By Ken Mahoney, President – Mahoney Asset Management
Huge amounts of fiscal stimulus have been injected into the US economy since the start of the pandemic, increasing the US national debt ‘bomb’ to $28 trillion. The reason this ‘bomb’ has not detonated is mainly because interest rates are so low, but as the economy reopens and inflation rises any tapering from the Federal Reserve would cause a ‘tantrum’ of such, having profound effects on the US and global markets.
We believe the US stock market has been in a two-act play as of late, the first act being made up of largely positive news surrounding vaccinations, lower Covid-19 cases, and massive fiscal stimulus, all of which have benefitted the market and investor sentiment.
Now comes the second act, which is higher income, corporate, and capital gains taxes combined with more regulation, and it is just a matter of time before all of that is implemented. However, one factor investors may not have priced-in as much is inflation, and with inflation, comes higher interest rates, something the markets will certainly feel the impact of.
Rising inflation can be a significant predecessor to interest rate hikes, and we are witnessing a rising inflationary environment unfolding here. At the start of the year inflation was under discussion and somewhat expected as pent-up demand was set to be unleashed in the economy. However, the rumours were confirmed this week when the latest CPI figures were released, and April 2021 CPI came in at 0.8% vs estimates of 0.3%, creating the largest year-over-year increase since 2009, and this pushed the 10-year Treasury yield up slightly to 1.62%.
When looking at the 10-year yield, we can see it started the year at 0.9% and ran up as high as 1.75% in March as fears the Federal Reserve were going to reduce asset purchases and go back on their promise of keep rates at 0-0.25% until 2023 set in. As investors digest the idea of a steepening yield curve one sector that will benefit from this are the banks, and we have seen the likes of JPMorgan outperform the overall market year-to-date.
When taking a step back and assessing your options, the equity markets are still the place to be right now, and with bond analysts expecting the 10-year Treasury note to yield anywhere between 2%-2.5% by the end of 2021, this could remain the rhetoric for some time.
Most economic policies work in motion, so because extensive unemployment benefits are being distributed, we are seeing individuals turn down work, creating wage inflation as brick-and-mortar stores and restaurants attempt to attract talent. There were attempts to squash this argument for the time-being as the Labor Department’s announced 266,000 jobs created in April, three times less than the expected figure.
However, we are seeing obvious signs of inflation in our everyday lives, just looking at the price of gas now compared with a year ago, but since many are suggesting this is transitory, we sure hope they are right. It is clear economist and analysts set the bar low for 2021 growth estimates and investors are starting to realize this as companies beat expectations by two or three times only for their stock price to fall.
Despite all of this, the Biden Administration is still keen on issuing another $4 trillion of stimulus, which we believe would be overkill for the economy and could prompt the Fed to respond, as after all, real GDP grew at a 6.4% annual rate in the first quarter, it doesn’t get much better than that.
The Federal Reserve will have a tough time being so dovish and keeping rates low if these numbers continue, and any sign of tapering from the Fed, could send the markets into freefall in the days that follow. That being said, investors must understand why this is happening; the economy is strengthening, spending is increasing, and confidence is coming back to the country after such a tough year for many.
The consequences are already unfolding as the technology trade unwinds with investors taking profits on 60, 80, or even 100% moves out of the March 2020 bottom. Dividend paying stocks and companies that benefit from a rising inflation and interest rate environment have been outperforming as of late, and these include energy, materials, and the banking sectors (XLE, XLB, XLF).
A rising interest rate environment should force stock market investors to assess their portfolios and make changes, if necessary, but one thing they should not do is panic and overcompensate.
We have seen the pendulum swing aggressively from growth to value this year, and because the majority of moves have been overexaggerated, volatility has remained, highlighting the need for a well-diversified portfolio.
For bond investors, reducing long term bond allocations is smart as prices begin to fluctuate and replacing these with shorter term debt instruments such as certificates of deposit can help mitigate risk, but any change should be done incrementally as it can take weeks or months for the effects of rising inflation and higher interest rates to unwind.