Summary

– We are making a significant reversal concerning the direction of Interest Rates.

– Importantly, we are not changing any of our sector calls. We are still OW FAANG and N Financials.

The healthcare situation may continue to deteriorate, but we continue to see strong protection from vaccines and continue to believe lockdowns will be an increasingly less-common policy response to COVID-19.

– Our strategy and favorites remain the same. Epicenter is solid, Energy is our favorite sector and we think FAANG recovers in July and should do well in spite of the transitory headwinds we anticipate.

Stocks closed up quite nicely today after enduring a tough week. This is not evident from looking at the indices, but there was a lot of turmoil. There has been a breadth deterioration. We’ve observed that only three sectors appear to still be in uptrends. Energy, FAANG and Technology are still in uptrend, whereas everything else looks like it is either consolidating or in a downtrend.

Delta Variant Growth Scare Likely Near Peak, Epicenter Likely To Lead If Rates Rise

We sent out an INTRADAY FLASH (please check inbox) about the most important reversals we see: the possible bottoming of US 10-year at 1.25%, touching 200D. The fact that the VIX performed weak yesterday compared to other scares and keeps making lower successive highs is also a major ‘risk-on’ element we see developing in markets. Thus, if these two conditions are correct, it would be appropriate to expect some major shifts in sector leadership. Specifically:

– S&P 500 might not fall to 4,100 as this might just be another rolling correction
– US 10-year will start drifting higher, possibly back to 1.75%
– Epicenter stocks will rally strongly, as they are the most sensitive to rising rates

Where Could We Be Wrong?

The natural question is where could we be wrong? If the 10-YR falls significantly below 1.25% we will reassess our position and similarly if the VIX were to eclipse its previous recent high of $22, we might also re-evaluate. So far, those outcomes appear like they might be avoided in the near-term.

Three main factors drive our change in view on interest rates versus the consensus. We don’t explicitly forecast rates. However, logically, there are three components of affecting interest rate change. The first is GDP growth expectations and if they are lower than consensus rates move to the downside. We think market will see growth potential and rates rise. Inflation expectations are also a major source for changes in rates. We at FSInsight now see them as relatively flat in the near-term relative to consensus. The other area that effect rates is the interest rate “risk premia” which we also think will be flatter than consensus since the FOMC removed key tailrisks.

ENERGY: Energy stocks undershooting Oil, which we see as a bullish divergence
Increasingly, the chorus of Energy bears has risen in recent weeks. The price declines have certainly added to the negativity (price dictates sentiment much of the time).  

That said, Energy remains our highest conviction sector. Here are some of our high level thoughts:
– Energy stocks ( XLE 1.08%  ETF as a proxy) is in an uptrend
– Oil curve has moved up sharply since January from $8 to $15 across all maturities = bullish
– Oil services companies like  SLB -0.16%  are showing tremendous operating leverage = good for equities
– Oil services revs are “exponential” versus rise in oil prices = upside to 2022 forecasts
– Energy stocks diverged from oil in past week, oil basically flattish while Energy stocks down big
– This is even more true since 2019, Oil +14% while Energy stocks down -14%

. ..Oil prices have risen across the curve since start of year = it’s not “temporary”
Also look at oil futures across all maturities through 2031, or 10 years ahead.
– since start of year, the prices have moved up +$8 to +$15 across the curve
– supply will get even tighter into 2022 as the $300 billion in shortfall in capex past 24 months robs future production capacity

Delta Variant Growth Scare Likely Near Peak, Epicenter Likely To Lead If Rates Rise

…Oilfield Services revenues rise exponentially with a rise in oil prices
It is worth remembering that revenues for oilfield services companies rise exponentially with oil prices.  Take a look at  SLB -0.16%  and  BKR 1.24% , the two largest stocks in  OIH 0.32% .  As you can see, there is an exponential rise in revs.  There is a lag of course:
– but if WTI reaches mid-$80s
– revs will be far higher than consensus forecasts
– upside to stocks
…SLB and BKR are already generating higher EBITDA margins on lower revs
And evidence of the operating leverage is below as EBITDA margins are already set to exceed 2019 levels, even with lower revenues.  This is the operating leverage story seen time and again across many Epicenter industries:
– operating leverage
– plus topline surprise
= positive surprise for stocks

Last 5 days, energy stocks over-reacting downside versus moves in oil
The last 5 days, WTI has barely moved, down 3% versus a week ago.  Yet:
–  XLE 1.08%  is down 5%
–  OIH 0.32%  is down 9%
Overreaction? Yes, especially considering this came when interest rates were falling and thus, coming on the heels of a growth scare.  See our INTRADAY FLASH from Thursday to get full context why we think the growth scare might be ending.

Figure: Way forward What changes after COVID-19
Per Fundstrat

Delta Variant Growth Scare Likely Near Peak, Epicenter Likely To Lead If Rates Rise

Figure: Fundstrat Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019

Delta Variant Growth Scare Likely Near Peak, Epicenter Likely To Lead If Rates Rise

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