By Justin Pawl, CFA, CAIA, CFP®
Last Week Today. The Dallas Fed Manufacturing Index jumped from 17.2 to 28.9 in March, its highest reading since 2018. | Consumer confidence rose 19.3 points to 109.7 in March, the strongest single-month increase since April 2003, which also happened to be the start of a new bull market. | President Biden unveiled his $2.25 trillion infrastructure plan, funded by a proposed corporate tax rate increase from 21% to 28%. There was no mention of an increase in personal taxes, though that is expected to come later this year. | The ISM Manufacturing Index rose to 64.7, its highest level since 1983. | Nonfarm payrolls increased by 916k in March, well above the consensus estimate of 660k. Positive revisions to the jobs reports from January and February resulted in 1 million net jobs gains, which pushed the unemployment rate down to 6.0%.
Strong economic data, additional stimulus, and an accelerating vaccination program created an ebullient mood last week for investors who pushed global equities up by more than 1%. For the year, global equities (MSCI ACWI) are now up ~6%, with U.S. Value (+12.3%) and small-cap stocks (+14.4%) leading the way. Interest rates continued to rise early in the week but backed off their highs, which allowed growth stocks some breathing room to move higher (+2.3% for the week). Year-to-date, gold is -8.9%, Silver -5.3%, WTI Crude +26.6%, the U.S. dollar is +3.4%, and Bitcoin is +102.4%. For detailed asset class performance, please click on the table below.
Interest Rates/Inflation/Stocks. The 2021 rise in yields is historic as 10-year US Treasury yields rose ~0.80% in just three months. The move’s speed and amplitude are about as close as reality can come to common bond stress test scenarios that consider a 1% “instantaneous shift” in rates. As a result of rising rates, the benchmark Barclays Bond Aggregate index declined 3.4% in the first quarter equating to an annualized decline of more than over 12%. To illustrate the shift higher in rates, the chart below compares the US Treasury yield curve as of 12/31/20 (gold) to the yield curve on 3/31/21 (green). The chart can be expanded by clicking on it. For those who haven’t seen this type of chart before, bond maturities increase as you move left to right. Hence yields on short-term UST bills (e.g., 1-month and 3-month) are included on the left-hand side of the chart, while yields on bonds maturing in 20- and 30-years are on the right-hand side of the chart. The vertical gold bars at the bottom of the chart show the change in rates from the start of the year along various points of the yield curve.
Notice that even as yields rose on USTs maturing in 3 or more years, interest rates on USTs maturing within 2 years remain anchored near zero. Why? Because the Federal Reserve’s monetary policy has a significant influence on the “short-end” of the curve, and the Fed has kept its target rate at zero since the pandemic invaded the U.S.
Source: Bloomberg, L.P. and Covenant Investment Research.
The following chart compares today’s yield curve to 12/31/19, when the Fed’s target interest rate was 1.50%. At the end of 2019, the yield curve was much flatter, and while short-term rates were elevated compared to today, interest rates on bonds maturing in 10 years or more were at very similar levels to today. Note that the gold bars at the bottom of the chart show how much movement took place in the curve’s short-end but little change in the intermediate and long portions of the curve since the end of 2019.
Source: Bloomberg, L.P. and Covenant Investment Research.
Essentially, yields on bonds maturing in 10 years or more have come full circle in just over a year. The relative level of bond yields may come as a surprise to casual observers who only hear the cacophony of media pundits breathlessly reporting on the “high” level of interest rates. The question is, what happens next with rates, and what is the likely impact on equities? This is an important question because equities tend to be the most significant investment in portfolios, if not on an outright dollar-weighted basis, then certainly on a risk-weighted one.
Like so many aspects of financial markets, the answer is neither straightforward nor clear. But we’ll do our best to frame the issue, which comes down to a few critical inputs: inflation expectations vs. realized inflation, changes to Fed monetary policy, and fiscal stimulus.
The market is expecting higher inflation ahead. The chart below shows Consumer Price Index (CPI) forwards (a “forward” is a contract between two parties to buy or sell an asset at a specified price on a future date). Indeed, FHN’s Chief Economist Chris Low remarked this is the first time he’s seen the market pricing in sustained inflation of more than 2% on a ten-year horizon.
Source: FHN Financial
The rise in inflation expectations is partly attributable to the economy’s reopening. Other critical factors influencing inflation expectations include the level of fiscal stimulus, pent-up consumer demand vs. disrupted supply chains, rising commodity costs, and the Fed’s new monetary policy framework that is evidenced-based vs. forecast-based. Some companies are already moving in response to higher input prices. For example, last week, consumer products companies Kimberly-Clark, J.M. Smucker, and General Mills announced plans to raise prices on some of their more popular products. At the same time, the Fed has said it will not raise rates until the economy is close to full employment and inflation is above 2%. With this backdrop, the market pricing higher inflation is logical.
The rise in inflation expectations has given way to higher interest rates. And it’s not just nominal interest rates that are rising, but real (inflation-adjusted) rates have moved higher as well. The following chart shows the historical relationship between the real interest rate on bonds issued in 5 years that mature 5 years later and the Price-to-Earnings (P/E) multiple of the S&P 500. Yields on the 5-year/5-year forward are inverted on this chart and measured on the left axis.
The pricing of future real yields was in negative territory from early 2020 until very recently, meaning the interest rate received on bonds was expected to be lower than the inflation rate. However, even though inflation expectations are higher, investors are extrapolating the recent jump in rates into the future and expect interest rates to exceed inflation. This would ultimately create a positive real interest rate on bonds, but for current bond owners that means a decline in the prices of bonds they own. Higher real rates generally correspond with lower P/E multiples, as it implies a higher cost of capital. Stocks can get to lower P/E multiples through higher earnings, lower prices, or some combination of the two. Note that in 2017 and 2018, the real rate was quite a bit higher than today, and with ample liquidity in the system (and more on the way), real-yields moving even higher than those levels is a possibility. The speed of the recent rate increase, and the historical correlation of these two data sets, imply that stocks may be vulnerable in the short term.
Though stocks could experience volatility, they appear poised for strength in the intermediate-term (e.g., 12-18 months). Yes, there are pockets of the market that are in bubble territory, and there are indications of speculative excess (e.g., SPACs or a ski instructor recently availing me of his success in trading GameStop). But for all of the comparisons to 1999, the financial backdrop is very different from the era of sock-puppets and the Dot-com Bubble.
A primary difference is that today’s companies are, for the most part, profitable when many of the Dot-com “companies” went public with no earnings. While the cyclically adjusted P/E multiple is elevated today, it’s ~10 points below that of the Dot-com peak (left-hand chart). Moreover, the Equity Risk Premium (the earnings yield minus the 10-year real interest rate) is positive today (right-hand chart). In contrast, it was deeply negative leading up to the collapse of the Dot-com Bubble.
Finally, the bubble’s collapse in 2001 was aided and abetted by a Federal Reserve in full tightening mode. In 1999, the Fed Funds target rate was 4.75%. The Fed raised interest rates six times in eleven months, culminating with a 0.5% hike in May 2000 that took interest rates to 6.5% and marked the beginning of the end of the Dot-com Bubble. Today, the Federal Reserve has a target rate of zero. It is purchasing bonds at a $120 billion per month rate, promised it won’t raise rates until it begins to taper bond purchases, and pledged to provide plenty of warning before they taper. In sum, the Fed’s policy is ultra-dovish today vs. ultra-hawkish in 2000. The old saying on Wall St. is don’t fight the Fed. When the Fed is aggressively tightening policy by raising rates, that translates into lightening up on your equity exposure. Current Fed policy implies the opposite.
Bottom Line: Equity valuations are elevated, but not unreasonably so except in some specific pockets of the market. Other areas of the equity markets look attractive from a valuation perspective. These tend to be the market segments that have lagged for the last ten years (Value, cyclical, international, and commodity stocks). Broad equity indices like the S&P 500 and Russell 1000 have thus far ignored rapidly rising rates. While the short-term is difficult to predict, longer-term, we expect equities to be higher in 12-18 months than they are today, though the road may be bumpy. Traditional fixed-income investments look vulnerable, but even if they do not decline in price, the yield on a 10-year bond is lower than the inflation rate, eroding wealth in the “safe” part of most investors’ portfolios. The new Fed monetary policy framework, which is designed to generate consistently higher inflation than we’ve witnessed since the Mortgage Crisis, challenges conventional portfolio construction. However, there’s no guarantee the Fed’s policy will work. Therefore, investors must consider a broader range of potential outcomes when constructing portfolio allocations to diversify the tail risks of an uncertain future.