Last week’s market action was one more example of a push and pull between stocks, bonds and the Federal Reserve which investors should expect to see more of throughout 2021. In fact, there’s reason to believe the battle over bond yields and inflation which has gripped stock investors may not peak until the summer.
The Dow Jones Industrial Average hit another new record last week as some of the sectors favored in a rotation away from growth gained, including financial and industrials, and gained further support from the new round of federal stimulus, while the latest inflation number came in below estimates. The Nasdaq rebounded sharply and beaten-up, big 2020 success stories like Tesla rallied. But investors looking for an all-clear signal to be sounded didn’t get one as tech sold off to end the week with 10-year Treasury bond yields hitting a one-year high on Friday.
The Fed meeting on Tuesday and Wednesday of this week may drive action in yields and growth stocks, but with Fed chairman Jerome Powell expected to maintain his dovish stance, some bond and stock market experts are looking a little further out, to the May-July period, as a key one for investors. A data point informs that view: inflation is expected to hit a one-year peak in May, and it will mark a dramatic rise.
Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a House Select Subcommittee on the Coronavirus Crisis hearing in Washington, D.C., U.S., September 23, 2020.
Stefani Reynolds | Reuters
Year over year gains in the Consumer Price Index (CPI) will peak in May at 3.7% for the headline number and 2.3% for core inflation, according to a forecast from Action Economics. That should not be a surprise. As the U.S. marks its one-year anniversary from the start of the pandemic, it is the May-to-May comparison which captures the shutdowns which gripped the country last spring and now will serve to magnify this May’s inflation print.
But even seeing this coming, the steep climb in inflation over the coming months will likely add to investor concerns that the Fed still may be under-appreciating upside inflation risks. It is just a matter of time before the economy is fully opened and economic expansion occurs at a rate which will drag inflation and interest rates higher.
There is growing belief on Wall Street that an era of low interest rates and low inflation is ending, and that a sea-change is coming.
“We’ve been through a very docile period in rates and inflation and that is over,” says Lew Altfest of New York City-based Altfest Personal Wealth Management. “The bottom has been established and rates are going to work there way back up and inflation will as well, but not that dramatically.”
“It’s the speed that is of greatest concern to investors,” according to CFRA chief investment strategist Sam Stovall. “There is naturally going to be an increase in inflation and we have been spoiled because it’s been below two percent for many years.”
The inflation rate has averaged 3.5% since 1950.
This week’s FOMC meeting will focus investors on what is called the “dot plot” — the outlook from members on when short-term rates will increase, and that may not change to a significant degree even though it does not take that many members shifting their view to move the median. But it’s the summer when the market will be pressuring the Fed on a higher inflation trajectory.
“It’s a pretty good bet that there is higher inflation, higher GDP and tightening on the horizon,” said Mike Englund, principal director and chief economist for Action Economics. “Powell won’t want to talk about that, but this sets the table for that summer discussion as inflation hits a peak and the Fed doesn’t give ground.”
As of now, Action Economics forecasts that inflation gains moderate in Q3 and Q4 and interest rates, anticipating CPI movements, hover around the 1.50% average in Q3 and Q4. But Englund is concerned.
“How dovish is the Fed really,” he asked. “The Fed has not had to put its money where its mouth is yet and say rates will stay low. …. Maybe the maybe real risk is the second half of this year and a shift in rhetoric.”
Some of the year-over-year comparisons in the inflation numbers, such as commodities which plunged last year, are to be expected.
“We know people will try to explain it away as the comparison effect,” Englund says.
But there is evidence in various commodity sectors of sustained gains, and upward pricing pressure in residential real estate, which is not measured as part of core inflation, but is an economic ramification of inflationary conditions. There is currently a record low supply of existing homes for sale.
These are inflationary pressures that make the June-July FOMC meeting and semiannual monetary policy testimony to Congress on Capitol Hill the potentially more consequential Fed moments for the market.
If housing affordability is going down and commodity prices are going up, it will be harder to tell the public there is no inflation problem. “It may fall on deaf ears in the summer when the Fed goes before Congress,” Englund said.
Altfest is acting on housing inflation in its investment outlook. His firm is starting a residential real estate fund because it is a beneficiary of an inflationary environment. “Volatility in stocks will continue given the strong plusses and minuses and hiding in the private market, focusing on cash returns and not prices in a volatile stock market, is comforting to people,” he said.
History shows that as rates and inflation increase with economic activity, companies can pass along price increases to customers. Last week, investors were pleased they could string four consecutive days of gains together. But in Stovall’s view, stock market investors have also been spoiled by how sharply equities have advanced, so while the trajectory is still higher, the angle of ascent has been reduced.
“If there was a guarantee that we only see a near-term pick up in inflation and rates and as we move past Q2, which looks drastically stronger than 2020, a guarantee the second half would see moderation in inflation and rates, investors would not be concerned,” he said.
But economic growth could force the Fed’s hand to raise short-term rates more quickly than anticipated.
“That’s adding to the agita,” Stovall said.
Altfest clients are split between the manic “Biden bulls” who see a period like the Roaring 20s ahead, and the depressives, the “Grantham bears.”
And he says both can be right. Interest rates can continue to move up and at the same time corporate profits pick up. More profits equals a better stock market, while higher interest rates pressure price-to-earnings ratios providing more opportunities in shares.
For bonds to be a real competitor to stocks, rates have to go over 3%, and until the market is close to that, Altfest says any effect from the bond market on stocks is dwarfed by economic growth potential and the outlook for corporate profits. Value remains much cheaper than growth even as those stocks and sectors have rallied since the fourth quarter of last year, though he is focused more on overseas stocks which will benefit from increased global economic demand and have not raced ahead as fast as the U.S. market.
For many investors there may not be enough confidence to add to significantly to holdings as we come closer to the “sell in May and go away” summer Wall Street period. But there will also be more money from the sidelines that may flow into equity prices relatively soon, including from the stimulus payments to Americans who do not need the money to cover everyday expenses, and that could help bolster share prices in near term, Stovall said.
The stimulus, while reaching many Americans with dire financial needs and including one of the largest anti-poverty legislative efforts in decades, has also reached many Americans with stimulus payments who have plowed it into the market, and increased savings. The savings rate in the country is at the highest level since World War II, and disposable income has experienced its largest gain in 14 years, at 7%, doubling the 2019 gain. “And that was a boom year,” said Englund.
The “sell in May” theory is a misnomer. According to CFRA data, the average price change in stocks during the May to October period is better than the return available from cash going back to World War II, and 63% of the time stocks have gained during the period. “If you have better than a 50-50 chance and the average return is better than cash, why incur taxable consequences by selling,” Stovall asked. “That’s why I always say you’re better off rotating than retreating.”
And for now, the stock market has been working for investors through the rotation into value and out of technology, though last week’s Nasdaq gains suggested investors watch for signs of stabilization there. Sector performance since the last S&P 500 correction in September 2020 shows the best-performing parts of the market have been energy, financials, materials and industrials.
“Exactly those sectors which do best in a steepening yield curve environment,” Stovall said. “As the Fed continues to dig in its heels on not raising rates those are the sectors that do well.”
Investors who already counted out this market were proven wrong, and investors rarely like to give up on a trend that is working. That is why Stovall’s view remains “rotate rather than retreat,” and more money into value and out of growth as stock market investors continue to stick with the companies that work in a steepening yield curve environment.
He also pointed to one technical factor to watch ahead of the summer. On average, there is a period of 283 days between S&P 500 declines of 5% or more going back to World War II. As of last week, it has been 190 days, meaning the market is not “really due” for another 90 days — or in other words, the beginning of summer.
By summer, the anecdotal pricing evidence will be working against the Fed. A quicker pace of recovery overseas, such as in the European economy which has lagged the U.S., could also accelerate global demand and commodities markets.
For both the inflation and stock outlook, investors face a similar problem in the months ahead: “You never know you’re at the top until you start the downtrend,” Englund said.