Stocks rose sharply on Friday, largely erasing the large losses experienced Thursday as the yield on 10-year Treasuries fell to as low as 1.25% in early morning hours. While the media tried to explain the sharp drop in yields via fundamental factors such as economic weakness or the spread of the Delta variant of Covid-19, the volatility in the bond market last week probably was far more impacted by technical factors and short covering. When too many leveraged traders are on one side of a trade and fundamentals go the other way, you get the sort of violent reaction we saw in the bond market late last week.
Excluding a collapse in yields during the early panic stages of the pandemic, the yield on 10-year Treasuries has stayed between 1.25% and 3.25% since the end of the Great Recession in 2009. When Fed intervention was strongest, yields tended toward the lower end of that range. When the Fed backed away, let interest rates rise, and started to reduce the size of its balance sheet, the higher end of the range came into play.
That brings me to the focus of this morning’s note. Transition. Markets tend to behave best when uncertainty is low. Almost by definition, transition brings uncertainty. Right now, we face three stages of transition.
1. Economic Growth – Second quarter earnings season is about to begin. Overall, corporate profits are expected to rise 50% or more from a year ago when much of our economy was curtailed or shut down completely. Undoubtedly, this past quarter will be the peak growth period for corporate earnings. That is not to say that earnings going forward will be disappointing. It simply means that they won’t rise by 50% or more in the foreseeable future. Thus, with almost 100% certainty, we face a period of decelerating growth going forward.
2. Monetary Policy – Since the start of the pandemic, the Fed has pumped money into the economy faster than it ever has while forcing the short-term Fed Funds rate to zero. All along the yield curve, real rates, adjusted for inflation, have been negative since the start of the pandemic. Now the Fed is discussing how and when to taper its pace of future bond purchases. So far, it hasn’t been determined when the process will start, or its pace. It is also uncertain when it might consider raising the rate on Fed Funds. But the future direction of monetary policy is almost certainly going to incorporate less intervention.
3. Fiscal Policy – The Biden Administration would like to approve spending of as much as an additional $6 trillion over the next decade, funded in part by trillions of dollars of new taxes. If its plans were fully approved, deficits would average over $2 trillion per year at least through 2026. In addition, the Administration would like to increase government regulation and restrictions on business with a particular focus on reining in large-tech companies. The rhetoric to date has been strong. How much actually gets accomplished is open to debate. Just look at one item, capital gains taxes. In two years, they could be anywhere from the low 20% range to more than 50% depending on the outcome of legislative initiatives. Right now, I couldn’t give you odds on anything related to what might pass. The only semi-agreement so far relates to infrastructure spending and Democratic leadership is holding that hostage to the passage of more expansive spending and tax initiatives. We may learn a lot more this Fall, the critical time for moving legislation forward. But for now, we are hearing more political posturing than actual steps forward.
As noted, markets hate uncertainty. They particularly dislike the idea of slower future growth, higher future interest rates, higher taxes, and more regulation on business. OK, slower growth doesn’t mean no growth. It doesn’t even mean below-average growth. It simply means that current growth rates can’t be sustained. That’s obvious. But how fast will growth decelerate? An uncertainty. When will growth stabilize and at what rate? An uncertainty.
Let me move to interest rates. The Fed has all but said in black and white that sometime between now and early 2022, barring a major unexpected shift in the economy, it will begin to reduce the pace of bond purchases, lessening its intervention in credit markets. At least, that is its intent. What would be the impact on markets as it buys fewer and fewer bonds each month? Another uncertainty. When might it decide to raise rates from a floor of zero? Yet another uncertainty.
As for fiscal policy, we have all seen the headlines. All kinds of taxes on those making more than $400,000. Spending beyond anything seen since the New Deal which, of course, was designed to bring our economy out from under the worst depression in its history. And last week, an emphasis on regulatory oversight of anything considered big and anti-competitive. It appears size alone will qualify for Government intervention. We have already seen a lot of executive orders, but they don’t carry the weight of legislation. Many will be challenged in court. Yet another uncertainty.
I don’t want to lose focus on the economy. It is vibrant and healthy. Right now, the biggest problem is too much demand. That’s a problem all businesses would love to have. But too much demand has messed up supply chains, caused shortages, and led to spikes in commodity prices that now seep through to almost everything. Most of these imbalances will be solved over the next twelve months. Hopefully, demand will remain strong. If prices rise too fast, they crush demand and will have to reset. But they aren’t likely to reset below levels seen pre-pandemic. Two underlying cost factors, rents and wages, are likely to keep rising at rates higher than at any time since the Great Recession for years to come.
The Great Recession created massive oversupply that took about a decade to absorb. That is the pattern of almost all financial collapses in our nation’s history. This time, however, just as the gaps were closing and full employment was at hand, the pandemic hit. While it created an immediate recession, in part due to rapid fiscal and monetary responses, the pandemic didn’t do the permanent damage of a financial disaster. Rather, the economy went to sleep and then woke up in pretty much the same condition as before. Yes, many businesses lost months of sales but supportive programs like the PPP loans limited the long-term damage. Zero interest rates and supportive credit markets gave access to money, even to businesses totally shut down like the cruise ship operators. Thus, cruises are starting again, planes are flying, and restaurants are full once again.
Pulling this all together, our economy is vibrant. But its growth rate is beginning to decelerate simply because it won’t be long before normal times get compared to normal times once again. Growth will be a function of demographics and productivity plus or minus the residual effect of monetary and fiscal policies. There will be times when growth may appear to be slowing a bit faster or slower than consensus expectations. There will be inflation reports that surprise in both directions. A year from now, the 10-year Treasury yield will likely still be in its 1.25%-3.25% range, but where within that range is an open question.
For the last year, we lived in world of rapid recovery, plenty of excess capacity, super low interest rates and barely any inflation, at least until the last couple of months. Now we face decelerating growth, uncertainty related to rates and inflation, and an anti-business Administration. That change can’t be viewed positively. It doesn’t mean stocks have to go down. But after a 30%+ gain in equities in 2019, an 18% gain last year, and a 15%+ gain in the first half of 2021, it’s time for some deceleration at a minimum.
Stocks don’t move in a straight line. There will be periods of strong performance. There could well be a 10-20% correction in between. With zero interest rates speculators have raced to everything from meme stocks to NFTs, SPACs and Bitcoin. When money can generate a positive return once again safely in money market funds or the bank, money will shift back away from the more speculative fringes. That won’t be tomorrow. In sum, expect more volatility amid an economy still likely to grow at above-average rates for at least another couple of years. That requires a level head and focus. 10% corrections can happen very suddenly. They culminate when weak hands panic, capitulate and sell, leaving buying opportunities for level-headed investors. On the other hand, valuation matters. Don’t capitulate and chase wonderful sounding stories with no fundamental base.
Today, Richard Simmons is 73. Bill Cosby turns 84.
James M. Meyer, CFA 610-260-2220