April, 2021
Markets respond to rising rates, but the risk of higher rates is still ahead
A lot has happened over the first quarter of 2021. More money has flowed into U.S. equities in the last 5 months than has occurred in the last 12 years. Energy stocks are up 28% this year, financials are up 23%, cyclical stocks have roared ahead (think Caterpillar, Home Depot, banks, autos and industrials). Both the TSX, the Dow and the S&P are hitting new all-time highs almost every day. New monthly job creation in the U.S. is approaching 1 million new jobs each month and unemployment has fallen to 6% (excluding those not looking for a job). Wage increases have stayed flat. Trillions of dollars of stimulus is flowing into the markets to help support economies around the world as central bankers promise to do whatever is needed to get the world’s economies moving again. The Federal Reserve(Fed) Chairman Jerome Powell is promising to keep interest rates low for longer, even if it means inflation rising above 2% for some time. The Bank of Canada (BoC) will most likely follow the Fed’s lead, leaving rates low for longer. Expectations are for as much as a 6% or better GDP growth rate in the U.S. economy in 2021, a level not seen since 1997, and with Canada not far behind. All of this seems exceptionally positive, yet, in spite of all this good news, investors are nervous. Let’s look at the reasons why.
Let’s start with the bond market, which has been falling since the beginning of the year because of growth and inflation expectations. 10-year Treasury yields have spiked from 0.5% last summer, all the way back up to over 1.7% in March. This rise simply reflects the markets view that the economy in the U.S. and likely elsewhere, is set to race ahead later this year as people get vaccinated for COVID-19 and can finally resume their normal lives. I think this is likely to be the case. Airlines will see their customers return, cruise ships will resume sailing, people will start taking vacations, spending money in hotels, restaurants and at sporting events and so on. Remember the service sector is two thirds of U.S. and Canadian GDP, so when consumers can get out and spend, the economy will thrive, for a while at least.
So why could rising 10-year Treasuries spoil the markets otherwise positive outlook? Because rising rates may also be pricing in expectations for rising inflation. In March, U.S. core CPI numbers were up 0.7% (annualized, that’s one of the highest reads of inflation in over a decade). Evidence of inflation is everywhere, from higher lumber prices, copper, food, furniture and autos (that’s if you can actually find the car you want at your local dealer). You can thank a shortage of semi conductors to run all the new safety gadgets in new cars for the half a million fewer cars on dealer lots this year.
In February, as interest rates rose, the market decided all the talk about inflation must mean that Jerome Powell and the Fed will have to start raising short term rates, to put a stop to this new inflation, sooner than he was saying. This would drive up borrowing costs and constrain the flow of easy money, putting the brakes on the economy. It also would mean high flying tech stocks could not sustain their lofty levels, as they are the most vulnerable to higher rates. So we had a sell-off of the highest priced growth stocks, with some dropping 20% to 30% from their recent highs as investors sold some of their growth names and rotated into the cyclical stocks. These boom and bust stocks do well when the economy opens up, and have fuelled the recent record new highs in the market benchmarks. Value stocks like banks also benefited.
Investors who owned banks, industrials, consumer, commodity and energy stocks experienced a more than 10% runup in their portfolios, while those in the long term growth names that did so well last year have seen a painful drop. But a funny thing just started happening in the first week of April. Those high flying Treasury yields have leveled off, fears of inflation spikes have moderated, and money is now flowing back into the high growth names that have been stagnant since the U.S. election in November. You can imagine all this is enough to give investors more than a little vertigo.
While we are undoubtedly in the midst of a bull market in 2021 and beyond, there are reasons for caution beyond just inflation. From a valuation perspective, multiples for growth stocks are high, and after the recent surge in cyclicals, valuation gaps in many cases have closed and these stocks are no longer cheap. This is always a concern but it often resolves itself with companies earnings growth catching up to valuations and stock prices stabilize. For example, in 2018 the Fed raised interest rates nine times and yet high quality dividend growth portfolios were essentially flat through this period of time because earnings and dividend growth offset interest rate affects. And this was during a year in which GDP growth was a modest 2.9% in the U.S. and 2.0% in Canada; we are expecting over 6% growth this year.
But if rates continue to rise steadily in the coming years, this will be the primary focus of concern for the markets: is inflation going to be a problem or not? As is so often the case when predicting the future, the answer is not clear. Some will argue inflation will rise this year and continue to rise in 2022, forcing the Fed and the Bank of Canada to intervene by raising rates and potentially disrupting the economic growth that is fueling the markets. Others, including the Fed, say inflation will rise this year as supply chains struggle to keep up with rising demand and the world’s economies open up, but then will recede once pent-up demand is satisfied and supply chains adjust.
I expect to see inflationary pressures this year and next as the world returns to normal activities and consumer spending picks up. But longer term, I don’t see inflation rising to dangerous levels that would force central bankers to dramatically increase rates. The reasons I believe this are as follows. Firstly, the average age of the population in developed economies is rising, and populations are stagnant with people having less children. As people age, they tend to spend less and save more. Also, if the population does not grow, economies slow. These trends are structural, are unlikely to change, and are disinflationary. Secondly, technological innovation will continue to create greater efficiency and lower the cost of goods. Thirdly, the internet allows consumers to instantly comparison price and so most retailers do not have the power to raise prices. Fourthly, wage increases are likely to be modest as unions no longer have the power they once held. Fifthly, the level of government and consumer debt in the developed world is near record high levels. This significantly reduces their ability to spend, as higher amounts have to go to service their debt. Finally, governments will not be in any rush to pay down debt, in fact, they may never repay the debt simply because they will not have to. Instead, governments will pursue policies that create modest growth and some inflation, with only modestly higher rates, as a means to grow their economies and therefore reduce debt as a percentage of larger GDP.
So my personal view is that while inflation is rising and will rise further this year and stay elevated into 2021, it will not be so high as to cause major changes to interest rates or disrupt the stock market. A recent Goldman Sachs report suggested the 10-year Treasury yield would have to exceed 3.5% before the stock market would be disrupted. That being said, the unusually low rates we are experiencing now will have to be reset to more normalized levels once the economy bounces back. That also means quantitative easing (government bond purchases of Treasuries to keep rates low) will also have to ease and eventually end. Remember the long term average level for the 10-year Treasury is closer to 2.7%, a level we will have to return to as part of a normally functioning economy. That’s a full percentage point higher than we are today. All of this represents a wall of worry which the market must climb if it is to go higher, which I believe it will. The Fed will have to do a masterful job of telegraphing the changes to monetary policy that are coming and gradually ease into the tightening policy changes over an extended period of time, in order to convince the market that these changes can be accommodated without major disruption to the economy. This likely won’t happen without a few bumps in the road, so I expect a continuation of the volatility we have seen in February and March as we move into the summer months. Don’t be surprised if we see a 10% pullback in the market later this year before the market resumes it’s upward trend to year end, finishing the year higher.
So how should investors interpret these recent developments? Is this the time to be more defensive and reduce equity exposure in the face of rising inflation and interest rates? I believe investors need to be cautious and stay invested. We are likely to see one of the strongest economies in decades later this year when the economy opens again. But we will also see interest rates slowly move higher. I expect the 10-year U.S. Treasury yield over 2% by year end, and the Fed and the Bank of Canada beginning to make adjustments as soon as mid- 2022. The market will have to adjust to these changes, and will likely do so in fits and starts, just as it has so far this year. But I believe the markets will end the year higher and investors who stay the course will be rewarded with another year of good returns.
High multiple growth stocks with no earnings will continue to take the brunt of market volatility as inflation fears rise and fall. Therefore, it makes sense to take some profit in growth names when you have it, in particular if they rally back to their all-time highs later this year. Investors also need to have a significant over-weight in cyclical stocks which will benefit the most from the re-opening of the economy. My barbell approach which I recommended in my January update remains intact. But I am tilting away from a 50/50 balance, to a more over-weight in cyclicals as I trim growth names.
Bonds will struggle this year if rates continue to rise. Investors can hold a small weighting in bonds for diversification, but exposure should be very limited as they will most likely lose value this year and next. I have reduced my maximum bond weighting to 15% this year for my most conservative investors, and for those still in the workplace and accumulating wealth for retirement, I recommend no bonds in their portfolios.
As always, if you have any questions about your own portfolio, please do not hesitate to call me.
This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2021.
Gord Forsey is an Investment Advisor with CIBC Wood Gundy in Halifax, NS. He and his clients may own securities mentioned in this column. The views of Gord Forsey do not necessarily reflect those of CIBC World Markets Inc.
