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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. This has led to profit-taking activities for the best performer for the month, the Nasdaq 100, which recorded a minor loss of -0.12% and saw a rotation into the more cyclical-oriented underperformers of the past three weeks.

The Dow Jones Industrial Average gained +0.61% in yesterday US session, the best among the major US stock indices. Overall, the technology-heavy Nasdaq 100 ended June with stellar results; its monthly and Q2 return stands out at 6.6% (the best monthly performance since November 2020) and 11.2% respectively. This surpasses the performances of the S&P 500, Russell 2000, and especially the cyclical Dow Jones, which recorded a monthly loss of -0.21% and a smaller gain of +4.61% for Q2.

The recent outperformance of technology stocks in the past four weeks, using the Nasdaq as a proxy, has occurred against the backdrop of a higher global inflationary environment. This has led to the US Federal Reserve signalling 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 see 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 stocks, which requires relatively more debt or leverage to drive revenue growth.

As a result, a conundrum has risen over doubts about the recent outperformance of technology stocks over its cyclical peers, as a hawkish Fed looks 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 downwards since it hit an eight-year high of 2.54% in early May, to end June at 2.32%. This current downward trajectory of inflation expectations suggests that the Fed's recent hawkish signal has started to tone down expectations, coupled with a resurgence of Covid-19 cases from a more infectious Delta strain, which is likely to put a dent on optimism on the reflationary/global economy reopening theme play. Based on such scenarios, the tapering of the Fed’s quantitative easing programme at a monthly purchase of $120bn and the first interest-rate hike may not come so soon as feared initially, which in turn tends to benefit technology growth-oriented stocks.

A second factor is momentum and quantitative-driven trading strategies deployed by fund houses to beat market benchmarks. Based on intermarket and correlation analysis, the outperformance of cyclical/value sectors (energy industrials, financials and 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 2-year treasury note. The uptrend of the rising yield spread started to reverse in late March, which led to the start of the underperformance of cyclical stocks, while technology stocks started to take the driving seat. So it's likely that such trading strategies can lead to short-term tactical portfolio adjustments and underweight cyclicals and overweight technology-related stocks (IT, communication services and semiconductors) with the possibility for a return on investment. Such trading strategies can also lead to significant fund flows, which in turn create a pronounced feedback loop into the market, where momentum breeds further momentum.

The lull of the summer months in Q3 may not be so quiet after all in the financial markets.

US 10-year breakeven inflation rate

Source: Federal Reserve Bank of St Louis

US 10 Treasury 10-year vs 2-year spread

Source: TradingView

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