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Why this strategist warns against recent outperforming areas of the market

Yahoo Finance’s Brian Sozzi, Myles Udland, and Julie Hyman discuss U.S. inflation, economic outlook, and market trends with Michael Darda, MKM Partners Chief Economist & Market Strategist.

Video Transcript

JULIE HYMAN: Let's bring it to a macro strategist to talk about all of this as well and throw the CPI in there, too. Mike Darda is with us, MKM Partners Chief Economist, and macro strategist. Mike, it's always great to see you. Let's talk earnings first. I do want to get your view on CPI, but because we are talking about earnings and we are talking about how the momentum is going to be in the second half of the year, I do want to get your take on this and what your view is as to how sustainable some of the growth that we've seen can be.

MICHAEL DARDA: Absolutely. Thanks for having me. So I was listening to your discussion, and I think all of you brought up the relevant points.

The earnings cycle has been jaw dropping, historic, unprecedented. But it's also largely behind us, and the equity market largely reflects it, right? We've seen a boom in equity prices over the course of the last year plus, almost like we've never seen before, off of depressed levels. But that is also reflected in the current reality.

So I think the discussion going forward is, A, what is propping up equity prices? The earnings story for sure, high liquidity, and low discount rates. So the threats to the market going forward would be that one of those three legs of the stool ends up getting kicked out.

And that brings us into a discussion about inflation this morning. So we're seeing quite a bit of pressure on inflation but a lot of complacency that these numbers are going to be temporary and transitory.

- Michael, and to that point on inflation, look, we continue to talk about PepsiCo's earnings out this morning. They're now having to-- going to-- they're telling us they're going to be raising prices in the back half of this year. I would argue JP Morgan, Goldman Sachs also seeing inflation in their own right, specifically on the labor front. I mean, does the market just need to correct here? Does it need to pull back to reflect these inflation concerns being with us for a more prolonged period of time?

MICHAEL DARDA: I think if it plays out in that fashion, then I do think we're going to have some downward pressure on equity market valuations. If we think about what's taken place over the last few months as bond yields have moved down from their peak in late March, it's really the areas of the marketplace that are carrying the highest valuations that have been leading the charge upward. So we had a period where, you know, cyclical value was outperforming in small cap stocks, and that's reversed recently with this down trend in bond yields.

But if these inflationary pressures persist, and they don't have to persist at exactly the year over year growth rates we're seeing now. But just as we move into next year above trend growth, much tighter labor markets, and ongoing pressures on inflation persisting above what we were seeing in the last cycle, then I think there's-- there's upside risk to bond yield.

Certainly from where we are now, simply a run back to where we were in late March in the 170s, I think, would be a considerable threat to some of the growthier, high-valuation stocks that comprise a pretty significant share of US market cap for the S&P 500. So that is the dynamic I think we need to be thinking about here, given recent trends.

- And, you know, Mike, against that backdrop, let's say that does come to pass, right? I think you do a really good job in your most recent note, talking about how different the factors driving that move would be relative to what we saw '10, '11, '15. I'm just curious if you could maybe outline for us what that environment was, that post-crisis, Fed might tighten environment was versus today, where it's kind of the economy is so much better than expected. Perhaps we could see some of these inflationary impulses come in.

MICHAEL DARDA: Yeah. Absolutely. So if we think about the bond rallies that were occurring between, say, 2010 and in 2019, the bulk of the last cycle, sustained declines in Treasury yields were also associated with widening credit risk spreads. Not happening this time, quite the reverse. Big slump in-- big slumps in industrial metals prices, also not happening. They flattened out but they haven't slumped.

And so what we're seeing this time is that bond yields are falling, but it's being driven by real rates. Over 70% of the decline since late March has been driven by real rates, not inflation expectations falling. So that would all speak to a liquidity effect, pulling rates down.

We have some technical factors that are kind of complicated that also might be influencing and-- and exaggerating the recent move down in-- in yield. So it's not really a reason to-- to get nervous about the growth outlook, but it's also, I think, a warning in terms of being super conflation-- super complacent about the inflation outlook.

The average real rate on the 10 year Treasury yield during the last cycle was just above 0, but inflation expectations were below 2%. Today we have inflation expectations over a 10 year horizon at 230 basis points, so above where they were averaging for the last cycle, even though that's not a high number. But real rates are a minus 1% versus just above 0 on average. So it's really the real rate component that explains why bond yields are so low right now.

And I think you have to be pretty comfortable with the notion that that is going to be sustainable for an extended period of time if you're bullish on these super high-valuation pockets of the equity market that dominate the market cap of the S&P 500 in technology and consumer discretionary and parts of comm services. And so if the market's not asking these questions with current valuations, then I think we need to be asking the questions as strategists and journalists and analysts.

JULIE HYMAN: So-- so just quickly, then, Mike what's your conclusion, or what would be your answer to those questions? Are you still bullish on those high-valuation areas of the market that you're talking about? Or are you doing some inflation hedging here, or how are you-- how are you approaching all of this strategically?

MICHAEL DARDA: Yeah, I would be-- I would be hedged against those high-valuation positions that have been outperforming recently. I think there's too much complacency in the bond market. I think this recent move lower in yields over the last few months probably will reverse. I think next year the growth outlook is good, but with sustained above trend growth, even if the year over year growth rates are somewhat slower above trend growth, probably means inflation persistence.

So I like the cyclical value areas that have been underperforming recently that would tend to do better if inflation is persisting and market interest rates go back up. And I would warn against the areas that have recently been outperforming that carry quite high valuations. I think it is an incredibly dangerous place to be at the moment.

JULIE HYMAN: Very interesting stuff. Michael Darda, it's always good to get your perspective. Thank you. MKM Partners Chief Economist and macro strategist. Thanks, Mike. Be well.