In this episode of Markets in Focus

Is the seemingly unstoppable rise of equities a concern or an opportunity for investors? Matt Waz, Senior Vice President and Head of Consultant Relations, switches things up with Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers for a Q&A on “peak everything,” inflation, interest rates, and whether fears of the delta variant are overblown.

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Transcript

Matt Orton:
U.S. equities have continued to march higher in 2021, with the S&P 500 posting its second strongest first-half performance since 1998. The path higher has been pretty smooth. The S&P 500 hasn't seen a 5% correction since November of last year. But, under the surface, it has been pretty choppy. Market breadth has weakened meaningfully as we've gone through a number of rolling corrections, the most notable of which has been the outperformance of growth over value again. In fact, most of the reflation trade investors were so excited about earlier this year has just about reversed. As a result, many investors are asking whether that's a problem for markets or an opportunity? I'm lucky to be joined by Matt Waz, senior vice president and head of consultant relations, who hears nearly every day exactly what clients are thinking and worrying about right now.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. We're going to do another change-up for this episode. I'm going to let Matt take over the hosting duties and I'll sit in the hot seat to answer his questions. So with that, are you ready to kick things off, Matt?

Matt Waz:
I am. And thank you, Matt, for your willingness to share your thoughts on the markets with our followers. As you just mentioned, markets continue to make new record highs and one of the key concerns I hear from clients right now is that equities seem to be priced to perfection and could face an ugly surprise should inflation be less transitory than we think. Can you talk about your view on this dynamic and where the biggest risks are lurking, should we have an inflationary surprise?

Matt Orton:
Absolutely. And you allude to a theme I've been hearing a lot about lately, which is “peak everything,” but it's not new. We've always known that the economy isn't going to grow at 6% to 7% annualized for more than a few quarters. And what gets lost in the sentiment of “peak everything” is that we're likely to settle into a growth rate that's above the long-term trend pre-COVID, which I think is very supportive for future equity gains. And it's also worth pointing out that when you look at some of the economic surprise indicators, they have actually turned negative pretty recently with some lighter than expected data. But markets are doing fine, and if anything, it's helping to normalize performance with quality starting to perform better and an increased focus on fundamentals.

We also get the benefit of continued low rates, which I think are too low, by the way, making it easier to discount the relatively expensive valuations for the market as a whole. And there's certainly a risk in all of this. But the market has shown us that it's siding with the Fed and that most of the inflationary pressures we're seeing creep into this economic data and our daily lives, quite frankly, are going to be transitory. A lot of prominent investors don't agree with this, but my assessment right now is to side with the Fed.

Matt Waz:
Thanks, Matt. You said you think rates are too low and I'm hoping that you can dive into that a bit more. I know that you tend to side with [U.S. Federal Reserve Chairman Jerome] Powell and the transitory camp regarding inflation. Perhaps you can also shed some light on your thoughts and what happens if we do end up finding their pressures aren't so transitory?

Matt Orton:
Yeah, this is a great subject and I'm going to do my best to keep it fairly concise as best as I can. And I'm going to start on the rates front. And to what I had said before, I do think rates are too low and that's because of two key reasons, the first of which is tied to inflation. We know that inflation is here, it's showing up in all of the recent economic data releases. The consumer can feel it when they go out to eat or go shopping or look for house or apartment. I'll come back to the transitory argument in a second, but transitory or not, there is a big dislocation between the massive CPI (Consumer Price Index) and PPI (Producer Price Index) beats. We've had basically inflation in the level of the 10-year [Treasury note]. In fact, we're the lowest 10-year yield given the CPI ratings over the past few decades. There's absolutely no margin of safety in a 1.2%, 10-year note set against realized inflation this high. So clearly there's a disconnect with rates and I think they are priced too low and overbought.

Second, I think yields are baking in too much fear around the impact of the delta variant on economic growth. We've seen yields push meaningfully lower as the delta variant has accelerated around the U.S. but I think the fears are overblown. Anecdotally, when I talk to management teams at hotels here in Florida, or if you listen to earnings calls with management teams at Vegas and regional casinos, business is robust. When you look at real time credit card data and OpenTable data, you're not seeing a meaningful slowdown in consumption activities of the consumer. So I think fears around delta are overblown. And I think as a result that has fed through into lower yields and they've probably come down too much as a result of those fears.

So now to address your transitory question, and as I said earlier, I agree that we're seeing some pretty elevated levels of inflation right now. The key question to ask though is whether these price increases will continue to accelerate? When you look at inflationary pressures caused by supply chain issues and rising input prices, I expect price increases will start to decelerate as we get further and further into the rest of 2021. And as some of the pandemic-induced supply chain constraints ease. I will say I'm not dogmatic in my assessment of inflationary pressures so I'm willing to make a change if I see it flow through to the data. While the factors contributing to inflation from the supply chain might be temporary that doesn't necessarily mean short-lived.

So given the complexity of global value chains, key potential issue that we need to look at is that all economies are not going to exit from the pandemic at the same time, which could lead to longer lasting distribution and logistical difficulties. So you've got to follow that, I think right now you're starting to see them ease a little bit, which is encouraging. But I think even more important to inflation over the longer term is the question about labor. When you look at the most recent JOLT (Job Openings and Labor Turnover) Survey, there were more than 9.2 million unfilled positions at the end of May with nine and a half million unemployed workers.

So on the surface, labor supply issues should resolve themselves. Given the supply demand backdrop, there's more jobs than there are people looking for jobs, but you're not seeing that play out. Something that concerns me is the reservation wage, the lowest salary at which people are going to come off the sidelines. It sits at over $72,000 per year, it's nearly 20% higher than it was last year. And it's totally disconnected from current wages. We need to follow whether the expiration of unemployment benefits and schools reopening are going to start to have an impact and getting more people back to looking for work and back into actual seats in the jobs. I'm biased to believe that we're going to see some normalization based on some of the initial data from states where unemployment has already rolled off unemployment benefits that is, but it's going to be critical, looking at all of this together, to assessing the true nature of whether or not this is going to be transitory.

Matt Waz:
Those are some really staggering statistics. I'd like to build on this theme and dive into how it impacts the equity markets. I know you've been very optimistic on equities for a while now, and that has been the right call with the S&P 500 hitting new all-time highs seemingly every week. But we haven't been through more than a 5% correction in over nine months. How do equities continue to move higher, especially if rates start to move higher as well?

Matt Orton:
That is a great question, Matt, because risks are definitely mounting, but not because we're seemingly overdue for a correction. I hear all the time from clients that we're overdue for a 10% correction because we haven't had one for a long time. And I understand that the equity rally might feel a little bit long in the tooth, but just because we haven't had that correction since October of last year, doesn't mean we need one or that one is imminent in the near future. The S&P 500 historically has had three to four corrections every year on average, greater than 5%. And the average peak to trough downside over the past 50 years has been roughly 4%. So based on this collection of data, we're way overdue for a market correction, but it doesn't mean one's going to come. And this has not been a typical rally.

There has been extreme bifurcation in the market between growth and value, as well as large caps and small caps. And we haven't seen multiple areas of the market work together this year. And that's resulted in a number of rolling corrections beneath the surface. And these corrections have occurred in a way such that the stock market has marched higher while what I'll call collectively the market of stocks, hasn’t been in the best shape. So to answer your ultimate question, Matt, which I think was, “how do we move higher from here?” I think we need to see this bifurcation start to abate, and you need to see both growth and value, large caps and small caps start working together.

Matt Waz:
Thanks, Matt. You mentioned small caps, and I want to dive into this a bit more because it has been an asset class that has been pretty volatile recently and also has surprisingly underperformed for the past few months, despite strong economic growth and earnings results.

Matt Orton:
You're exactly right. Small caps have been trading in a range since February, and they failed to break out despite a few attempts back in April and May, but I'll also point out that they haven't broken down. I think the problem really started with investor fatigue. The Russell 2000 had its best quarter on record in Q4 of last year, and it had it second best quarter on record in Q1 of this year. So it's understandable that investors would need to take a breather to reset sentiment. And historically speaking, rallies tend to be fast and furious in the small cap space followed by longer periods of sideways consolidation. So now we're getting that sideways consolidation, but we're also grappling with concerns over peak growth and the impact of the delta variant on U.S. economic growth. Quality has also been outperforming in the market and small caps lack quality characteristics, especially compared to mid and large caps. Non-earners have been outperforming low return on equity ROE, those companies have been underperforming and that's all indicative of a quality rally. So I think that has also been holding small caps back.

Matt Waz:
So with that, Matt, what do you think it takes to get small caps working again?

Matt Orton:
I think that small caps inability to follow large caps to new all-time highs despite superior earning strength, it really argues that the market is concerned about this idea of peak growth, it's concerned about delta variant casting doubt on those expectations going forward. So I think getting to the other side of the delta curve is going to be helpful. Also seeing more data that highlights that we're not actually seeing a slowdown in consumer activity, I think is going to help put investors at ease about the potential impact of delta or peaking economic growth. And I always think that earnings are ultimately what drives the markets, and we're getting into the busiest period of small-cap earnings right now. So seeing positive results, positive guidance, I think all of that is going to help or should help maybe help move small caps or help them break out.

Matt Waz:
And, Matt, it's clear from this discussion that not all reflation trades have corrected equally. And I would assume that not all areas of growth have done equally well either. Where do you see the biggest opportunities going into the second half of 2021?

Matt Orton:
That's a good point, Matt. Because even though we look at growth versus value at a very, very high level, there's a lot of nuances beneath the surface. And so growth overall has done well over the past few months, it's largely been driven by the higher and highest duration areas of the sector like software and semiconductors areas like IT services. That has been much more challenged and that's more tied to I'd say the overall economy. Healthcare which tends to be more represented in growth and especially in small-cap growth has underperformed with biotechnology and pharmaceuticals being somewhat out of favor even in consumer discretionary. And there has been a bifurcation in areas that have all done well and areas that haven't. Going forward, I think there's some very good opportunities, mega-cap technology, broadly speaking, isn't that expensive. And it's actually been a drag when you look year to date in many cases on the relative performance of say the S&P 500. And they had pretty stellar earnings so I think there's definitely room for some upside there.

We're also seeing some better performance from healthcare more recently. And I think there's definitely room to run, to see continued outperformance given a very strong earnings backdrop, and a continued growth trajectory. And this isn't really going to be part of the growth story, but I'll also mention mid caps. Mid caps never really get discussed, but they've held up incredibly well year to date. They held up well when small caps were outperforming, they held it well when large caps were outperforming. Earnings have been coming in strong, they have a good balance between leverage to the domestic economy, diversification and maturity in their businesses and a growth acceleration. So I think the setup there is very, very attractive whether or not it's growth or value. I think mid caps are a very interesting place to be as well.

Matt Waz:
Those are very interesting comments on midcap, Matt. I would be remiss if I also didn't ask about the biggest risks looming today?

Matt Orton:
I think a big risk is what happens regarding labor costs and inflation, and we talked about this a little bit earlier. The market itself is just not priced for inflation to linger over the longer term. And if you get a sharp rise in rates that's tied to inflationary concerns that could definitely cause a pretty meaningful pullback or correction in the market. It could also change the growth trajectory for the underlying economy. I think it's low probability, but it still definitely needs to be considered. I'll add to this concerns over the recent Chinese crackdowns on technology, what's going to come next? The government has clearly shown a willingness to get more involved and I wonder if there might be any potential implications to other areas of the economy related to supply chains where we're already seeing issues and backlogs? So that could also pose a risk to how quickly we normalize some of the input cost pressures that we're seeing.

I'll also add to the inflationary risk, too much fiscal spending. Some of the legislation being considered under reconciliation right now might be adding too much fuel to the fire that's already burning pretty hot in the economy and it could create more distortions in the labor market that clearly isn't behaving normally right now. So it's definitely a risk and might also necessitate a change in monetary policy, which has been keeping equity valuation sustainable at these more elevated levels. So all of that could exacerbate some of the market reactions to any downside surprises or quick changes in overall policies. So definitely something to think about when we contextualize issues to the broader market.

Global growth and the pace of global growth is another potential risk, has it peaked? And will it remain above trend to support current valuations? I think that's where these issues with delta are coming into play. But again, I'm biased to believe that that we will settle at an above-trend rate and that both the U.S. economy and the global economy is handling it pretty well. I still am very optimistic on the markets. I don't think any of these risks might cause a recession or a prolonged downturn, but they certainly could spur that 10% to 15% correction that we all love to hypothesize about. But given the current backdrop, I would definitely be inclined to use any sort of downside to that degree opportunistically and really lean into that downside because overall, I'm still very optimistic on where the markets can go.

Matt Waz:
Thanks, Matt. I think that's all we have time for today. Thank you for taking the time to share your thoughts on the markets and the reflation trade with our listeners. And as always thanks to our listeners for tuning in. Have a great day.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.