Last week is one most Americans will never forget. But you wouldn’t be able to tell by the behavior of the stock market. Despite the historic events, stocks climbed to new record highs. As incongruous as that might seem, the activity in financial markets punctuates the point I make so often that stocks are a function of earnings and interest rates.
Despite the unnerving news cycle, stocks continue to react to added fiscal stimulus, negative real interest rates, and a favorable earnings outlook going into 2021. Even Friday’s disappointing December employment report couldn’t unnerve investors. They view the report as a temporary slump. The belief is that the benefits of new stimulus and wider distribution of Covid-19 vaccines will start to be reflected in employment data early in 2021. In addition, weak employment numbers and continued high weekly unemployment claims put downward pressure on wages. This helps to keep inflation at bay.
2021 is going to be a clash between a tailwind of robust earnings growth and a headwind of rising rates. Real rates, nominal rates less the impact of inflation, are what matter most. With 10-year Treasury yields still hovering near 1% and inflation staying within a 1.5-2.0% range, real rates remain negative. Even the move up in long rates recently, about 15 basis points, isn’t enough to drive investors toward bond purchases. Over time, as the economy gathers steam in a post-pandemic world, rates could rise to the point where real returns can be generated in the bond market. At that point the clash between higher earnings and real returns available from bonds will start to tip the scales away from equities.
The obvious question is when might this happen? Consensus expectations still have bond yields sporting negative returns throughout 2021 and even into 2022. But consensus is rarely right. The Fed continues to pour money into financial markets, buying bonds at a pace of over $100 billion per month. It shows no signs of abating. Friday’s weak employment report certainly won’t be a catalyst to slow down the easy money pace.
One issue is how fast Americans can get vaccinated. So far, the pace has been disappointingly slow. Bureaucracy and lack of leadership at the Federal level are contributing factors. President-elect Biden promises to accelerate the distribution of stockpiles. When all is said and done, most Americans who choose to get vaccinated should be able to do so before the end of the second quarter. Combined with normal seasonal declines in the infection rate as the weather turns warmer, it is logical to expect meaningful improvement before summer arrives. The extent to which that timetable can be sped up (or delayed) will have an impact on the pace of economic recovery.
Markets will react to the pace of recovery. If it becomes stronger than currently expected, watch bond yields. If they reflect concerns of growing too fast and igniting inflation fears, stocks will pause. But as we saw last week, a modest increase in rates, still leaving real rates distinctly negative, won’t start a significant correction. It will only be when the rise of rates accelerates to an uncomfortable pace that equity investors will take serious note.
With rates sharply negative today, the pressure right now is fairly minimal. As growth accelerates and 10-year rates rise toward 1.5% and beyond, the concerns will rise. That is why I expect the first half of 2021 to be better for equities than the second half. That doesn’t mean I expect a surge in inflation before the end of this year. We have all been watching for the return of inflation for over a decade and it hasn’t happened. It may not happen this year or even next. But then again, if the pandemic fades quickly in the second half of 2021, job growth returns, and animal spirits are unleashed, inflation could return quicker than consensus now expects.
That is a lot of ifs and coulds. Predictions and timing are never precise. That’s what makes predicting markets so difficult. The good news is that the earnings outlook is quite good, barring unforeseen events that carry enormous economic consequences. Recession seems far off. Barring runaway inflation, a very small risk today, the overall outlook is still pretty good. Brief bursts in rates or unforeseen events may be temporarily disruptive. But for now, the wind is at our backs. If there is one date to watch for investors, it is January 27, the end of a two-day FOMC meeting. If the Fed discusses slowing the pace of bond purchases, or otherwise hints at any form of tightening, stocks could correct. After all, there hasn’t been any correction since last March. I am not expecting any major change, as the Fed normally telegraphs change early. This meeting will be only 7 days into Biden’s term of office, not an ideal time to take the foot off the accelerator. Thus, I don’t expect change, but simply note that the meeting is worth noting and watching.
Today, singer Mary J. Blige is 50.
James M. Meyer, CFA 610-260-2220