So much has transpired since a year ago, it is as if someone pressed fast forward on the remote control of life. It was only a year ago that the first wave of the pandemic was building, California became the first state to issue a stay-at-home order and financial markets were engulfed in a historic crash. Fund managers were busy raising cash in anticipation of a highly uncertain economic environment and a second COVID wave was cited as the biggest risk to future market recovery.
It is incredible that a year later, there are several safe and highly effective vaccines, 113 million doses already administered, and the biggest risk fund managers see now is that of inflation, brought on by the quick pace of the recovery and policy responses to jump start the economy.
Recent economic releases from regional Fed districts lend some support to the higher inflation case. Businesses are reporting supply chain bottlenecks and production cost increases, as winter storms and port delays disrupted a logistics network not yet recovered from the pandemic lockdowns. And in the latest NFIB survey, 25% of small business reported that they are raising prices- the highest number in seven years.
Fueling the inflationary concerns is the continuing easy monetary policy from the Fed. During this week’s press conference, Powell was clear that the Fed views any inflation increase this year as transitory, and that monetary policy will continue to be accommodative until we make “substantial further progress” towards maximum employment and sustained inflation of 2%. And, despite boosting this year’s forecast for GDP growth and inflation, the long-term outlook was not changed, so money will be plentiful and flowing.
Inflation is kryptonite for bond investors and the latest $1.9 trillion stimulus added fuel to the fire. The bond market is not waiting for the Fed to make up its mind. Interest rates have been on a slow climb since the summer, but the move higher accelerated this year, with the yield on a 10-year Treasury bond climbing to 1.75%. Long-dated Treasuries are down 15% year to date, wiping out eight years of income in the span of a few weeks.
The toll from rising bond yields is spilling over into the equity market, with growth equities feeling the brunt of the adjustment, as future earnings are discounted at a higher rate. The Nasdaq 100 is now negative for the year. Granted, after a 48% move last year, an 8% decline is not exactly a devastating result, but the move is notable as other equity indices with less exposure to growth sectors are positive for the year.
While higher interest rates typically decrease the market multiple, it is not a given that the market will decline. Earnings matter as well. As vaccines continue to ramp up and COVID numbers improve, the continuing economic reopening will lead to a recovery in travel, entertainment, hospitality, and a boost in consumption, driving S&P earnings higher.
For most newbies, there is nothing like experiencing the euphoria of greed and the despair of fear firsthand to get an appreciation for how the market works. No textbook or a YouTube tutorial can teach you about your own behavior during those critical moments, that make us self-aware as investors. Trading is like tequila. You hear cautionary tales from your friends, but until you have that ONE NIGHT with it in college, you won’t learn the lesson. And it is better to learn the lesson in your 20s than in your 50s, when you have a lot more to lose.
There is pent-up demand to shop and travel and plenty of consumer savings to support it, even before the $1,400 checks are sent out. Household net worth, relative to disposable income, has never been higher.
Rates are likely to drift higher, putting pressure on valuation of the high-flying growth stocks. But, value stocks and cyclical sectors will assume the leadership position and pick up the slack as their earnings rebound. Higher rates don’t spell doom for the equity market.
Enjoy your weekend.
Alexander Bass CFA, CFP®
Chief Investment Officer
1) BofA Global Research
2) Federal Reserve Bank of St. Louis