Stocks fell yesterday but finished well above their worst levels. After 7 straight up sessions for the S&P 500, I will attribute the decline to profit taking. There was no significant new news.
For more than a decade, growth stocks outperformed cyclical and value stocks by a wide margin. That coincided with a slow steady economic recovery and a steady decline in long- term interest rates. Without getting into the math that backs up what I am about to say conclusively, when rates fall, P/E ratios increase. Not only do they get larger, but the spread between low and high P/E stocks widens. More precisely, the impact of dividends becomes less important; appreciation makes up a larger proportion of overall equity returns. Conversely, when rates rise, P/Es fall and the spread between high and low P/Es narrows.
Actually, interest rates have been in decline since the early 1980s. The decline hasn’t been perfectly steady. For instance, after the stock market bottomed post the bursting of the Internet bubble and the tragedy of 9/11, interest rates staged a modest but noticeable rally for about 5 years. During that period, cyclical and value stocks were relatively good performers. For the most part, since inflation peaked once Paul Volcker took over Fed leadership and stepped on the brakes, the stock market has been dominated by growth stocks only periodically, taking a back seat during market crashes in 1987, 2001, and 2008. Even during the Covid-19 crisis, growth stocks maintained leadership as they were largely impacted less by the closing of much of our economy.
That all began to change last Fall. Starting around Labor Day, after a relatively calm Summer, the economy began to reopen. Although schools and offices remained closed, people began to eat outdoors. Stores beyond those selling essentials reopened. Slowly, a few more people began to travel, even getting on planes. The market panic of last Spring, with hindsight, was an overreaction. Life slowly returned and markets rallied on hopes of continued gains. 10-year Treasury yields, which got below 0.4% last Spring, got back close to 1% before year end. In January, vaccines began to roll out. More people ventured out. With a few exceptions, like concert venues and cruise ships, life not only came back toward normal, it did so much more rapidly than anticipated. By the end of the first quarter, rates were all the way back to almost 1.75%.
Amid that recovery in rates, at a pace of over 25 basis points per month, equity markets saw a marked change in leadership. For a while, the sequential and year-over-year growth in economic sectors virtually shut down in early 2020 was about to be spectacular. We are about to see the peak in year-over-year growth over the next several weeks as second quarter earnings are reported.
But a funny thing happened on the way to peak recovery. Markets, as they always do, looked ahead. Once vaccines became prevalent and normal became normal again, it was clear that many sectors left for dead, mostly in the travel and leisure parts of our economic world, would get back to where they were before the pandemic. Some, saddled with more debt, may not get all the way back. Others, however, learning valuable lessons during the pandemic, will not only recover but forge ahead. Those companies that responded to change, for instance, moved quickly to take advantage of online sales, curbside pickup, and cloud computing infrastructure. Old line manufacturers, suddenly swamped with orders, learned how to be more productive. All this got discounted in the market before it happened, not afterwards.
By April, investors could see the benefits of a steepening yield curve, resurgent demand, and higher commodity prices. The Federal Reserve saw this as well. It started to warn months ago that over the short term, demand was likely to rise faster than supply. With inventories depleted during the pandemic, as companies converted stockpiles to precious cash, supply chain disruptions and commodity price spikes were sure to follow. Markets listened to the Fed. The Fed isn’t always right, but the old saw “Don’t fight the Fed” usually is the right strategy. The Fed said the price spikes would be transient, and it would wait longer to raise rates. Yields started to recede. Instead of rising 25+ basis points per month, 10-year Treasury yields reversed course. Today, they are very close to the 2010-2020 (pre-pandemic) lows of about 1.35%.
It should be no surprise that growth stocks resumed leadership as they almost always do when growth accelerates and interest rates decline. If we learned nothing as investors between 2009 and 2020, it was that growth wins when the economy is strong and rates are declining.
But that is all in the past. What now? Here’s what we do know.
1. The economy is super strong, unsustainably so. Real growth in the second quarter, excluding changes in inventories and the impact of the trade deficit, will be close to 10%. Soon almost everything will have reopened. No more cutouts in arena seats instead of people. Even cruise ships are starting to sail. By Labor Day, transatlantic flights should resume in some fashion. Schools and offices will reopen in the Fall, if not sooner. By this time next year, the economy should still be strong, but growing at perhaps half the rate of Q2. Maybe even a bit less.
2. The Fed sees what I just described, strong but decelerating growth. The economy added well over 800,000 jobs in June. It probably will add 600,000-900,000 jobs per month for a few more months as the reopening process continues and expanded unemployment benefits end. A year from now, our economy should be at or near full employment. That will allow the Fed to start a process of reducing its pace of bond purchases.
3. There is no question that buying $120 billion of bonds each month impacts interest rates. How much is open to debate. The Fed has been buying at that pace since the pandemic began. In some months, rates rose despite the Fed’s impact on bond prices (more buying increases price and should lower yields). In recent months, rates have stayed muted despite surging growth. The Fed purchases are an important impact but not the only impact.
4. With that said, if the Fed leaves the market entirely, and the Treasury will have to sell record amounts of new debt to fund deficits that could average $2 trillion for several years, there is a void to be filled. Without additional buyers of debt, bond prices will fall and rates will rise. As we have seen for over a decade, the Fed appears willing to tolerate higher rates than today, but anything over 3% would raise concerns. High rates, undoubtedly, will have a negative impact on future growth. That conflicts with the Fed’s mandate of fostering growth that could sustain full employment.
5. We know this is all a grand experiment. Never before have central banks been so accommodative amid an economy growing 2-3 times normal sustainable growth rates. One definition of GDP growth is population increases times productivity gains. Population is growing at a rate of about 1%, including immigration. Productivity growth in excess of 2% has been unsustainable for decades. 3% would seem to be a sustainable growth ceiling looking forward, excluding the impact of inflation.
6. Thus, we have several conflicting forces at work. More Fed intervention than in the past. Faster growth gradually slowing toward sustainable rates. Record deficits and record amounts of debt that required sustained low interest rates to maintain a growing economy. Record amounts of fiscal stimulus that will flow through the economy for decades. And finally, zero short-term interest rates for at least another 12-18 months if not longer. Can we have all those tailwinds without fomenting inflation? Can we avoid disinflation with sustained fiscal and monetary stimulus? These are questions that remain unanswered.
We aren’t going to answer them today. It’s not that there isn’t an answer. Of course, there will be. We simply don’t have enough data yet to make a predictable decision we can count on. Clearly, the stimulus is inflationary. Clearly forces like the Internet and other technological advances are deflationary. For decades, the disinflationary forces have been winning. But we have never witnessed the degree of stimulation we have seen over the past 12 months.
But we do know some things. We know that technology is becoming more dominant in our daily lives. It isn’t just the obvious of using the Internet for price discovery and for convenience. Your mailbox is now half full or less compared to a decade ago. You don’t write checks or use cash anymore. Contracts are signed electronically. FedEx delivers boxes, not overnight letters. Your computer is your phone. Your menus are electronic. Your cars step on the brakes while you daydream. Robots assemble your cars. The newspaper delivery man will soon go the way of the milkman. Every one of these “improvements” saves cost. These changes will only accelerate as time marches on.
That is one reason rates are now hovering near pre-pandemic lows. Can the Fed slowly retreat and let this force do its dirty work? They are going to try. But there has been a lot of stimulus. Whether it can all be withdrawn is an open question.
We also know that while some inflationary pressures are transient, they all aren’t. Wages are going to rise faster than they have simply because the employment gap created by the Great Recession is finally closing. The process was interrupted by the pandemic but it is now resuming. In addition, the housing shortage is real. It will take years to resolve itself. Higher home prices will elicit more sellers, but only at higher sustained prices. Rents have lagged the surge in home prices, but they are starting to catch up. They will rise at a sustained pace for a few years at least. Shelter costs are over a third of most inflation indices. Add in higher interest costs and you will sustain inflation above levels of the past decade. How much above is key.
The other thing that is logical is that if the Fed withdraws completely from monetary easing, meaning it works to keep its balance sheet level over time, real rates should gradually return to levels that afford investors a positive return adjusted for inflation. Thus, a 10-year Treasury yield could be 2.5% with just 2% inflation if the Fed returned to the sidelines.
All this suggests that the impact in the stock market over the past three months from a slow but noticeable decline in long-term interest rates may be coming to an end. While the disinflationary forces described earlier remain, the tailwinds of aggressive monetary easing, and the effect of rising rents, energy prices, debt service costs, and higher wages, should lead to sustained inflation expectations above 2% for some period of time. 10-year rates may not respond today, but they are likely to respond once the Fed outlines its game plan to reduce stimulus. If the plan isn’t enunciated at the Jackson Hole conference in August, it will be by the September FOMC meeting.
Markets have enjoyed the benefits of returning to normal. We are just about there. We will be there almost completely by year end barring a resurgence of Covid-19 beyond all expectations. Today’s great news becomes tomorrow’s tough comparison. As a rising tide lifts all boats, a buoyant economy creates rising earnings. But 2-3% growth is a far more modest tailwind than 10%. A return to normal will separate the wheat from the chaff. 2-3% is still a tailwind. Good times lie ahead. But if rates start to creep up again, many stocks will require more of a lift than 2-3% to move higher. Markets often have a tough time during transitions. We have enjoyed rapid recovery and ultra-low rates. Now we face stimulus withdrawal and slowing growth. The path forward is going to be a lot choppier.
James M. Meyer, CFA 610-260-2220