Last week's market action was another example of a push-and-pull between stocks, bonds, and the Federal Reserve that investors should expect more of over the course of 2021. Indeed, there is reason to believe that the battle for bond yields and inflation has hit stocks, investors may not peak until the summer.
The Dow Jones Industrial Average hit another new high last week – and the Dow futures were strong on Sunday – as some of the sectors preferred a turn away from growth, including financials and industrials, and further support from the new round of federal incentives received The latest inflation figure was below estimates. The Nasdaq rebounded strongly and hit, big 2020 success stories like Tesla rebounded. Investors looking for the all-clear signal got no signal, however, as the tech sold out by the end of the week and 10-year government bond yields hit a year-long high on Friday.
The Fed meeting on Tuesday and Wednesday of this week could lead to action on yields and growth stocks, but with Fed Chairman Jerome Powell expecting to maintain his cautious stance, some bond and stock market experts will look a little further out from May to July Period as the key for investors. One key data point supports this view: inflation is projected to hit a year-long high in May and rise dramatically.
Federal Reserve Chairman Jerome Powell speaks during a House Select subcommittee on the coronavirus crisis hearing on September 23, 2020 in Washington, DC, United States.
Stefani Reynolds | Reuters
Action Economics predicts that consumer price index (CPI) gains will peak in May at 3.7% for the headline and 2.3% for core inflation. That shouldn't come as a surprise. With the US celebrating its one-year anniversary since the pandemic began, it is the May-May comparison that captures the stalemate that hit the country last spring and is now used to add to inflationary pressures in May.
But even if that happens, the steep rise in inflation in the months ahead is likely to heighten investor concerns that the Fed is still underestimating the risks of upward inflation. It is only a matter of time before the economy is fully open and economic expansion occurs at a rate that drives inflation and interest rates high.
A worldly shift in interest rates and inflation
There is a growing belief on Wall Street that an era of low interest rates and low inflation is coming to an end and that fundamental change is imminent.
"We have had a very docile phase of interest and inflation and that is over," said Lew Altfest of New York-based Altfest Personal Wealth Management. "The bottom has been set, and rates will rise again there, and inflation will rise too, but not as dramatically."
"Speed is what worries investors most," said CFRA chief investment strategist Sam Stovall. "There will of course be an increase in inflation and we have been spoiled because it has been below two percent for many years."
The inflation rate averaged 3.5% since 1950.
This week's FOMC meeting will focus investors on what is known as the "scatter chart" – members' prospects of when short-term rates are going to rise, and this may not change much, even if their members do not have as many members Members must switch views in order to move the median. But it's the summer when the market will push the Fed on a higher inflation rate.
"It's a pretty good bet that higher inflation, higher GDP and tightening are on the horizon," said Mike Englund, chief executive officer and chief economist for action economics. "Powell won't want to talk about it, but this sets the table for this summer discussion as inflation is peaking and the Fed gives no reason."
Commodities and real estate prices
Action Economics now predicts that inflation growth will be moderate in the third and fourth quarters and that interest rates will average around 1.50% in the third and fourth quarters, taking into account movements in the CPI. But Englund is concerned.
"How reluctant is the Fed really," he asked. "The Fed hasn't had to put its money where its mouth is and say interest rates will stay low. … Perhaps the real risk is the second half of this year and a shift in rhetoric."
Some of the year-over-year comparisons of inflation numbers, such as commodities plummeting last year, are to be expected.
"We know people will try to explain it as a comparative effect," says Englund.
However, there are signs of sustained gains and a rise in residential property prices across various commodity sectors, which is not measured as part of core inflation, but rather an economic impact of inflationary conditions. There is currently a record low supply of existing properties for sale.
These are inflationary pressures that make the June-July FOMC meeting and the biannual Congressional Monetary Policy Testimony on Capitol Hill the potentially more momentous Fed moments for the market.
As housing affordability falls and commodity prices rise, it will be harder to tell the public that there is no inflation problem. "It can fall on deaf ears in the summer when the Fed goes before Congress," said Englund.
Altfest is reacting to real estate inflation in its investment outlook. His company sets up a residential real estate fund because it benefits from an inflationary environment. "Volatility in stocks will persist, given the strong ups and downs, and hide in the private market, with an emphasis on cash returns rather than prices on a volatile stock market, which is comforting to people," he said.
Investor sentiment amid impetus
History shows that as rates rise and inflation increases with economic activity, companies can pass price increases on to customers. Last week, investors were delighted to be able to tie four consecutive days of earnings together. According to Stovall, however, stock market investors were also spoiled by the strong performance of the shares. While the trajectory is still higher, the angle of ascent has decreased.
"If there was a guarantee that inflation and interest rates would only rise in the short term, and as we move past the second quarter, which looks drastically stronger than 2020, a guarantee for the second half of the year would bring inflation and interest rates down , investors don't. " be concerned, "he said.
However, economic growth could force the Fed to raise short-term interest rates faster than expected.
"That contributes to the agita," said Stovall.
Altfest customers are split between the manic "Biden cops", who see a time like the Roaring 20s ahead of them, and the depressed, the "Grantham bears".
He says either can be right. Interest rates can continue to rise and corporate profits rise at the same time. More profits mean a better stock market, while higher interest rates put pressure on value for money and offer more opportunities.
For bonds to be a true competitor to stocks, interest rates must be above 3%, and by the time the market gets close, the bond market's impact on stocks will be dwarfed by economic growth potential and the outlook for corporate earnings, according to Altfest. Value remains much cheaper than growth, even if these stocks and sectors have rallied since the fourth quarter of last year. However, he is more focused on overseas stocks, which are benefiting from increased global economic demand and have not moved as fast as the US market.
Stock sectors that work
For many investors, there may not be enough confidence to add stocks significantly as we near the Wall Street summer period when we sell and go in May. But there will also be more money on the sidelines that could flow into stock prices relatively soon, including stimulus payments to Americans who don't need the money to cover daily expenses, and this could help prop up stock prices in the short term, said Stovall.
While the incentive reached many Americans with urgent financial needs and included one of the largest poverty reduction legislative efforts in decades, it also included many Americans with incentive payments that plowed it into the market and increased savings. The country's savings rate is at its highest level since World War II, and disposable income has seen its biggest gain in 14 years at 7%, doubling its 2019 profit. "And that was a boom year," said Englund.
The "sale in May" theory is a misnomer. According to CFRA data, the average change in the price of stocks over the May to October period is better than the return on World War II cash, and 63% of stocks rose over the period. "If you've got a 50:50 chance and the average return is better than cash, why are there tax consequences of selling," asked Stovall. "That's why I always say that you are better off spinning than pulling back."
And for now, the stock market has been working through the rotation in value and out of technology for investors, although last week's Nasdaq gains suggested investors there are looking for signs of stabilization. Industry performance since the S&P 500's last correction in September 2020 shows that the top performing parts of the market have been energy, finance, materials and industrials.
"The very sectors that do best in a steeper yield curve environment," said Stovall. "As the Fed continues to try not to hike rates, these are the sectors that are doing well."
Investors who have already counted this market have proven wrong, and investors rarely give up on a trend that is working. Because of this, Stovall's view remains "rotate rather than retreat" and make more money in value and out of growth as stock market investors continue to stick with companies operating in steeper yield curve environments.
He also pointed out a technical factor to watch before summer. On average, there is a 283 day period between S&P 500 declines of 5% or more, dating back to World War II. It's been 190 days as of last week, which means the market isn't "really due" for another 90 days – or in other words, the start of summer.
By the summer, the anecdotal evidence of prices will work against the Fed. A faster pace of recovery overseas, for example in the European economy, which has lagged behind the US, could also accelerate global demand and commodity markets.
For both inflation and the stock outlook, investors face a similar problem in the coming months: "You never know you will be at the top until you start the downward trend," said Englund.