Stocks stumbled last week as long-term interest rates spiked. While the Fed remains committed to keeping the Fed Funds rate anchored near zero, investors sold bonds as economic data suggested more rapid inflation than previously thought. The impact of the most recent round of $600 stimulus checks showed up in the January spending numbers. It also impacted the savings rate which jumped to over 20%. With more stimulus on the way (the House passed a $1.9 trillion bill last week that included yet another round of direct stimulus, this time $1,400 per person), growth rates and the savings rate are both headed higher. But that is driving interest rates higher as well.
I have said often that 2021 will be a tug of war between the tailwinds of accelerating growth and the headwinds of rising long-term interest rates. We saw that last week. Despite the good news on the growth front, the yield on 10-year Treasuries has risen by 50% in just two months. When rates rise, P/Es fall. As long as the pace of rate increases can be offset by the impact of higher earnings, stocks can continue to rise in price. But when long rates spike, as they did last week, the headwinds are too strong and stocks pull back.
The pullback has been most impactful to high multiple growth stocks. Basic math shows that P/E spreads widen as they rise and compress as they fall. Thus, growth stocks take a bigger hit if rates rise too fast. That ignores any additional impact on changes in speculative behavior or investor euphoria. Clearly if growth stocks correct for any significant length of time, momentum traders will move elsewhere. Speculative fever will face its own headwind.
What is sometimes missed is how thin, and therefore how erratic, the long end of the Treasury curve might be. There are a bit over $2.8 trillion of U.S. government bonds outstanding, but almost $1.1 trillion of that is held by the Federal Reserve. That leaves a net balance in public hands of just $1.75 trillion in round numbers. That seems like a big number, but it is less than the market cap of Apple#. The size of trading surrounding long- term Treasuries is quite a bit larger if one considers all the related derivatives, but the point to be made is that sudden changes in trading behavior can have an outsized impact on the market. Last Thursday, the move in 10-year Treasury yields was almost equal, at one point, to the entire change in rates year-to-date.
While some may fear a continuation of the pace of rate increases for days or weeks to come, there are reasons to expect a pause for now. The spike in rates, and the decline in price, is bound to attract buyers. The spread between U.S. Treasury yields and those attainable for top quality sovereign debt overseas has widened and become more enticing. The pullback may have already started Friday afternoon. With that said, it wouldn’t be surprising to see another ratchet move higher in rates in late March, assuming the $1400 stimulus checks contained in the House bill make it into law as most assume, and are distributed by then.
Indeed, the acceleration of economic growth, plus the sharp jump in savings, promises to accelerate both growth rates and inflation expectations over the coming months. The year-end consensus for 10-year yields, currently centered around 2.0%, could become 2.25% or 2.50%. Such a move could offset the impact of higher growth.
But there are depressants to inflation that remain in place. Spikes in commodity prices are not likely to be sustained. Some are caused by ruptured supply chains that will be repaired. Some were caused by low inventory levels. All will invite more production. The spike in timber prices has more to do with a shortage of sawmill capacity than a shortage of trees. Oil prices are down because the Saudis and Russians withheld production at the same time U.S. oil fields shut down due to low prices. U.S. production is already starting to rise, and Saudi Arabia postponed its last production cut. Wages are starting to rise but even if they rise by a 3-4% rate by the end of 2022, the impact on inflation will be offset by rises in productivity. Thus, the rise in inflation won’t be rapid. There are still 10 million fewer Americans working than there were a year ago. The near 6% unemployment rate is lower than it appears, caused mainly by a sharp drop in the working population. Better times and more good jobs available will bring some back into the work force.
On balance, the economic picture is enormously encouraging. GDP growth this year should be at least 8% and could approach 10% assuming Covid-19 impact fades in the second half of the year. 1 out of 5 American adults have already received at least 1 vaccine dose. Anyone who wants to get vaccinated will have the opportunity to do so by mid-summer. While some vaccinated Americans will still have hesitation to go to concerts or eat indoors, most will resume normal life later this year. The combination of higher growth and robust savings will be powerful economic drivers.
That doesn’t mean stocks will repeat their 2019 or 2020 performance. Higher interest rates promise some giveback. Stocks could achieve modest gains or losses depending on where rates sit at year end. While the bond market decline last week was scary, sober reality suggests a more sluggish rise going forward, particularly once the near-term impact of the next set of relief checks is baked in. While some feel a quick return to normal is going to release a makeup spending spree, I don’t think it will be long lasting. Rather, while some will take a great vacation or hold a big party, reality is that life will quickly reset into a new normal. Housing will stay strong, but no one is going to run out and buy a closet full of new suits or lease new office space. Look for growth in 2022 to settle back toward a more normal 3%. Rates will still rise in 2022 but at a slower pace.
Thus, 2021 is likely to be a transition year for financial markets. It should favor cyclicals over growth stocks for two reasons. First, cyclicals will show higher year-over-year earnings increases having been more impacted by Covid-19. Second, as noted earlier, higher rates bring P/E compression. That will weigh more on growth stocks. But, with that said, there is no recession in sight. By 2022, we would expect a move back in the direction of growth toward normality based on productivity and demographics. The remaining “dark cloud” is the specter of euphoria-created bubbles ruining the party. So far, that is happening around the edges. The median revenue for dozens of SPAC acquisitions made to date is less than $50 million per year. This is equivalent to early stage venture investing in a non-diversified portfolio. That bubble isn’t going to last long. But it doesn’t have to spoil the overall party when it bursts. The core market sells at a reasonable price based on today’s interest rates. It is not in a bubble.
Today, Justin Bieber is 27. Ron Howard is 67. Harry Belafonte turns 94.
James M. Meyer, CFA 610-260-2220