Private Wealth

Weekly Research Briefing: The Rotation Accelerates

May 11, 2021
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Even Metallica sounds like Alvin and the Chipmunks at 78 rpm. Sometimes the talking heads on Financial TV sound like Alvin trying to get every word in to explain how their growth stocks can justify current valuations. But it doesn't matter how fast they talk and how many points they make, the market doesn't want to own growth stocks right now. It wants to own businesses where earnings growth is accelerating and where inflation protection might exist. Also, if interest rates are rising, the market should continue to gravitate toward short duration business models that are gushing free cash today, not biotech or technology stocks that go free cash flow positive in 2028. It's not the fault of any specific four-letter stock. It is just what incremental investors want to own right now. The fewer the ticker count the better. 

Friday's jobs report was a surprise with non-farm payrolls rising by only 266,000 and the average hourly wage rising by +0.7%. Plenty of digging in the dirt this weekend by the economists and strategists to make some sense of it all. Some pointed to too many supplemental unemployment benefit checks. Some pointed to the many people still afraid of the virus. Some pointed to the fact that the childcare industry has been slow to recover from COVID. And others pointed to the semiconductor shortages leading to major factory shutdowns. It is likely a solid mix of all these factors. But if it continues, high labor count businesses are going to need to cut hours of operation if they want to stay in business. 

This wouldn't be the worst thing. We don't need to have everything open 24 hours a day. Especially when most white-collar office workers are only spending two-to-three days a week in the office. For businesses that make it, the minimum wage cost will move to $15 or more. If they have volumes, they will do fine as they pass along higher prices. For other businesses that don't have volumes or pricing power, their margins and profits could suffer. The recovery has been easy for all stock prices to this point. But going forward, it will only be the best operators and business models who can absorb the increasing labor and input price pressures. 

Earnings estimates have continued to move sharply higher in May. This has helped many stocks to shrug off the market's earlier earnings day disappointments. Again, maybe stocks were bid up too sharply into the start of earnings season. And now that investors have had a chance to sit down and look at the earnings across 90% of the S&P 500 Index, they are reallocating their investment armies like a giant RISK board game. If you look at the stock sectors which have performed best during the Q2 and even year-to-date, it should be little surprise that it is occurring in the those companies which are seeing the most upward earnings revisions. Materials, financials, and energy are among the sectors most rewarded. Difficult to see how these rewards reverse unless the economy decides to slow down quickly.

Three cheers for materials, financials and energy stocks...

2Q 2021 EPS Guidance Scorecard by Sector

(@EarningsScout)

Value stocks are back...

@granthawkridge: Highest reading since 2016 for the percentage of value sector stocks making new 63 day highs! $XLB $XLI $XLF % of Value Sector Stocks Making New 63 Day Highs

Plenty of one, two and three letter stocks pushing these indexes and sectors to all-time highs right now...

All Time Highs Right Now

The four-letter stocks are no longer getting invitations to the party...

@WillieDelwiche: NYSE vs NASDAQ dichotomy in full display in new high data. NYSE new highs near March peak, NASDAQ new highs at a fraction of where they were in February. 52-Week New Highs: NYSE vs NASDAQ

Arguing with myself over this chart...

While it is true that most of the FANG stocks generate fountains of free cash flow, it is also true that the central bank creating liquidity has lifted their valuations. 

@carlquintanilla: B of A: The Fed “has been tech’s best friend for past 10 years.” The bad news “is global tapering has begun.” [Hartnett] 

FANG & Fed's Excellent Adventure

Easier to see how the overall equity market will have a challenging future of returns...

@ISABELNET_SA: Current S&P 500 valuation suggests anemic returns over the next 10 years S&P 500 forward P/E ratios and subsequent 10-year returns

(FinancialTimes)

The May numbers are going to have the markets even more on edge...

Nonfarm payroll growth slowed sharply to 266k in April and was revised down by 78k on net in prior months—a massive disappointment relative to expectations. We do not believe technical factors or statistical distortions can explain the miss, as the April seasonal factors and birth/death adjustments were similar to pre-crisis averages. That being said, the spring hiring season typically produces large seasonal gains in construction and several services categories, and we note the possibility that firms were more focused on bringing back their pre-crisis workforce than on expanding their businesses. If so—and if reopening continues at a similar pace—it would argue for a rebound in headline payroll growth in coming months (seasonal hiring peaks in April).

(GoldmanSachs)

It continues to be a great time to be looking for a job...

@PantheonMacro: "April Payrolls Constrained by Lack of Supply, not Demand" Lack of Labor Demand was not the problem in April

One would have thought that a spike in wages would have created more new jobs...

US Average Hourly Earnings MoM (@SoberLook)

Chipotle is raising the ante to all other employers by moving to $15/hour...

Hoping to attract more employees, the fast-food chain Chipotle said on Monday it was increasing its wages to an average of $15 an hour by the end of June.

The company, which is looking to hire 20,000 employees for its peak season and to staff the more than 200 restaurants it plans to open this year, said the wage increase would result in hourly workers making between $11 and $18 an hour.

Chipotle is the latest restaurant chain to raise wages or offer incentives as it struggles to staff its restaurants. As coronavirus vaccinations have increased and government restrictions eased, the restaurant industry, which laid off or furloughed millions of employees during the pandemic, suddenly went on a hiring spree, as did several other service-related industries.

That sudden high demand for restaurant workers has been tough to meet. Some potential employees, whether concerned about the safety of serving customers dining indoors or buoyed by government stimulus checks, are wary of returning to work.

(NYTimes)

Starbucks will also give employees insurance, tuition reimbursement, Spotify premium and free coffee...

@BullandBaird: $SBUX be like “we need people”

Starbucks Always Hiring sign

Janet Yellen stepped on the market's toes last week before recalling her comments later that night...

U.S. Treasury Secretary Yellen said today “we expect to be in a low-interest rate setting for a while, but we must ensure that deficits remain manageable.” She also “reallocation may result in some small increases in interest rates” and “rates may have to rise to stop economy overheating” – none of these comments were well received by stock markets today, with major averages sinking to their lows late morning after she spoke. Her comments on rates rising contrast with Federal Reserve Chairman Jerome Powell's insistence that the central bank will be patient and isn't "thinking about thinking about raising rates" until there's "substantial progress" in meeting its goals of full employment and inflation exceeding 2%.

(TheHammerstoneReport)

Meanwhile, the market is moving its inflation expectations toward 3%...

@SoberLook: Market-based inflation expectations keep grinding higher. 5yr USD Inflation Swap

Could enough price spikes slow the economy? It has happened before...

@ISABELNET_SA: The ISM Prices Paid Index tends to lead the ISM Manufacturing Index by 12 months, suggesting a mid-cycle shift this year PMIs illustrate and signify the timing of the mid-cycle transition (@MorganStanley)

It is easier to make money in equities when the ISM is rising...

@ISABELNET_SA: More than 90% of the gains in the S&P500 Index have occurred when the ISM Manufacturing Index rises

ISM Manufacturing vs S&P 500 Performance

(@RealAlpineMacro)

Inflation reads from Tyson will support your move toward more plant-based eating...

TYSON: "We’re seeing substantial inflation across our supply chain, which will likely create margin pressure during the back half of the year”. (@knowledge_vital)

Tyson (@MylesUdland)

So the copper rocket will continue?

The price of copper needs to rise 50 per cent to encourage enough new supply to meet projected demand from the global green revolution, says the chief executive of Glencore.

Ivan Glasenberg said the mining industry would need to produce an extra 1m tonnes of the metal a year to meet many governments’ goals of reaching net zero carbon emissions by the middle of this century, yet most of the world’s easy deposits had already been mined.

“You will need $15,000 copper to encourage a lot of this more difficult investment,” Glasenberg told the FT’s Global Boardroom summit on Thursday. “People are not going to go to those more difficult parts of the world unless they’re certain.”...

Kathleen Quirk, chief financial officer of Freeport-McMoRan, another big copper producer, told the FT summit more use of scrap copper would help to meet rising demand.

“We always say necessity is the mother of invention...but in copper, it’s not like the oil industry where there was a new source of supply coming from the shale production,” she said. “All the easy projects have been done.”

Copper prices have risen

(FinancialTimes)

Stockpiling electric-vehicle battery metals will only add to rising industrial metals demand...

Western governments should consider stockpiling critical battery metals such as cobalt and lithium, the International Energy Agency said, in a stark warning of the geopolitical risks that accompany the green-energy transition.

That call comes as some policy makers worry the shift from burning fossil fuels to a greener economy will expose the world to new threats. Unlike oil, a relatively ubiquitous commodity, production and processing of minerals such as lithium, cobalt and some rare earth elements is highly concentrated, with the top three producers accounting for more than 75% of global supply.

Stockpiling programs could provide a valuable buffer as leading industrial nations look to develop reliable supplies of metals and minerals that will play a critical role in a decarbonizing world, the energy watchdog said in a report on Wednesday.

Battery Boost

(Bloomberg)

The only thing that will cure 1% a month housing price gains is four-to-five months of housing inventory...

In February, months-of-supply was at 2.0 months, and the Case-Shiller National Index increased 1.1% month-over-month. The arrow points to the February dot.

In the existing home sales report released last week, the NAR reported months-of-supply at 2.1 months in March. There is a seasonal pattern to inventory, but this is just above the record low of 1.9 months for December 2020 and January 2021 - and prices are increasing sharply.

Housing: Months of Inventory vs. House Prices

(CalculatedRiskBlog)

Great chart showing the impact of rising lumber prices...

@LizAnnSonders: To understand impact that lumber prices can have, @VisualCap shows number of homes that can be built with $50,000 worth of lumber, last year vs. this year, during which time, price of lumber has increased 377%—reaching a record high of $1,635 per 1,000 bd ft.

$50k Worth of Lumber

(@VisualCap)

Next up, cardboard shortages...

@JeffreyKleintop: There's a cardboard box shortage. It's not just semiconductors, shortages have extended all the way to plastic and boxes used for making and packaging nearly everything. 

Containerboard-used to make cardboard boxes-at record low weeks of supply

But good luck finding a shipping container at an affordable price...

@jsblokland: The Baltic Dry Index Index, for a long time seen as a reliable indicator for future #GDP growth, is up almost 700% against the low in May last year.

Baltic Dry Index

(@jsblokland)

And you will need even more luck finding a new boat to ski behind...

Tweet from @1MainCapital (@1MainCapital)

Can a marriage afford to make it to their 5th year anniversary...

Tweet from @tracyalloway

(@tracyalloway)

A decade of negative free cash flow has pushed the energy sector to 90-year low valuations...

Could any capital expenditures (CapEx) and merger and acquisition discipline combined with the constraint of ESG investment restrictions into the sector lead to future positive returns in energy stocks? If you have tobacco industry-déjà vu, you are not the only one. Energy sector valuations at all-time lows vs the market (JPMorgan)

Everyone wants to get away...

@carlquintanilla: It’s like someone flipped a switch and we all started booking travel. Spending on airlines

Or everyone wants to drive away in a new vehicle...

@calculatedrisk: April Vehicles Sales increased to 18.51 Million SAAR; Highest Since 2005 U.S. Light Vehicle Sales

Private equity growth versus public equity growth…

Last week, we looked at the returns of the private equity buyout space versus the S&P 500 Index and found 27% better returns with 36% lower risk over the last 25-year quarterly sample period. While buyouts are the largest category of private equity, I was intrigued and decided to look at the next largest category, growth equity. For this group, I decided to compare it to the broader universe of U.S. growth stocks found in the Russell 3000 Growth Index. Like last week, I chose a U.S. centric universe since two-thirds of the private equity growth equity group has been U.S. companies and picking any public international equity index just makes for much worse comparisons. 

Bottom line, for the PE growth versus the Russell 3000 Growth Index comparison, PE growth returned 38% greater returns with 28% lower risk over the 25-year quarterly sample period. For those still interested in comparing to a global benchmark, I'm using the MSCI World Index, the private equity growth numbers are 90% better return for 18% less risk. Private Equity Growth versus Public Equity Growth (Source: Hamilton Lane Data via Cobalt LP and Morningstar)
Past performance is not indicative of future results.

Henry McVey of KKR had this interesting analysis on public equity performances...

After updating our forecasted returns for all the various asset classes that we track, we then turned our attention to whether now is actually a good time – given the recent rip upward in liquid markets after the pandemic-induced liquidity surge – to allocate more towards private markets. What we found is that private market asset classes actually tend to perform better as mid-to-late cycle asset classes, which helps to boost their overall performance statistics relative to liquid markets over the life of a fund. One can see this in Exhibit 40. In particular, when public markets returns are less than 15% per year (which is clearly what we are forecasting), then Private Equity as an asset class almost always outperforms Public Equities. In fact, the illiquidity premium actually moves above its 500 basis point historical average to 6-10% when Public Equity market returns are less than 10%. Meanwhile, we also looked at whether investment climate or regime makes a difference in light of our Another Voice thesis calling for a shift in portfolio construction. What we found was encouraging. Specifically, a stronger backdrop for Value, which is consistent with our framework, also tends to foreshadow better returns for Private relative to Public Equities. One can see this in Exhibit 41. This relationship makes sense to us because buyout deals are generally tied to some sort of value-unlocking thesis, so it tracks that the asset class tends to outperform best when markets are rewarding more than just secular growth stories.

Private Equity

(KKR)

Okay, this is funny...

Just imagine traveling 10 years back in time and trying to explain this to someone; just imagine what an idiot you’d feel like. “There’s going to be this online currency that people think is a form of digital gold, and then there’s going to be a different online currency that is a parody of the first one based on a meme about a talking Shiba Inu, and that one will have a market capitalization bigger than 80% of the companies in the S&P 500, and its value will fluctuate based on things like who is hosting ‘Saturday Night Live’ and whether people tweet a hashtag about it on the pot-joke holiday, and Bloomberg will write articles and banks will write research notes about those sorts of catalysts, and it will remain a perfectly ridiculous content-free parody even as people properly take it completely seriously because there are billions of dollars at stake.”

(Bloomberg)

The hack on the Colonial pipeline this weekend was not funny...

This crime would not have happened if not for cryptocurrencies. Will this be the awakening event which will get the U.S. Government to regulate crypto? If so, how will that affect their market prices?

The hacker group blamed for this weekend’s ransomware attack on the Colonial petroleum pipeline has insisted it only wanted to make money and regretted “creating problems for society”.

In a statement posted on Monday, the criminal group known as DarkSide said it was “apolitical” and attempted to deflect blame for the attack on to “partners” that had used its ransomware technology.

The hack has taken a key US oil pipeline offline for three days, threatening to drive up fuel prices and forcing the US government to bring in emergency powers to keep supplies flowing.

“Our goal is to make money, and not creating problems for society,” DarkSide said, adding that it would “check each company that our partners want to encrypt to avoid social consequences in the future.”

Ransomware attacks involve hackers taking control of an organization’s data or software systems, locking out the owners using encryption until a payment is made.

(FinancialTimes)

And finally…

I would like to congratulate the Hamilton Lane Cobalt LP team on being named to the Drexel LeBow Analytics 50 list. Presented by the Center for Business Analytics at Drexel University’s LeBow College of Business, the initiative connects academia and industry, highlights best practices and applauds data-driven business impact.

(Hamilton Lane)


Disclosure

The information presented here is for informational purposes only, and this document is not to be construed as an offer to sell, or the solicitation of an offer to buy, securities. Some investments are not suitable for all investors, and there can be no assurance that any investment strategy will be successful. The hyperlinks included in this message provide direct access to other Internet resources, including Web sites. While we believe this information to be from reliable sources, Hamilton Lane is not responsible for the accuracy or content of information contained in these sites. Although we make every effort to ensure these links are accurate, up to date and relevant, we cannot take responsibility for pages maintained by external providers. The views expressed by these external providers on their own Web pages or on external sites they link to are not necessarily those of Hamilton Lane.

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