Market Update April 2021 – Interest Rates Don’t Matter…Until They Do 

CAPITAL MARKETS

“Buy the rumor, sell the news”. Like many popular sayings that persist overtime, this one is also hard to prove true or wrong.  Regardless, the idea behind the phrase makes sense; investing is about committing capital to an asset that an investor believes will be worth more in the future.  The idea of a “rumor” in this context isn’t so much about the uncertainty of the plan, but rather it’s in reference to the uncertainty of its impact, which is what provides the opportunity (i.e., risk). And the uncertainty since March 2020 has tested investors’ mettle unlike any other market event: global in nature, impact across all asset classes, swift changes in conditions, very little guidance from history.

We have now seen one of the greatest “buy the rumor” periods ever experienced, which appears to be moving towards the “news” phase.  The “rumor” over the past twelve months had focused on a potentially swift recovery.  While seemingly unlikely last spring, a narrative began to develop suggesting that an economic rebound could quickly take shape once businesses would be able to reopen.  At the heart of this paradigm was the need/belief that vaccines could/would be developed and that between the strength of “stay at home” businesses and the support of monetary and fiscal authorities, the slowdown could be bridged. 

While the narrative had merit, it remained questionable through the summer of 2020.  And the uncertainty of this playing out can be characterized as the “rumor”.  The paradigm was plausible, but without much evidence to build confidence in its execution. 

But now, the vaccinations are being administered at increasingly faster rates, economic and earnings reports are showing evidence of a recovery and future guidance suggests the momentum will continue through the year.  Has the “news” phase arrived?  Have equity markets already priced in further strength for 2021?

As any good economist would say, “yes, and, no”.  “Yes” in the sense that the rebound phase of the economic recovery has made much progress.  And “no”, given that the recovery continues as vaccinations are administered and many business re-openings are still in the works.

Interestingly though, is that the move towards the full “news” phase is occurring just as another “rumor” phase is developing.  Although somewhat controversial, a new catalyst for further economic growth and earnings gains is on the cusp of being implemented in the form of the unprecedented fiscal stimulus plan as approved by Congress along party lines.  This two trillion-dollar initiative is set to begin being administered in the coming months and is designed to provide direct support to individuals, along with creating new/additional business activity.  

Where does this leave investors?  History suggests that this type of support can be a powerful economic catalyst, although not without related consequences.  If so, should the recovery “rumor” turn to “news” and a pause in market gains, the “stimulus” rumor may be the next catalyst.  But any economic improvement or additional earnings growth that is aided by external support demands caution.  While further gains ahead would be the most plausible outcome, factors exist that could change this path.  Two items in particular bear watching; the magnitude and speed of any outsized jump in interest rates, and a slowdown or reversal in the progress of vaccinations.  

Has the “rumor” of a recovery hit the “news” phase?  Is the next “rumor” phase already in play?  The coming months will tell.  While a pause in equity market gains might be expected, the impact of fiscal stimulus could be quite powerful.  And barring an interruption from COVID or interest rates, equity markets may reward this next “rumor”.

CHART OF INTEREST – Interest Rates Don’t Matter…Until They Do 

Investors have a love/hate relationship with interest rates.  On the one hand, investors can benefit from the higher yields of many income producing investments such as government and corporate bonds.  On the other hand, existing fixed income investments may decline in value as their lower rates are not as attractive as those of newly issued bonds.  For business, rising rates may signal improving economic and business health, a better environment for corporate growth.  Yet, for some businesses, rising rates and associated increased costs of doing business may be an impediment to growth and profitability. 

So, are rising rates good for investors, or a cautionary signal?  The chart below from Jim Paulsen at The Leuthold Group provides context for this complicated relationship.  As can be seen, history suggests that when the ten-year Treasury yield is rising, but below three percent, equity gains can be quite strong.  Presumably, investors’ see these conditions as synonymous with opportunities for economic and business growth.  But, the chart also shows that when rates are falling from below three percent, its often a sign of declining conditions, which have taken their toll on equities.  Conversely, when the ten-year Treasury rate is above three percent, investors appear to see rising rates as a hindrance to equities, as rates take their toll on business and the broad economy, while falling rates at these levels look to act as a “relief” to equity investors as the market provides gains.

To date, we remain in the chart’s sweet spot of a rising ten-year Treasury rate, yet below three percent.  Equity markets have responded in-line with the chart’s historical relationships and, from here, further gains will likely coincide with evidence of continued economic improvement. Will three percent be an important line in the sand?  Possibly.  For now, history suggests rising interest rates alone are not yet a hindrance to equity markets.  But the pace of further increases will bear close watching. 

 

 

 

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