Respect the Rotation in Equity Markets

As the U.S. economy continues to reopen and pick up steam, we have seen a notable rotation in the market. Late last year and into the second quarter, investors were favoring value stocks to gain exposure to economically sensitive sectors. In the last couple of weeks, however, we have witnessed massive movements under the surface of the market, back to growth.

As we head into the second half of the year, Federal Reserve Chairman Jerome Powell is taking a balanced tone when it comes to inflation. As the economy strengthens, the Fed now sees inflation hitting 3.4% this year, significantly above its previous target of 2.4%. The Fed has insinuated that inflation is transitory, but in my view, since the bulk of inflation is wages, it is not all transitory and will continue to climb. I expect a tapering announcement at the August Jackson Hole Fed meeting, or in the fall.

The Fed also signaled that it expects to raise interest rates in 2023, but based on the data we're seeing, that increase could come as early as mid-2022.

Inflation Is Creeping Up, Particularly Wages

We've seen several economic indicators to support this, including the recent Philly Fed Manufacturing Prices Paid Index, which hit a level not seen since 1979 — currently 80.70, up from 76.80 last month and up from 11.10 one year ago. Other signs of inflation rising faster than expected are the U.S. consumer price index, which rose 5% year-over-year, the fastest pace since August 2008, and the producer price index, up 6.6% year-over-year and the largest annual increase on record.

Employment, meanwhile, continues to recover. The May non-farm payroll number was up, increasing by 559,000; the unemployment rate fell to 5.8% from 6.1%. Notably, the wage inflation indicator in the report showed that in 11 of the last 12 months, average hourly earnings have risen, according to a Marion Capital analysis of Bureau of Labor Statistics data.

The Job Openings and Labor Turnover Survey (JOLTS), which tracks data on job openings, hires and separations, showed that job openings hit a record 9.3 million in April. With many enterprises struggling to attract staff, we will likely continue to see upward pressure on wages to fill those job openings.

With above-trendline growth, I see inflation being persistent. The Fed will methodically and purposefully address this by slowing its bond purchases, and this tapering will keep markets calm ahead of a likely rate increase.

Market Rotation Underway: Adjusting Portfolios

With consumers venturing out and resuming their demand for services, the Institute for Supply Management Services PMI registered 64% in May — a 1.3-percentage point increase versus the April number of 62.7% — with year-on-year growth for the 12th consecutive month.

We are still looking at significant pent-up demand: The consumer savings rate was last recorded at 14.9% in April. Compare this with a historical rate in "normal" times of just 5%, and you have a recipe for robust spending moving forward.

The renewed demand for services — such as restaurants, hair salons, flights and hotels — is an exciting theme, as services represent a larger portion of the economy than consumer goods. We can expect strong Q2 earnings growth, which is why I'm seeking exposure to these themes in my portfolio.

Looking at specific rotations, the financial, technology and communication sectors are up, while industrials, metals/mining and materials have seen a notable pause.

For now, I'm looking at a little more growth than value, while maintaining a barbell. While I have no major changes to my portfolio on the margin, I've been adjusting in line with recent economic indicators, and taking profits where I can, such as cyclicals and economically sensitive stocks. I've been trimming some industrial and materials companies, while looking for names that have been lagging in technology.

I'm pairing reopening names with secular growers, while steering clear of high-multiple stocks — and always on the lookout for businesses with stable cash flow and good operating leverage.

Financials are particularly interesting right now, ahead of the Fed's next Comprehensive Capital Analysis and Review. In the next CCAR report, we can expect to hear that financials are flush with cash — making them attractive buys with potential for returns in the coming months.

To keep the markets on a positive trajectory, the Fed appears ready to address inflation pressures in a slow and steady fashion, with a goal of getting us to a "Goldilocks economy" of steady economic growth. Bond yields are artificially low right now, but the imminent tapering, combined with continued economic growth and transitory inflation, are the right mix for risk assets.

There's still a significant amount of stimulus in the system, which puts us at a crossroads. Investors should respect the change of tone in the market: Now is the time to trim a few winners and look for bargains. And given the recent volatility and rotational shifts, we may have a shot at doing so.