Will tech be the defensive play for Q3?
The US stock market has ended on an upbeat tone in general for the month-end of June and Q2 2021 amid some portfolio rebalancing adjustments that led to profit-taking activities for the best performer for the month, Nasdaq 100 to record a minor loss of -0.12% and a rotation into the more cyclical oriented underperformer in the past three weeks, the Dow Jones Industrial Average that recorded a gain of +0.61% in yesterday US session, the best among the major US stock indices. Overall, the technology heavily weighted Nasdaq 100 ended June and Q2 with stellar results; its monthly and Q2 returns stands out at 6.6% (the best monthly performance since November 2020) and 11.2% respectively that surpassed the performances of the rest; the S&P 500, Russell 2000, especially the cyclical Dow Jones that recorded a monthly loss of -0.21% and a smaller gain of +4.61% for Q2. On the contrary, the recent outperformance of technology stocks in the past four weeks, using Nasdaq 100 as a proxy has occurred on a backdrop of a higher global inflationary environment that has led to the US central bank, the Fed to signal a hawkish guidance in its latest FOMC meeting on 16 June via its dot plot of future interest rate projections. A significant number of Fed officials have brought forward the start of the interest rate hike cycle to 2023 from 2024 and sees at least two hikes before 2023 ends. A reduction in monetary policy support coupled with a higher interest rate environment tends to impact negatively on the bottom lines of technology firms in general as they are considered growth oriented which requires relatively more debt or leverage to drive revenue growth. Hence, a conundrum has arisen on the possibility and doubts on the recent outperformance of technology stocks over its cyclical peers considering a hawkish Fed to combat the risk of heightened inflationary pressures. A likely humble answer can be found from a psychological and technical analysis perspective where related tradable financial instruments move in cycles of behavioural trends from optimism to pessimism and vice versa. Firstly, the US 10-year breakeven inflation rate, a gauge of inflationary expectations in the next 10 years on average derived from the 10-year Treasury inflation-indexed bonds has continued to drift down wards since it hit a 8-year high of 2.54% in early May to end June at 2.32%. This current downward trajectory of inflation expectations suggest possibly that the recent hawkish signal from Fed has started to tone down expectations coupled with the resurgence of Covid-19 infection cases from a more infectious Delta strain that is likely to put a dent on the optimism on the reflationary/global economy re-opening theme play. Thus, based on such scenarios, the tapering on the current pace of Feds quantitative easing programme at a monthly purchase of $120 billion and the first interest rate hike may not come so soon as feared initially which in turn tends to benefit technology growth oriented stocks. Secondly, momentum and quantitative driven trading strategies deployed by fund houses in seek of alpha to beat market benchmarks. Based on intermarket and correlation analysis, the outperformance of cyclical/value (Energy, Industrials, Financials, Industrials) in Q1 and the first half of Q2 has been positively correlated with a rising yield spread between the US 10-year Treasury over its shorter-dated in 2-year. The uptrend of the rising yield spread has started to reverse in late March which led to the start of the underperformance of cyclical stocks while technology stocks started to take the driver seat. Hence, it is likely that such trading strategies can led to short-term tactical portfolio adjustments; underweight cyclicals and overweight technology related stocks (Information Technology, Communication Services, Semiconductors) with the possibility to obtain alpha. Also, such trading strategies can also lead to significant fund flows which in turn create a pronounced feedback loop into the market; momentum breeds further momentum. Overall, the lull summer months of Q3 may not be so quiet after all, at least in the financial markets. US 10-year breakeven inflation rate    click to enlarge chart  Source: Federal Reserve Bank of St. Louis  US 10 Treasury 10 year-2-year spread  Source: TradingView