Jay Powell, chairman of the Federal Open Market Committee (FOMC), appears to have a particular affinity to the word “transitory.” In May of 2019 after a two-day FOMC meeting, he had described the low inflation numbers as transitory. This was after the FOMC had stubbornly stuck to its disastrous tightening stance which led to the steepest Christmas eve equity market selloff in December 2018. Markets had been expecting rate cut indications from the FOMC before the May 2019 meeting and so the transitory description led to another selloff. As it turned out, the FOMC eventually reversed that policy in the wake of Covid-19 in early 2020 and commenced one of the most aggressive easing of monetary policies in its history.
Against that historical context, the FOMC’s April 2021 meeting statement was quite notable because the word transitory appeared once again. This time, however, the committee appears to have a high degree of conviction on the opposite side of the inflation expectations. It attributed the recent rise in inflation numbers to “transitory factors.” We wish Chairman Powell well with his latest prognostication because he is unlikely to get any slack from market participants if it were to go wrong. Markets haven’t forgotten December 2018.
On the larger question of inflation, the chart above clearly shows that it is on the rise. So, is it transitory? The problem with that question is the subjective timeframe involved to define transitory. Are we looking at one month, 6 months, 12 months, or longer? Any of those timeframes could be considered transitory because eventually inflation will likely come down given our assumption that the U.S. still has a functioning economic system with an independent central bank. In other words, the Federal Reserve (FED) could wait out this inflation surge and eventually claim victory. For us, more important than the timeframe, is how the FED will respond to increasing demands for actions. Will it have the fortitude to remain patient and test the sustainability of inflationary pressures or will external pressures to act overwhelm their preferred stance?
We are in the camp that believes external pressures will force the FED to act even though their preference would be to wait and let inflation run hot for a while. With numbers already reaching levels not seen since the financial crisis, we suspect that pressure from media and politicians, who are always obliging to amplify even marginal concerns, will probably force the FED to tighten monetary policy much earlier than what they are planning for. Unfortunately, the independent character of the FED will likely not be of much relevance as FOMC members will likely crack under intense public pressure.
We think Chairman Powell’s stance of current inflation uptick being transitory will be reversed … again!
Performance Review
Growth strategy
OppoQuest's GROWTH (GROW) strategy continued its strong performance against its benchmark despite recording the highest margin of outperformance in just the preceding 6-month period which, in turn, was the best outperformance margin since inception. This period’s outperformance (+7.13%) was primarily driven again by Financials and Technology positions while Healthcare again detracted. The top contributor was Wells Fargo (WFC) as the bank finally delivered on the potential for margin expansion by controlling costs and growing its loan book. The rise in interest rate and the steepening of the curve also helped the sector in general. We think there is more upside to come for WFC as we expect the valuation discount to its peers to fade and eventually regain the premium valuation that it had historically enjoyed. ROKU was a close second contributor as it resumed a stunning run that began in early 2020.
Oil services position (XES) was GROW’s main performance detractor as the sector cooled off late in the half after a strong run on the back of higher crude oil prices. We think this pullback is temporary and expect oil equities to resume their upward trend as oil & gas demand is recovering quickly fueled by economic reopening globally. Healthcare names NVS and GSK were the other notable detractors as defensive ideas lagged cyclicals.
Moderate Strategy
OppoQuest's Moderate strategy (MODR) also outperformed significantly (+14.13%) with the margin actually increasing from the previous 6-month period. Financials contributed positively and outdistanced all other sectors by a mile while Healthcare again detracted.
WFC was the top contributor in this strategy as well and the color provided earlier is applicable here too. One additional point would be that WFC is a larger position in the MODERATE strategy compared to GROWTH and so the impact obviously is also larger.
Like in the GROWTH strategy, XES, NVS and GSK were the biggest drag in the MODR strategy too.
Conservative Strategy
OppoQuest’s CONSERVATIVE strategy (CNSR) also continued its sharp rebound and outperformed by 8.63%. Financials, Transports, and Energy sectors contributed positively and notably, there were no meaningful negative contributions from any other sectors.
Global X Energy Infrastructure Fund (MLPX) was the top positive contributor for this strategy as the fund rose by around 37% in the half. West Texas Intermediate (WTI) crude oil prices surged ~55% during the period and drove all energy related names higher including midstream equities. Although the rise in oil prices seems steep numerically, they are coming off a very low base and hence we think there is more upside coming.
Outlook
As indicated in our last update, we had built ~ 50% cash in all strategies and were waiting patiently to start deploying that cash when opportunities arouse. We found the first of those opportunities in the month of March when the Nasdaq index which is more representative of the Technology sector pulled back by ~7%. Our caution on Technology earlier was based on expectations that interest rates would rise and Tech stocks with long duration cash flows would decline disproportionately. Also indicated in earlier updates, was our inclination to add to the Tech sector at lower valuations given its secular growth outlook and highly defensible business characteristic with global reach.
So, we were not surprised by the March pullback on rising rates and, as telegraphed, we did add some Tech exposure during that pullback. However, we were surprised by the quick turnaround in markets although some of it can be explained by intertest rates backing off notably in the 2Q21. By the end of 1H21, Nasdaq index was actually higher than its all-time Feb’21 high. With the benefit of hindsight, of course, we probably should have been more aggressive in adding to risk. That said, maintaining our discipline is very important to us which includes not chasing ideas that run away from our identified buy levels. Opportunities will show up again because inflation concerns will likely linger a bit longer until markets get more clarity on the scope and cost of pending federal spending plans (i.e., Build Back Better).
We remain constructive on the overall market even as we continue to believe that the Tech sector remains vulnerable to higher interest rate expectations. While the 10Y Treasury yield did move up substantially (+83 bps) in the 1Q21, it retraced a big chunk (-30 bps) of it in the 2Q21. Nevertheless, the absolute level still remains quite low at 1.44% and supportive of economic activity. The other factor that keeps our outlook positive is the reopening trajectory of the global economy. Although the Delta variant of the covid-19 virus has emerged recently and has heightened concerns of lockdowns, we don’t think most countries will resort to the types of restrictions imposed last year. Our expectations are that authorities will be more measured and nuanced.
Currently, we retain healthy cash levels (~ 40%) in all our strategies and await the next opportunity. Inflation, FED, and Interest rates are all at crossroads and likely to instigate multiple rounds of volatility. We intend to fully capitalize on them by adding risk…thoughtfully and incrementally!
For OPPOQUEST
PARESH JAIN
Founder & Portfolio Manager
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