Quality and growth ride the waves

Emergency measures that shut down economies and flood the financial system with money leaves investors facing a shortage of quality companies and those that are generating robust revenues.

Looking at equity markets via their broad levels misses an important aspect of what has been happening beneath the surface. There is a preference for security and that dovetails with the slumbering level of sovereign bond yields and crestfallen commodity prices. These market indicators paint a picture of weak economic activity and, at least initially, deflationary, rather than inflationary pressure.

Now, a number of readers are certainly worried about surging money supply in many countries as central banks have fired up their engines. Greater fiscal stimulus than what was seen after the financial crisis of 2009, may well spur a faster inflation pulse in time. Much rests on whether consumers and companies batten down and save a lot more once the pandemic passes. Such an outcome suggests an extended process of recovery and one that cuts across the chatter in some quarters about a new equity bull market.

What particularly worries some is the narrow leadership, led by tech, which on Tuesday in New York is on the defensive ahead of earnings from leading names over the coming few days (see Quick Hits). Typically, a narrow group of winners has in the past indicated the broad market is not far from a drop of some magnitude. The activist role of central banks has certainly prompted a sharp recovery in broad equity markets, but the lack of wider participation is worrisome. This suggests that expectations of an economic recovery that lifts cyclical sectors is not in place, only that central banks have placed a floor under asset prices.

Over at Unigestion they note:

“Breadth, measured by the percentage difference between index and median stock distance to highs is extreme, indicating that a very concentrated number of stocks are thriving.”

And as Société Générale highlights here, four-tenths of blue-chip tech Nasdaq 100 stocks sit above their 100-day moving average, in contrast to far lower figures for other US equity benchmarks.

In turn, the divergence in performance is also stark, with the Nasdaq 100 close to flat on the year, whereas small and mid-cap benchmarks are off by a quarter. As shown here, a ratio of the Nasdaq 100 to the Russell 2000 is trending towards the peak that was notched at the turn of the century. This is where expectations of rising defaults and downgrades in high yield and for plenty of fallen angels in the lower echelon of investment grade (the weighty triple B-rated club) are blowing back into equities.

Now, many readers with long memories may look at this and think a sell signal is flashing for tech and growth stocks. There is also a tendency to fight previous battles and the current positioning seen in equities reflects expectations of a lacklustre recovery that distinguished the path taken by the economy during the post-financial crisis era.

Herding is a regular component of markets, but among companies, the ranks of thoroughbreds are thinning. Here via Goldman Sachs, they highlight the divide between companies in the MSCI World Equity index generating revenues or top-line growth beyond 8 per cent, versus those that can’t eclipse 4 per cent, or what they describe as “a simple definition of high versus low growth”.

High-growth companies are scarce (MSCI World)

Goldman’s portfolio strategy team led by Peter Oppenheimer notes:

“Global markets have become increasingly dominated by slow-growing companies in recent years, and that there is a smaller proportion of fast-growing companies.”

Over in Europe and away from the US Fangs club of big tech, Goldman identify the “Granolas”, a group of companies with “relatively strong balance sheets, low volatility growth and good dividend yields, around 2 per cent-2.5 per cent”. They include a mix of healthcare, consumer staples and tech: GlaxoSmithKline, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, SAP and Sanofi.

It will certainly require evidence of a V-shaped economic recovery to ignite demand for cyclical and value stocks. The signal here is an appreciable rise out of negative territory for real yields, which in the past (briefly last year from August) has triggered a rotation from growth towards stocks that are more geared towards a better tone in the underlying economy. That may well arrive and spur another big value trade at the relative expense of growth.

John Higgins at Capital Economics says the US tech “mega-caps will have some success in consolidating their positions as the world slowly gets back to normal, provided they can avoid an antitrust backlash. However, we would be surprised if their shares continued to outperform so much then.”

But at this moment, investors are not really buying the end of equity market leadership from technology companies, particularly when they are benefiting from an acceleration in digital trends from the pandemic, such as working from home, greater use of cloud services, and online shopping among others, which is explored in this FT Markets Insight.

As Goldman observes:

“The backdrop of likely low bond yields and growth continues to make companies that do have growth more attractive. We do not think this has changed.”

That leaves US tech and European Granolas topping their list of long-term winners.

Quick Hits — What’s on the markets radar?

Upcoming earnings from tech titans this week loom as an important near-term test of sentiment for Wall Street. Alphabet kicked things off after the closing bell on Tuesday, and the shares rose 4 per cent in after-hours trading after a drop of 3 per cent in the regular session. Expectations of a hefty hit to online advertising that peaks in the current quarter has punished the stock lately. Its share price has lagged other big tech rivals (Facebook, Microsoft, Apple and Amazon) and also the S&P 500 since hitting a record in mid-February. Buyers of the dip await whether company guidance indicates the worst is behind them. Analysts are not so sure and expect advertising to fall behind for much of the year.

The sale of a record sized $35bn of US Treasury seven-year notes attracted solid demand (as did sales of two-, and five-year paper on Monday) and here’s a note of caution from Wrightson Icap:

“The decision to push this offering up aggressively is an admission by the Treasury that it won’t have the luxury of being choosy when deciding how to finance the surging budget deficit: it will have to raise a staggering amount of cash in the coming quarters, and it will tap any maturity that it can.”

For now, the bond market is absorbing issuance, buoyed by the presence of the Federal Reserve, but the size of upcoming Treasury sales and signs of a recovery will open the way for the Treasury market establishing how high yields must adjust.

Staying with the US central bank, their current two-day meeting concludes on Wednesday and expect Jay Powell to stick to a tight script during his press conference. The next policy gathering is not until early June, so there’s a six-week window for gauging how the economy looks as it hopefully reopens for the summer.

Steve Englander at Standard Chartered thinks Mr Powell will on “balance” sound “an asset-market-friendly message, because there is no benefit in doing otherwise. With little visibility on an economic rebound, the FOMC’s incentives are to talk up its ability and willingness act, even if no short-term moves are likely.”