Let’s Not Conflate Inflation with Rates
“Reflation” was the key buzzword in the financial press over the past month. The “reflation trade,” as it is referred to, may have had some investors looking to lock in profits on more highly valued stocks now that bond yields are beginning to offer a higher degree of secure income. However, higher interest rates predicated on a positive growth outlook have historically been positive for stocks as some degree of inflation is a good thing. Despite all the buzz, inflation remains well below the Federal Reserve target. Current levels of employment and the level of expected inflation being priced in through inflation‑protected bonds leads us to believe this fact is not changing anytime soon. The question for investors to consider is: Does a modest tick up in inflation signal actual growth or is it a byproduct of record amounts of fiscal stimulus, with more on the way? Only time will tell if the recent focus is warranted.
The 10‑Year U.S. Treasury yield rose 0.37% in February to close at 1.46%. This is the largest one‑month jump in the bellwether Treasury since 2016. Investors, concerned that rising intermediate‑term rates signal future inflation, anticipated the Fed may move to raise short‑rates sooner than expected, despite Fed chairman Powell’s assurances to the contrary. A rise in borrowing costs creates headwinds for the economy and corporate profits, which weighed on investor sentiment and was a likely factor in pressure on stock prices experienced toward the tail end of the month. Bond prices also declined given the inverse relationship between price and yield.
On the corporate earnings front, in addition to much more favorable outcomes than had been anticipated (known as “earnings surprise”), companies that have been reticent to provide guidance amid a global pandemic have been more transparent with forward guidance. The consensus outlook is a decidedly positive view for forward revenue and earnings.
|Market Index Returns||Feb 2021||YTD 2021|
|S&P 500 Index||2.8%||1.7%|
|Russell 2000 Index||6.2%||11.6%|
|MSCI EAFE Index||2.2%||1.2%|
|Barclays US Agg. Bond Index||-1.4%||-2.2%|
|FTSE 3 Mo. T‑Bill Index||0.0%||0.0%|
Stock Market Review & Outlook
A Cyclical Rotation or Merely Short‑term Profit Taking?
Headlines of pullbacks in previously high‑flying large technology stocks perhaps have drawn attention away from the fact that major U.S. stock market indices have had more than 30 new record highs in the first two months of the calendar year. The S&P 500 recovered modest losses incurred in January and moved into positive territory on a year‑to‑date basis.
Financial stocks rallied on a more positive outlook for banks as a steeper yield curve benefits net interest margins (the amount banks earn on lending to customers versus interest paid on deposits). Previously battered Energy companies rallied into the news of rising commodities prices, while Utilities companies, that are particularly sensitive to changes in interest rates given their high dividend payouts, were the weakest segment of the index. Small cap stocks added to gains and stand out for their particularly strong returns. Small company leadership is typically indicative of investors expecting strong economic times to come.
|S&P 500 Sector Returns||Feb 2021||YTD 2021|
Economic Review & Outlook
Previously Dormant Interest Rates are Now Fully Awake
Fed chairman Jay Powell reiterated the stance of the Federal Open Market Committee that they remain committed to holding off on short‑term rate hikes until the economy reaches full employment and inflation not only reaches 2% but is anticipated to remain at that level. Read “lower for longer” for short‑term rates, despite a pick‑up in rates further out the yield curve. Eventually the Fed will need to taper their bond buying which has brought concerns of a repeat “Taper Tantrum” like we saw in 2013. If intermediate‑term rates continue to rise on this trajectory, expect a cooling in the red‑hot real estate market as mortgage rates follow suit.
Retail Sales picked up in the latest reading for the month of January after three months of declines. Durable Goods followed suit, coming in well ahead of expectations in the first month of the year. Rising incomes, driven predominantly by stimulus payments, have led to an increase in both consumer spending and personal savings.
Chart of the Month
Positive Earnings Surprises Are Not Being Rewarded by Investors
As shown in the chart above, investors have clearly not rewarded recent positive earnings surprises to the extent that they have in the past. The stock price of companies that have beaten expectations in their latest quarterly reports have modestly declined on average, versus a nearly 1% increase on average over the past five years.
The proposed $1.9 trillion additional stimulus package called the “American Rescue Plan,” which includes $1,400 checks to individuals, is working its way through Washington, now decoupled from debate on a federal‑mandated minimum wage hike. The Federal Reserve continues to purchase an astounding $120 billion in bonds per month. COVID‑19 hospitalization and transmission rates have improved in a meaningful way. These factors will all be a tailwind for investor sentiment and financial markets. Elevated equity valuations, a potential federal minimum wage increase and the impact it may have on businesses and future inflation, as well as the sustainability of an economic recovery once stimulus is tapered and eventually removed are some of the counterbalancing risks to be considered. These are among an ample list of factors we continue to consider as we seek to balance risk and return when deploying capital on behalf of our clients.
Please reach out to one of your Account Officers or any member of our Executive Leadership Team to discuss topics raised in this letter or anything else we can be helpful with.