Welcome Back — Week of July 12, 2021

As of market close July 9, 2021. Returns in percent.

Welcome Back

Not from the holiday — we are welcoming back market volatility, however brief. July is traditionally the gateway to summer slumber in the markets. Most traders are anywhere but in front of their screens this time of year. For the first full week of July, S&P 500 volatility spiked 28% and drew Bulls and Bears into a daily cage match. We do not usually break down market action day by day, but last week was instructive. The action started Friday the 2^nd with a strong up move after the solid jobs beat. The three quarters of a percent jump after the jobs report created a nice chart gap that had to be filled. 

Coming in Tuesday, traders blended the “old” jobs news with new weekend news about the spread of virus mutations and promptly took futures lower. Okay — one chart gap filled. “Now markets can resume their rally,” we thought. Wrong. As slowing growth data rolled in from around the globe, Bears proceeded to push futures lower each of the three mornings. After lunch the Bulls jumped into the ring and fought back. Thursday was the Bear hurrah, opening in the U.S. down 1.5% after Japan’s emergency declaration earlier in the day. Bulls again fought back, limiting the day’s damage to -0.8%. Short covering and no news fueled another Friday rally to close the week. 

All the back-and-forth left a lot of market watchers a bit frazzled. Nearly three weeks of no volatility had lulled more than a few participants to sleep. Last week was a good reminder that there is always action going on, either front row or under the surface. A longer-term investor, following our process, would merely note that prices moved back and forth a bit, but that the Dow Industrials, S&P 500 and NASDAQ all finished the week at record highs. 
 

Down with Supply

Interest rate moves were one of the primary drivers of stock jitters. Long-term rates, ten years and longer, had drifted lower since the end of March. The ten-year Treasury hit 1.77% that day, running higher on fears of rampant inflation. We argued through most of the second quarter that growth and inflation would soon peak and think the bond market came to the same conclusion. Rates dropped a quarter of a point into June and were settling into summer slumber mode until last week. The ten-year dropped from 1.43% on Friday the 2^nd to 1.25% on Thursday. Two tenths of a percent does not sound like much, but in the hundreds of a percent bond world that is a very big move in a short amount of time. Some of the drop was short covering by traders positioned for higher rates, supply and some flight to safety. 

Supply and demand are a little-noticed factor in financial markets. Part of the rise in rates before March was due to the increasing supply of Treasuries needed to fund stimulus spending by Congress. Once that program ended, supply dropped month over month. There have been no new note issues since June 24^th until today’s 3-year note auction. Meanwhile on the demand side, the Fed continues to buy $80 billion per month in Treasuries and $40 billion per month in mortgage securities. 

Why flight to safety in a strong economy and markets setting new highs? Capital around the globe still sees the U.S. as a stable haven in times of uncertainty. China’s economy has slowed rapidly over the last several months because many of their trading partners, especially in Europe, are not bouncing back from shutdowns as quickly as hoped. China’s central bank responded last Thursday by lowering the amount of capital Chinese banks had to hold in reserve. This should free up additional funds for banks to loan to business. The head of the European Central Bank, Christine Lagarde, made it official yesterday that the ECB will consider changes to its bond-buying program at its next meeting. Any uncertainty in future monetary programs gives traders an easy excuse to buy Treasuries. 
 

On Deck

Earnings and inflation are the headliners this week. The second quarter earnings season starts with the big banks. JP Morgan and Goldman lead off tomorrow, followed by Citi, Wells and B of A on Wednesday. Frankly, we do not expect much excitement from the banks. Loan growth has been anemic at best and most of their profits have come from trading and pulling reserve funds back into earnings. FactSet reports that for the S&P 500 as a whole, this quarter should see earnings jump 64% over the second quarter last year. Remember, last year’s second quarter marked the highest number of shutdowns and restrictions. 

While earnings continue to improve, many areas of the economy have recovered and their growth rates have peaked. Inflation is likely to be one of them. We are not talking about the level, merely the rate of change. If you want to impress your mother, talk about the second derivative here. The rate of change, or improvement in the recovery, is slowing. We saw this last week in the ISM surveys. The overall growth in new business and activity slowed in June from May’s levels. Now, remember the growth rates are still very strong, but over the next few months you will be treated to media reports of “a slowing economy.” Not true. Slowing down the rate of improvement means things are continuing to get better, just not at a runaway pace. Consumer and producer price inflation should show similar trends this week. June’s price changes will stay about the same as May’s, likely around 4.9% to 5%. Much of the recent rise in consumer prices were driven by used cars (yes, pun alert) and their prices have leveled off and for some types of vehicles begun to drop. 

Wrap-Up

Despite the summer calendar this will be a busy week for news. Fed chair Powell will testify before Congress on Wednesday and Thursday. He will reassure Congress that the Fed is not changing its bond buying or short-term rates anytime soon. Congress has three weeks before summer recess to figure out infrastructure, the debt ceiling and 2022 spending. Spending, as always, is key. If Democrats can pass a budget resolution, then they will be able to enact spending programs in the fall session by reconciliation, which would need no Republican votes. 

We expect stocks to move around from both earnings reports and Friday’s option expirations. Reactions from governments to the delta and new “delta plus” variants should give some markets pause. Japan’s state of emergency through August will lower their third-quarter earnings and GDP. Sydney, Australia, has had two weeks of lockdown, but is still seeing increases of cases. South Korea is also considering restrictions after setting a new one-day record for cases last Thursday. 

Mega cap and tech rallies over the last week have pushed their indices into overbought territory. The rest of the market here and abroad remains in neutral territory. All are fundamentally sound and most have solid technical underpinnings. Barely 51% of the 2,400 NYSE stocks and not even half of the 2,500 NASDAQ are above their 50-day moving averages. This tells us mid and smaller size stocks have plenty of room to run. We are ready for some growth excitement on the earnings calls.

 
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.