CPLIX’s Grant Looks for Sustained Equity Gains…And Maybe a Correction or Two

Dubbing the theme of Thursday’s call “We haven’t come this far to just come this far,” Calamos Co-CIO Michael Grant, Senior Co-Portfolio Manager and Head of Long/Short Strategies, presented a positive outlook on the case for further upside in equities. Listen to call here.

“The uncertainty is clearing with the business cycle expanding and risks diminishing, with gains in the first half to be driven by a strong earnings cycle," he said.

Grant's positive outlook is notwithstanding his expectation of one 10% or greater correction sometime between February and April and possibly a second correction this year.

He outlined two risks for the market:

• The likelihood that investors are underestimating the eventual upside for interest rates. “The forthcoming battle at the frontier of yields [with 2% on 10-year Treasuries as the battle line] is the most significant market story of 2021,” he predicted.
• A second risk is that we are underestimating the potential for COVID to again “get out of control.” Grant called vaccination relief “the assumption that defines the year.”

Preemption to Replace Momentum

Calamos Phineus Long/Short Fund (CPLIX) returned 19.81% for the year, exceeding the 18.4% S&P 500 return—and despite an average net equity exposure during the year of only about 50%.

“A key factor in this outperformance,” Grant said, “was our preemptive move to shield clients from the historic disconnect between the safety/defensive/quality parts of the market on the one hand, and the beneficiaries of cyclical recovery on the other.”

Grant believes that preemption—which he described as “the antithesis of momentum investing”—will be decisive for return outcomes in the coming decade.

Momentum has worked for the last 10 years because the economic expansion has been slow and stable. “For momentum to work for investors, you have to be willing to say, 'I’m going to miss the first big part of the move because I believe that move will be sustained over time'…You have to believe that trend will persist.

“Our belief,” Grant explained, “is that if we do see more cyclicality in the economy and real interest rates do create reflation, that means everything will be moving a bit faster and with a bit more volatility. It will be much harder to play the momentum game because once the momentum emerges, by the time you buy it, there’s a real risk the momentum will get reversed. That’s why I argue we’re going to have to be much more preemptive in both buying and selling our positions versus the last decade.”

Grant structured his discussion around what he described as five central debates.

Will the Rally Continue?

According to Grant, drivers of the current market rally are:

• Vaccines and the assumption that the second half of the year will be a normal economy.
• The monetary and interest rate setting, including central bank commitment to a virtually unlimited amount of liquidity. “Equities are the only asset class that makes sense at this juncture,” according to Grant.

What’s more, he believes that the unprecedented fiscal and monetary policy shift will continue after the pandemic dissipates.  

Is the Dominance of Growth Stocks Ending?

The late March to May revival of cyclical and value faded from June through September. It was too early in the recovery, Grant said, and it wasn’t accompanied by any pickup in bond yields, nor by any improvement in cyclical earnings revisions.  

Since November, both pieces are now in place and the CPLIX team believes that the rotation to cyclical has legs. Grant cited several catalysts that support the rotation to cyclical opportunities.

“Last week, Fed Chair Powell noted that the FOMC will not raise rates until there is ‘troubling inflation,’ nor will it raise rates to ward off threats of inflation. Meanwhile, bond yields are grinding higher because wage growth and the velocity of money have bottomed. This backdrop amidst $2 trillion of fiscal stimulus is steepening yield curves.”

“Inflation expectations are rising, resulting in negligible increase in real interest rates as inflation breaks higher. This negative interest rate setting is the fundamental support for reflation and thus, the move in cyclicals,” he said.

Sentiment, Positioning and Bubbles

Acknowledging that investor positioning is stretched in the short term, Grant sees the potential for approximately $1 trillion of equity inflow this year. This alone could provide an important tailwind for cyclicals. Most portfolios are still heavily weighted to the traditional growth, quality and long duration sectors, he said.

He also believes that pension funds (“still overexposed to bonds”) and quant strategies will drive flows.

“We do not believe equities in general are in bubble territory,” said Grant. “Equities have suffered outflows for the past decade, for the past five years, for the past 18 months. If a bubble is the footprint of excess and unsustainable capital flows, we should be worried about bonds rather than equities.”

The Lasting Impact of the Pandemic: Monetary and Fiscal Profligacy

The pandemic has resuscitated the role of big government across many developed societies, resulting in a surrender to the impulse for higher public spending, higher debt levels and greater government interference in many walks of life. This may be the pandemic’s lasting effect, Grant believes.

An “overreliance” on monetary tools may be shifting to a new and unprecedented partnership between central banking and fiscal expansionism—a convergence Grant refers to as “monetary and fiscal profligacy.” It’s symbolized by the appointment of Janet Yellen as the new Treasury secretary, he added.

“Today’s race to spend without any consideration of the cost, without any coherent exit strategy is a policy of capitulation. It is a product of expediency and a confession of failure…What matters today—for the investment horizon that matters for your clients—are the conditions for a strong cyclical catch-up in economic activity through 2021 into 2022.

“These conditions are fermenting pricing pressures as the deflationary effects of the pandemic fade,” Grant continued. “In this respect, the behavior of the American consumer through this year will be decisive.”

Is There a Constraint On Policy Largesse in the U.S.?

“What happens to interest rates when the pandemic is perceived to be over? How do central banks react to the unleashing of pent-up demand?” Grant asked.

Prior to the pandemic, 10-year Treasury yields were 1.5% to 2% versus about 1% today. CPLIX’s equity targets assume a 10-year yield of 1.5%. As long as yields are rising in anticipation of better economic activity, the equity risk premium can move lower and equities can move higher because the downside tail risks are reduced, Grant said.

When the yield approaches the 2% level, however, the team’s models imply no valuation upside for the S&P 500.

Interest rate risk is what will eventually constrain the new policy regime in the U.S., Grant said.

“Financial markets rather than governments will eventually change the rules of the game…The investment regime is in transition, the controversy concerns its duration,” he said.

Negative interest rates imply more cyclicality, according to Grant. “Investors will need to preempt these moves because they will be sharper and shorter and reverse more quickly. Investors must be prepared for greater active allocation across sectors and styles in coming years.”

CPLIX Forecast and Positioning

The team’s base case calls for an S&P 500 price range of 4000 to 4400, with heightened risk beyond May. “The backdrop could remain constructive in the second half, but the market will have priced in a full recovery. In financial markets, it is invariably better to travel than arrive,” Grant said.

While 2020 was a year of managing beta, 2021 will be more about how much recovery has been priced across subindustries. He looks for equity upside to be dependent on earnings potential.

Summary of Portfolio Positioning:

• Cyclicals over defensives
• Less mega-cap exposure and a preference for companies that can exhibit strong operating leverage in an ongoing recovery. “We want to own stocks whose earnings over the coming year can rise more than the potential valuation compression in the major benchmarks,” Grant said.
• The focus will be on companies that will generate earnings in 2022 that are comfortably above 2019 levels. “Many recovery stories will not meet this hurdle due to the lingering nature of the virus and due to capital raises that have diluted their earnings power,” he added.
• A continuation of the team’s long-held bias to U.S. versus non-U.S. “America has the greatest capacity to reflate,” said Grant.
• However, a broadening of the global recovery may see the balance shifting more in favor of non-U.S. equities. Expecting the Biden administration to calm nerves on the trade front, Grant named Financials and Energy as two factors that should perform well in 2021. They tend to have larger weightings in many emerging markets.
• For now, the “new politics of stimulus” will likely have more influence on financial markets than the recent political change in Washington.
• Continuing deep skepticism of the outlook for continental Europe. “The economic dynamism of the EU has been suffocated by the subsidization of incumbency and its monoculture of regulation and interventionism,” said Grant. “Europe’s real enemies are neither the pandemic nor Brexit, but poor governance and economic stagnation. Its hostility to shareholder governance will not die easily.”
• UK equities, however, offer “intriguing value.” Grant said, “The Brexit debate has distracted investors from what matters, which is that the virus has hit the country very hard, yet the British are about to enjoy the first fruit of leaving the EU. The UK is a leader in vaccine rollout and will likely be the first country to reach herd immunity.”

As positive as he is about a sustained cyclical upswing as the developed world returns to normal in the second half of the year, Grant ended his remarks with a caution.

This “bullish capitulation into equities” can continue to work for a time, Grant said, “but the fault lines of the past decade are beginning to fade. Investors should prepare for the sector and style turmoil that appears inevitable…The real problem for equities will emerge when the pandemic passes and the debate over how to withdraw all of this stimulus begins. The world beyond the pandemic will not be a return to the prior status quo.”

Investment professionals, for more information about Grant’s perspective or CPLIX, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.