When Bad News is Good News
Handwringing over higher interest rates continued this week, with the upward trend further exposing a split amongst investors. One camp sees rising interest rates as a mortal threat to the bull market, while other investors see this as a natural process in the re-opening of the economy. Our own long-term views align with the latter perspective.
The 10-year US Treasury note climbed to 1.55% this week, its highest level since before the pandemic. At the same time, Chairman Jerome Powell reiterated the Fed’s commitment to accommodative policy and signaled no intention to raise the Fed Funds Rate any time soon — though he also gave no indication the Fed would take measures to push the 10-year yield lower.1 The Fed is not raising rates, but the bond market sure is.
Is the Party Ending?
The Nasdaq 100 index, which includes the largest 100 stocks in the technology-heavy Nasdaq Composite, fell into correction territory by declining -10.2% from its February 12 record high. This swift pullback is a direct response to higher interest rates and progress toward economic re-opening (we explained why tech stocks fall when interest rates rise in last week’s reflection — The Upside of Inflation). The current price moves should also be viewed in the context of the sector’s dramatic increases last year, and the lofty valuation the market has assigned.2
One phenomenon that emerged over the past year is known as TINA, or “There Is No Alternative”. This refers to the fact that income-oriented investors could get paid more from the dividend yield of stock indexes than they could get from bond yields. Many investors who would otherwise prefer more stable assets opted to buy stocks due to this imbalance, which in turn resulted in even higher prices. While it makes for a nice story of stock market strength, it is not hard to see that this distortion is neither a healthy nor sustainable market environment.
As the world continues to see evidence of economic recovery and vaccination progress, the market relationship between stocks and bonds is normalizing. The 10-year yield is now higher than the S&P 500 yield, signaling there is again an alternative to stocks for income-oriented investors. That doesn’t mean that the stock market will crash or the current trends will continue unabated, but it does mean the market environment is evolving and conditions may support a broader set of industries beyond large technology companies.
A Robust Economy
While some investors feel threatened by higher rates, many others are encouraged by the positive news that is leading rates higher. The unemployment rate improved to 6.2% this week, which is well below the pandemic high of 14.8% — though still above the 3.5% unemployment rate from February 2020.3 Retail, education, and health services industries added a significant number of new jobs in the past month. We expect further employment gains as the economy continues to evolve towards post-pandemic normalcy.
In that landscape of recovery, there remains uncertainty for some sectors. The same interest rate shifts that are presenting a headwind for technology stocks with their earnings far in the future are a tailwind for financial stocks and companies with strong current earnings and low debt. Progress on economic re-opening is a headwind for Zoom and Peloton, but it is a tailwind for hotels, airlines, and the restaurant industry. Another example of this transformative chaos is the real estate sector — which is balancing an acute housing shortage nationally with a cloudy outlook for commercial and office real estate. We’ll explore what these real estate shifts mean for investors and portfolios in our Friday Reflection next week.
Improving conditions and sector rotations are a sign of a healthy market and another reason why we remain staunch believers in diversification. Our clients will benefit as a broader set of industries grow and will receive higher interest rates on an incremental basis as the bonds within their portfolios reinvest at higher and higher rates. This will lead to stronger income on bonds and interest paid on bank savings — a novel concept over the past decade.
Like many transition periods, it will take time. Fear and price volatility will continue to be common themes alongside economic progress. For markets and people alike, change can be hard — but it is a necessary component for healthy growth.
1 Powell Confirms Fed to Maintain Easy-Money Policies. By Paul Kiernan. Published March 4, 2021, WSJ.com
2 The P/E ratio on the NASDAQ 100 was 38.46 as of 2/26/21; the P/E ratio from one year prior was 25.63. This equates to an approximately 50% increase over the past year in the price investors were willing to pay for a dollar of current earnings from these companies.
3 The 3.5% unemployment rate in February 2020 marked a 50-year low. https://www.bls.gov/charts/employment-situation/civilian-unemployment-rate.htm
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