Are equities ready for non-transitory inflation?
Head of Equity Strategy
Summary: The US jobs report on Friday showed that the interest rate sensitivity theme is not over yet, but given the 17% EPS growth in Nasdaq 100 over the past two fiscal quarters the impact from rising interest rates and inflation should be less than the 12% drawdown back in February and March. We also take a look at the surprise Chinese PPI figure today and what it means for US CPI figures on Wednesday. We also outline the various factors behind deflationary and inflationary pressures in the economy today. Finally, we show which US companies could benefit from the $1trn US infrastructure bill which is set to pass today in the US Senate.
The US jobs report on Friday extended the recent rally and turnaround in US yields. Last week we got two news marking an interesting pivot point in US yields; a hedge fund called Alphadyne had lost $1.5bn betting on higher interest rates and Japan’s public pension fund, the largest in the world, announced that it had cut its US Treasury weight from 47% to 35%. Both events signalled an inflection point and the much stronger than expected US jobs report on Friday took the US 10-year yield as high as 1.30%. The reaction in US equities could not have been more divergent. Nasdaq 100 futures decline substantially while S&P 500 futures cruised higher on the strong labour market data. In other words, the interest rate sensitivity theme is back in growth and technology stocks.
While the US 10-year yield is a bit lower today, the signal in the noise today is the worse than expected PPI figures out of China showing a higher degree of persistency. This suggests that there are upside risks to inflation as highlighted by Clarida and Weidmann last week. China’s PPI figure is an interesting lead into the US CPI report on Wednesday which, if showing a hot m/m reading and the rent component picking up, could put enormous pressure on the Fed to change its language and outlook for inflation setting Jackson Hole up later this month to be one of the key events to shape markets for the rest of the year.
What is the impact on technology stocks and Nasdaq 100 from rising interest rates? The drawdown back in February and March of this year was 12%, but we do not expect the same drawdown if the US 10-year yield goes back to 1.8% because EPS is up 17% in Q1 and Q2 combined. In other words, if earnings growth for technology companies remains robust it will counter some of the higher discount rate from higher rates. For now we remain constructive and positive on equities despite higher inflation in the short-term and we believe investors so far have been correctly discounting the inflationary and economic outlook.
The drivers of deflation and inflation
The Fed and many bond investors have bet on inflation to be transitory. Many of the underlying drivers are well-know. Demographics in the developed world is a drag on economic growth and will keeps savings high and interests and inflation low. The current period of technological change with digitalization and automation Is deflationary by nature and is perceived to be stronger than in previous long-term economic cycles. Low productivity growth and low real-rate economic growth in the developed world coupled with high debt levels will put a natural lid on inflation and interest rates.
But what are some of factors that could lead to sustained higher levels of inflation? The four main pillars of higher inflation are:
- Decarbonisation of the economy which will lead to the world adopting technologies for electricity production that are currently at higher cost curves compared to natural gas and coal, which put upward pressure on energy prices and thus feed through to all the economy. Decarbonisation policies have recently led Canada to limit supply of wood for sawmills in the US due to the environment which has made it more costly to produce lumber for housing construction. Weather patterns as a function of warmer climate is also increasing volatility in our agricultural production and that is expected to increase over time leading to more food inflation.
- Urbanisation in Asia will together with electrification of the transportation systems in the developed countries and the green transformation drive a usually high demand for certain commodities and underpin a new supercycle in commodities.
- Tensions between the US and China will dictate a reconfiguration of global supply chains which longer term will mean production will increasingly be spread out across more countries which is logistically more expensive, and China has kept input costs very low since 2001 to gain employment and manufacturing market share. But China is now putting a higher weight on its environment which will lead to China likely “exporting” more inflation going forward.
- The EU border tax will put taxes on goods produced with high carbon intensity forcing developing countries exporting goods to the EU to adopt technologies that are less carbon intensive which in the short run will be more expensive and thus inflationary in developed consumer markets.
US infrastructure bill and construction related equities
The Senate is set to convene at 1600 GMT today in what looks like the US will get a $1trn infrastructure bill in the most constructive bipartisan agreement in years. The bill adds further and much needed stimulus to the US infrastructure sector which is desperately in need of funds. In the table we have highlighted the US companies with a market value above $5bn within building products, construction & engineering, and construction machinery. These companies could get a boost from the infrastructure bill in the years to come.
|Name||Mkt cap (USD mn.)||Last price||P/E||Return YTD (%)||Return 5Y (%)|
|Johnson Controls International plc||51,330||72.07||28.55||56.04||91.84|
|Carrier Global Corp||48,921||56.38||42.55||50.27||NA|
|Trane Technologies PLC||46,809||197.00||34.67||36.67||308.34|
|Westinghouse Air Brake Technologies Corp||16,282||86.13||30.11||18.01||22.98|
|Fortune Brands Home & Security Inc||13,751||99.73||18.52||17.00||67.39|
|Quanta Services Inc||12,851||92.35||23.81||28.40||276.00|
|Lennox International Inc||12,406||333.80||24.88||22.46||123.79|
|Trex Co Inc||12,142||105.27||62.60||25.74||610.68|
|A O Smith Corp||11,408||71.67||26.27||32.32||64.17|
|Carlisle Cos Inc||10,712||205.51||32.76||32.40||109.22|
|Builders FirstSource Inc||9,799||47.29||8.41||15.88||276.51|
|Advanced Drainage Systems Inc||8,165||115.72||43.01||38.70||363.59|
|EMCOR Group Inc||6,522||121.33||20.54||33.12||119.47|
|WillScot Mobile Mini Holdings Corp||6,469||28.60||32.85||23.44||193.33|
|AZEK Co Inc/The||5,832||37.69||NM||-1.98||NA|
|Armstrong World Industries Inc||5,206||109.36||32.12||47.96||154.52|
|Valmont Industries Inc||5,078||239.39||24.91||37.43||95.12|
Source: Bloomberg and Saxo Group
The five-year chart below of Nasdaq 100 futures vs S&P 500 futures is for compliance reasons