. The headline number showed April sales were flat from March, below the consensus 1.0% gain. Remember that March sales were a 10.7% surge thanks to stimulus check spending. So, March jumps higher and April is flat – in other words the same level of elevated spending occurred in April. Additionally, the three-month average of retail sales showed steady increases of 2.6%, well above pre-pandemic sales growth. 

Industrial production improved 0.7% in April. Manufacturing represents about ¾ of industrial production. It managed to eke out a 0.4% gain, fighting a 4% drop in vehicle production. Retail sales and manufacturing make up a large portion of GDP. Consumer spending and industrial output remain in uptrends, but their growth rates are slowing. We wonder when a post-recovery cresting of improvements will occur. A crest is on our radar but not in the windshield. Fine by us. 

Wrap-Up

Stitching a mosaic of information together to form a big picture is always a difficult task. Trendless, rotating markets looking for direction make it nearly impossible. Inflation has been with us for nearly a year. In some commodities like lumber the price moves were underway pre-pandemic. The economy has nearly recovered and is now fighting the headwinds of higher prices and lower numbers of workers. As we went to press, at least 13 states had announced plans to leave the $300-per-week unemployment supplement program.  

Consumer spending is on the upswing as more businesses reopen and restrictions are loosened. The rate of improvement may slow in the coming months suggesting a crest in activity possibly sooner than many economists anticipate. Our green dashboard of indicators suggests to us that rates are going to stay relatively low, and GDP growth will meet or exceed forecasts for this year.

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Greg Kalb is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts from The University of Texas at Austin.

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