A dovish update from the Federal Reserve did nothing to disappoint investors. Or did it? Initial reactions from Chairman Powell’s comments led to gains across the board late Wednesday afternoon, while yields fell from their highs and stocks staged a strong rebound. The committee’s median projection on the economy points towards 6.5% GDP in 2021, coupled with unemployment falling to 4.5% and inflation rising to 2.4%. They continue to expect this year to be more transitory in nature, with growth and inflation trending back to historic norms after their initial pop. From here forward they will be data dependent (again), and most members expect to keep rates near zero at least through the end of 2023.
After taking the night to digest this data and a Q&A session, markets flip-flopped. Being data dependent, prior to upcoming inflation and growth reports which are about to explode, may also mean the Fed will be ready to react. Fed Fund futures are pulling forward the first rate hike from 2024 into 2022 already, a full year ahead of the committee’s dot plots. Policy remains outcome-based and investors are expecting even rosier data over the coming months. Stimulus checks, continued money printing, and massive pent-up demand are all catalysts for faster than expected growth. Investors believe inflation will run rampant until the Fed does something.
The Fed also did not hint at any attempt to control the long-end of the yield curve. Ten-year Treasury yields popped yet again yesterday, closing at 1.73%, up 9 basis points. I think you can tell how equities reacted. Tech stocks took it on the chin with the Nasdaq down over 3%. Losses were led by high P/E stocks such as Crowdstrike, Square, Snapchat#, and Tesla, which were all down more than 7% while low P/E tech stocks like IBM# and Oracle# were in the green.
It won’t take long to figure out what held up better than Technology either! Banks, Industrials and other value stocks outperformed, helping drive the Dow Jones to a fractional loss of 0.4% on the day. Stocks making new annual highs yesterday are quite impressive and broad based: Honeywell#, JP Morgan#, Caterpillar, 3M#, Bank of America, General Motors, Morgan Stanley, MetLife and CarMax#, to name a few. All of this is occurring while FANG related stocks are still down 10% – 20% from their recent highs. Quite a different market than the past several years.
The question on investors’ minds now is how much forward-looking good news is priced in for both sides of the coin (interest rates and cyclical stocks)? Let’s take a look at rates first.
Outside of the pandemic-induced shutdown, our 10-year Treasury interest rate has been range-bound between 1.5% and 3.0% since 2011. This occurred during a period of average GDP growth of 2%. A decade ago, unemployment was 9% and gradually dropped towards 3.5% in 2019. Inflation averaged 1.7%.
In short, the Fed is expecting this year to produce 3X normal GDP growth rates, a return towards the bottom end of the unemployment rate range, and a bounce to the high end of recent inflation data. This leads us to believe the 10-Year Treasury’s path of least resistance is still higher. Economists expect 2% by year-end. We may get there over the next month if economic data keeps pointing upwards.
Individual bond investors should continue to remain patient. Now is not the time to lock in ultra-low interest rates on the buy side. There will be a better time to invest, we just have to wait for stronger data to keep coming in. Bond funds are even worse off, as they have to remain tied to a specific benchmark. Therefore, every bond maturity is replaced at today’s current low yield. Here are the total returns for some large bond funds in 2021:
Ticker Description YTD Performance
HYG High Yield Corporate Bond ETF -1.8%
TIP TIPS Bond ETF -2.3%
BND Total Bond Market ETF -4.3%
EMB Emerging Markets Bond ETF -6.1%
LQD Investment Grade Bond ETF -7.0%
IEF 7 – 10 Year Treasury Bond ETF -5.7%
TLT 20+ Year Treasury Bond ETF -15.0%
ZROZ 25+ Year Zero Coupon US Treasury ETF -20.4%
For the first time in many, many years, bond investors are going to realize a loss of principal. The 40-year tailwind of lower rates and higher prices has likely ended. That does not mean interest rates will skyrocket, but a more subdued, gradual rise should be expected before we settle back into a stable range.
Jim Meyer and I already touched on the transitory aspects of today’s inflation boost. Supply chains will get fixed so we’re not paying top dollar for out-of-stock automobiles, refrigerators, household furniture or vacation hot spots by this time next year. Oil, copper, lumber and steel capital investments today will bring forth more supplies next year. Oil prices have already declined five straight days as more supplies come to the market after we neared $70/barrel last week. Inflation is not going to stick around too long.
Growth isn’t going to be 6%+ year after year either. The Fed’s assessment seems accurate, although they are usually late to the party, so inflation could go higher than many expect in 2021. However, today’s inflation and growth will eventually revert back to normal. Longer-term factors such as globalization, technology, aging demographics and printing too much money to only get a tiny boost, are strong deflationary forces which does not support long-term growth over and above the recent 2.5% rate. The ascent to an upper-bound level of 3% interest rates won’t be as fast as the past six months’ jump from 0.50% to 1.75% either.
A gradual, slower rise will allow equity market P/E adjustments to normalize. Value stocks are handily outpacing their growth brethren for the past 6+ months. How much is left in that move though? Without singling out specific companies, many Industrials, Banks and other cyclical stocks are 25% – 50% above their all-time highs already. Some deserve it, some don’t. Much like the SPAC craze from a few weeks ago, momentum is powerful here too. A rising tide lifts all boats, but upcoming earnings reports will prove who deserves to keep making new highs.
By no means is this rotation over, but picking stocks from here will take more discipline and analysis on the true long-term trends in place. The trend is still our friend and that points to higher rates, higher cyclical stock prices and a less than rosy outlook for high P/E go-go growth stocks without long-term growth trajectories. However, it will not be this easy forever. First quarter earnings reporting season is right around the corner. Last night, FedEx# proved they’ve earned this higher trading range with a solid update. Here’s hoping it’s the start of a trend.
Yippee Ki Yay, its Bruce Willis’ 66th birthday! LA Dodgers star Clayton Kershaw turns 33 today. Actress Glenn Close is 74.
James Vogt, 610-260-2214