The Bottom Line
The projected pace of the economic recovery has accelerated since the beginning of the year.
This is causing an increase in interest rates that has made the stock market nervous about where interest rates will be relative to economic growth.
However, APCM expects this to be a short-term issue as accelerating economic and earnings growth will overcome the headwind of higher rates.
Historically, at the start of recoveries investors begin to feel more comfortable taking risks, and concerns about inflation, Federal Reserve (“Fed”) policy decisions, and federal debt all increase. These same dynamics are playing out in this recovery, recently prompting a pick-up in market volatility. Global stocks have climbed +82.3% off the March 2020 lows in one of the most remarkable market rebounds of all time. Recently, improving economic growth projections, increasing inflation expectations, and higher fiscal policy prospects have exerted upward pressure on interest rates. The U.S. ten-year treasury yield has climbed 1.19% off the 0.50% low.
Why are interest rates rising?
Markets have priced in above-trend economic growth in 2021 as widespread immunizations are expected to allow economies to fully reopen, leading to a strong pickup in growth, particularly in the second half of the year. Unprecedented easy fiscal and monetary policy is anticipated to amplify the strength of the recovery. These improving economic growth prospects have exerted upward pressure on real interest rates (the rate of interest excluding the effect of expected inflation).
Inflation expectations began moving higher when the Fed unveiled a new policy framework amounting to Average Inflation Targeting. Rather than aiming for 2% inflation annually, the Fed will now aim to for 2% inflation on average over time which will support economic recovery by allowing the Fed to remain accommodative for longer. The Fed has clearly communicated it “will likely aim to achieve inflation moderately above 2 percent for some time” after periods of persistently low inflation. Recall, the 2% target inflation rate was never achieved after the Global Financial Crisis, then in 2020, lockdowns created a massive collapse of the global economy, and inflation was below target in 84% of countries. The question is then, when will inflation begin to rise? Once economic growth exceeds potential (estimate of the highest level output an economy can sustain over a period of time) inflation will begin to rise.
With the passage of the $1.9 trillion COVID relief package, higher fiscal spending with a patient and accommodative Fed will increase the pace of economic normalization and the output gap (the difference between actual economic output relative to potential) will close faster.
Why is the stock market uncomfortable with rising bond yields?
If the return to economic normalization occurs more rapidly than initial expectations, this will increase the odds that the Fed’s economic goals are met much quicker than anticipated. The Fed has communicated its intentions to keep rates at zero throughout 2021 and into 2022 but a faster recovery could force the Fed to abandon its forecast and hike earlier.
Who will win the tug of war?
The volatility in the markets suggests investors are uncomfortable with the faster pace of recovery but interest rates are still very low. As long as interest rates remain below the rate of economic growth the stock market will resume an upward trend. Stock market gains are likely to be restrained until there is more clarity as to the ultimate level of bond yields relative to longer-term economic and earnings growth. The IMF estimates that the U.S. package, equivalent to 9% of GDP, will increase U.S. GDP by a cumulative 5 to 6% over three years. Inflation, as measured by the Fed’s preferred index, would reach around 2.25% in 2022, which is nothing to be concerned about. Furthermore, Central Banks will likely push back against the recent rise in interest rates, and factors influencing economic and earnings growth remain positive. Given this outlook, APCM is looking through this recent bout of volatility and maintaining our preference for stocks over bonds.
Brandy Niclai, CFA®
CIO, Multi-Asset Strategies