You might reasonably think that investors are worrying about two contradictory things at the moment. Last week the concern seemed to be too much inflation on both sides of the Atlantic; this week attention has shifted to the likelihood of too little growth as the Delta variant takes hold. On the face of it, that makes no sense. They can’t both be a problem at the same time, can they?
In the absence of 1970s-style stagflation, they shouldn’t be. And if you look behind the headlines at what the markets are telling us, the apparent contradiction quickly disappears. On the basis of where they are actually putting their money, it is clear that investors are more worried about growth than inflation. They long ago bought into the central bank mantra that inflation is a transitory problem and recognised that economic growth is the real concern.
That’s the backdrop to this week’s market wobble. And it is no coincidence that the sharpest falls in share prices should have happened on the very day that the UK cautiously embraced freedom from Covid restrictions. This is so often the case in investment. It is much better to travel than to arrive. Buy the rumour, sell the news.
Look beneath the surface of a stock market still flirting with all-time highs and it is clear that investors moved on several months ago from the optimistic reflationary narrative that began last November with the hope that vaccines would open the door to a post-pandemic future.
Small companies that typically prefer a strong economic environment started to underperform in March at exactly the moment that the rate of improvement in the economic data rolled over. Peak re-opening, you might call it. The same effect could be seen in the performance of cyclical shares that earlier in the year were hailed as the principal beneficiaries of the re-opening of economies. The Dow Jones Transportation index, which includes shipping, railway and airline stocks, is down more than 10pc since May.
At about the same time, previously out of favour value shares, which had been outperforming growth stocks since September, started to lag again. They began to underperform precisely when a widely watched gauge of inflation expectations (the difference between nominal and inflation-protected bond yields) topped out. For investors, this marked peak inflation, not the backward-looking inflation data that were announced last week.
It is uncanny how markets see what is happening long before the picture is confirmed in the official announcements. Another good example has been the 10-year US Treasury bond yield, which you might have thought would rise while everyone was worrying about the return of inflation but actually fell sharply from its peak in March of 1.75pc to just 1.2pc this week. Fixed income investors have been focused since the spring on growth not inflation.
Lurking behind the headline stock market indices are another couple of worrying indicators. First, the breadth of the market has narrowed meaningfully in recent weeks. Even as the S&P 500 has been pushing forward to new highs, the proportion of companies whose shares are trading above their average for the past 50 days has fallen to just 30pc. More than two thirds of companies are, therefore, running out of steam.
This divergence between the benchmark index and most of its constituents is very rare. And it tends to be a harbinger of a rethink by investors. It happened before the 1998 correction after the collapse of the Long-Term Capital Management hedge fund. And it happened two years later ahead of the bursting of the dot.com bubble.
The second canary in the coalmine is the performance of commodity-sensitive stocks versus the broader market. Commodities tend to move early in both directions. In March 2020 resources stocks turned higher while stocks generally were still falling. Then recently they started to underperform while the main share indices were still going up. A good example of markets moving ahead of the conventional wisdom - commodity shares peaked just as we were all talking about the next commodity super-cycle, an idea that has been put on the back burner for now.
The narrowing in market breadth is particularly interesting because it is coinciding with a peak in corporate earnings expectations. It’s early days yet because only around a tenth of the largest US companies have reported their numbers for the April to June quarter. But, as it stands, earnings are likely to rise by more than 70pc year on year and by nearly 40pc for 2021 as a whole. This is encouraging, and will help to support markets, but it will almost certainly represent peak earnings growth.
So, what can we take away from these ebbs and flows beneath the surface? First, that markets move much faster than the headlines. By the time you are reading about it, smarter investors have already moved on to the next story. Most economic data simply confirm what happened some time ago. From an investment perspective that kind of information is no help at all.
Since the spring, the sectors which have been leading the pack, again, have been the defensive parts of the market that look relatively attractive in a lower growth environment but which the conventional wisdom said would suffer as interest rates rose - technology, healthcare, consumer staples.
The reality I suspect is that none of us are smart and nimble enough to beat the rest of the market to it. It really isn’t worth trying. Spread your eggs around enough baskets and you’ll find yourself in the right place with at least part of your portfolio - and long before you even realise it’s where you need to be.
Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63
