Last week, we noted that Treasury yields have been declining while other market signals were not suggesting that growth and inflation were declining. Last month, we noted that on a longer-term basis cyclicals, higher beta, and lower quality securities were outperforming even though they had been recently lagging. We believe it would be helpful to clarify those comments this week.
The current market signals and economic data are not suggesting that deflation (negative inflation) or a recession (negative economic growth) are very likely to occur soon. However, they are suggesting that the pace of economic improvement has likely peaked as the weakest data occurred during the second quarter of 2020.
We can see evidence of this in the recent update of the U.S. and global ISM PMI data.
Both remain high and suggest economic activity will remain positive, but the index is calculated based on relative improvements and the likelihood of improving from these levels is declining.
The global leading indicator composite is still improving which suggests that economic growth is unlikely to contract (recession), but the rate of change is slowing which suggests the best levels of growth have already occurred for this cycle.
Inflation data continues to show signs of accelerating, both on a monthly (not impacted by 2020) and core basis (not impacted by commodities). 
As we have written about recently, while some of the areas that are currently showing signs of decelerating price growth as the impacts of COVID are regressing (lumber, goods, used cars), areas like Shelter are starting to increase. Shelter is a large component of the Consumer Price Index (CPI) and is still well below trend on a year-over-year (YoY) basis.
Other CPI calculations that adjust for outliers like median and trimmed mean are also starting to increase.
The economic data is suggesting that growth is likely to remain positive, but the rate will start to decline in coming quarters as comparisons get harder and the fiscal support starts to phase out. At the same time, inflation data will likely remain elevated and potentially increase as shelter returns to previous levels or beyond and commodity prices remain well above prices from a year ago. This implies that a recession or period of deflation are not likely.
The market signals are suggesting a similar outlook.
The U.S. dollar has been increasing for the last two months but remains below the prior highs from the last 18 months.
Source: Koyfin.
Recession risk remains a low probability with the S&P 500 and NASDAQ just below new highs made in the prior week.
Source: Koyfin.
Source: Koyfin.
The volatility index for the S&P 500 (VIX) and the NASDAQ (VXN) continue to remain below prior spikes in the last year and are well below levels consistent with economic contractions.
Source: Koyfin.
Source: Koyfin.
Source: Koyfin.
Source: Koyfin.
The commodity index is also just below a recent high and is at the highest level since the end of 2014.
Source: Koyfin.
Source: Koyfin.
Oil volatility also remains below 40 (which is lower than prior spikes in the last year) and below levels consistent with economic contractions.
Source: Koyfin.
Source: Koyfin.
High yield credit spreads continue to remain stable and are near the lowest levels since 2007.
Source: Koyfin.
Source: Koyfin.
All of these signals suggest a recession or negative economic growth are not being priced in at the current moment.
What does appear to be getting priced into financial assets is a return to the economic growth rates that were in place prior to 2020. These below trend levels of economic activity favored companies/factors that were higher quality, had organic growth potential, and were lower beta and was a headwind for cyclical, lower quality, higher beta companies/factors.
In contrast to the larger cap indexes, the last few months performance shows that the Russell 2000 small cap index has not made a new high since March 15th.
Source: Koyfin.
At the same time, the Russell 1000 Growth Index made a new high last week, highlighting the preference for larger size and higher growth potential companies.
Source: Koyfin.
From a factor standpoint Defensive, Quality, Large Growth, and Low Volatility have been outperforming Value and High Beta on a one- and three-month basis.
Source: Koyfin.
Source: Koyfin.
On the industry side, a similar dynamic is in place as Real Estate, Health Care, and Technology are outperforming Materials, Financials, Industrials, and Energy on a one- and three-month basis.
Source: Koyfin.
Source: Koyfin.
These macro and market signals suggest that the economic cycle is progressing away from the early stage and, as this takes place, economic growth will likely return closer to prior trends. This has implications for the amount and the type of securities that can perform well.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
