New highs were reached, almost across the board, as the Nasdaq continues to break all-time records with the Dow Jones and S&P only a few points away after yesterday’s session. Most large-cap companies have reported earnings over the past few weeks with retailers the last to come. Nearly 90% of them have beaten estimates and by an average of 15%+. Both metrics are handily above a typical quarter and to be expected with such a rapid recovery relative to last year’s global shutdown.
However, guidance is a tad more cautious than expected with the Delta variant throwing some curveballs at management teams. All in all, it was a really solid first half. Stock prices are certainly reflecting that, leading the S&P 500 to an 18% return already in 2021. History would say this party continues, but we’re not in a period like any other so some caution is warranted with peaking growth, unemployment checks ending and a possibility of higher taxes going forward.
Gains are mostly attributed to an earnings rebound, but one can’t help but believe lower interest rates continue to allow higher than normal P/E’s. Not to mention massive stimulus, flush consumer pocketbooks and easy lending conditions. Low rates are also pushing investors up the risk spectrum with money flows into equity ETF’s handily ahead of last year’s record inflow:
As Jim Meyer has noted, interest rates are a massive wild card for equity valuations. Explosive bond purchases by central banks around the globe helped soak up trillions in stimulus since last March. The 10-year Treasury bottomed at 0.40%. Turning the page to 2021 we had vaccines, reopenings, more checks mailed out and corporate profits bouncing back to 2019 levels, leading to the 10-year Treasury touching 1.76% in March. What to do from here? Let me play devil’s advocate with Jim Meyer as I make the case that rates are staying lower for longer, albeit maybe not the 1.20% level we see today.
Take a step back to 2008, which is really the only other period to which we can compare this. Back then, the Fed started this never-ending road called Quantitative Easing (QE). They purchased ~$4 Trillion in Government debt over a 6-year period (we did this same amount in 3 months last year). Most of the 2008 – 2012 purchases were concentrated in longer-term securities before Operation Twist really ramped up buying on the long-end. Below are their holdings by maturity. You can see the 10-year categories explode higher and were 80% of their total holdings, or over $3T by 2013. That Fed was intent on lowering borrowing costs to promote lending. This makes sense after a credit bubble collapses, at least from an economic policy standpoint.
What’s clear today is that the Fed is now purchasing a broader range of maturities. While they rotated T-Bills into long-term bonds in 2011, today nearly 70% of new purchases are under 7 years, with 35% of new purchases happening in the under 2-year range. Only 25% of new buying is going into 10 year or longer bonds. In round numbers, of the $80B in monthly Treasury purchases only $20B goes towards the long end of the curve. This amount of stimulus is substantially lower than a decade ago with respect to controlling the long-end of the yield curve relative to supply (supply is 3X that of 2011 levels). Even though the balance sheet has tripled, the dollar amount of 10-year Treasuries on hand is similar to 2014.
Here is the Fed’s balance sheet history:
Therefore, one can conclude that this recent collapse from 1.76% in March down to 1.20% today is tied to an expected growth slowdown, inflation peaking and global demand for income (10-year rates in Europe are mostly negative). The Fed has not impacted the long-end as much as one might think over the past few months, albeit the impact is not zero either. They aren’t purchasing as much from a dollar or percentage standpoint and there is less supply coming than in prior QE’s.
Next, on to Taper Tantrum concerns. We’ll take another look at our only case study which happened in 2013. Recall, “taper” basically means a slowdown in the rate of new bond purchases from the Fed. This does not change the overall size of its balance sheet as maturities are still reinvested. Chairman Bernanke surprised everyone when noting a potential for slowing down bond purchases in May of 2013. Markets threw a fit and interest rates jumped from 2% – 3% in just 5 months. Our economy still grew 2.6% in 2013, slightly better than the normal rate over the last decade.
Tapering didn’t actually start until a few months later as the pace of asset purchases dropped by $10B on a monthly basis from a starting point of $85B. Expect something similar this time around as well, a gradual easing of new purchases. Nine months later and that asset purchase program finally hit zero. In spite of a massive buyer leaving the market, 10-year interest rates only declined from 3.0% to 1.9%. It wasn’t until the Fed actively started to shrink their balance sheet in October 2017 (let maturities roll off instead of reinvesting) that rates moved back to 3.25%, a whole 4 years later. Fears of exploding rates any time soon looks to be years away given this comparison.
This time, the Fed took a broad-based approach to purchases, hitting every maturity level, instead of concentrating on the 10-year. On a monthly basis, they are only purchasing ~$1B in 10-year notes. Gradually lowering that shouldn’t have too much real effect. Every Treasury auction ends with about 2 times as many buy orders than supply given. Further, the last taper actually caused investors to shift out of stocks and into bonds. When monetary and fiscal conditions tighten, which tapering would accomplish, growth rates slow and pricing power, i.e. inflation, declines. An investor’s risk/reward calculation could lead to more fixed income purchases instead of overvalued equities with a headwind of tighter standards.
Lastly, the size of the Fed’s balance sheet is nearly 3X pre-pandemic levels, with $5.3T in Treasuries, which is still expanding. They own 20%+ of all outstanding Treasury bonds and have over $1.2T in maturities next year alone. Until they actually reduce reinvesting maturities, they are buying 3X the supply coming to market, as prior periods. That supply is also peaking. Gone are stimulus checks and extended unemployment. After this infrastructure bill and the Democrats’ wish list bill, there is unlikely to be much desire for more spending (if they even get that approved). As GDP rises, Government receipts rise as well. We’re unlikely to have $4T deficits as we exit 2023. Couple this all together and you have a massive buyer, less supply and increased institutional/international demand.
That does not mean we stay at 1.2% on the 10-year. My main point is that we’re unlikely to get back towards 3% for a few years, if not several. What this also means is that equities can maintain elevated P/E’s over the coming years. Companies with solid growth prospects, not reliant upon stimulus measures or higher interest rates, should continue to lead.
Those starved for income may not get a chance in bond land until later this decade. Allocations towards preferred stocks, growing dividend payers or slow growth, stable sectors like Utilities, Consumer Staples or Telecommunications might make more sense than waiting for higher interest rates. However, risk tolerance comes first! These are all much more volatile asset classes than bonds. It is going to be a tough road ahead if one focuses on income instead of total return.
Soleil Moon Frye, probably more commonly known as Punky Brewster, turns 45 today.
James Vogt, 610-260-2214