Market Update June 2021 – Word of the Month
As we move into summer it’s a good time to review where markets are following 2021’s furthering of the equity market rebound that began in 2020. The yearly experience of the capital markets can often be loosely generalized as three phases: January through May, Memorial Day to Labor Day and Fall/Winter. As we consider what lies ahead, reviewing where the various markets stand entering the summer months can be insightful. And context is critical.
Starting with interest rates, the yield of the bellwether US ten-year Treasury bond has risen from 0.91% at the start of the year to 1.59% as of May 31, 2021. While this move in interest rates has been sharp, this level remains meaningfully lower than the ten-year’s average rate, post-Great Financial Crisis (GFC), of 2.3%. And at 1.59%, it remains below the 1.9% yield of December 31, 2019, a time prior to the beginning of the COVID era.
For equities, the S&P 500 Index gained 12% year-to-date through May 31, 2021, and the annualized rate from January 2020 through May 31, 2021, was 23%. While these rates of return for the S&P 500 Index may be higher than long-term averages, this era’s low interest rates and sharp earnings rebound factor into considerations when comparing today’s valuations against history. How might we judge if the current market is at risk due to the size and speed of the advance? And if markets do reverse course is the catalyst most likely fatigue? Or an “event”?
One measure of context for equities may be the post-GFC era. From the April 2009 bottom, the S&P 500 Index moved higher into early 2010 before a pullback. The magnitude of the gains and the duration of the advance were very similar to the current era. Did the 2010 pullback occur because of the large gains from the bottom? No, the duration and size of the advance were not the culprits. Was it due to policy changes or an economic setback, the potential of which had been concerning to investors? No, it was not an economic or policy issue. The interruption to the first phase of the post-GFC rebound was an unexpected culprit, memorialized as the “Flash Crash”, the details of which are for another discussion. But let it suffice to say that the event was largely unpredictable and heavily caused by market operational issues, which have since been addressed in a variety of ways. Now this kind risk, the unpredictable, exists every day for investors. These uncertainties are part of “why” certain assets may provide higher returns than others (e.g., stocks vs. Treasuries) and is foundational for investment decisions by understanding the relationship between risk-taking and return potential.
Back to 2021. Are further gains at greater risk today than during the preceding 14 months? Only to the degree that policy changes are deemed threatening to equity valuations, or the unpredictable “event risk” emerges. For most investors, the latter (unknown and/or unpredictable) is part of constructing a diversified investment strategy. And the former resides in Washington DC at the White House, Congress, and the Federal Reserve.
Today, it appears likely that the economic rebound will continue. And if the expected policy changes are gradually finalized, a choppy, sideways equity market this summer may be the pause that refreshes moving into the fall.
CHART OF INTEREST – Word of the Month
Throughout time, various words or phrases become popular, defining issues that are at the forefront. For the capital markets it may be “stimulus”, “growth”, “dot com”, etc. Today, market participants are focused on what might derail the current bull market, with concerns regarding inflation now beginning to appear.
Inflation has not spent much time in the heads of investors during recent years but, with its re-emergence, the debate has moved to the forefront as to whether current data supporting increasing inflation pressures are sustainable or transitory. Suddenly, “transitory inflation” seems to be a part of nearly every market or economic conversation.
Transitory: of brief duration; tending to pass away, not persistent. Inflation tends to be a variable that doesn’t matter, until it does, and then it can really matter. Given current conditions, this phrase merits attention. Some inflation is healthy, and necessary, for an economy as it is a natural byproduct of economic growth. Howeverif there is no inflation you have “stagflation”. High inflation and economic stability can be threatened as economic participants can’t keep up. With both documented and observed inflation on the rise, “transitory” is indeed an important aspect of today’s economic environment. Is current data supporting further inflationary pressures? Or is the current data reflecting a temporary condition due to the initial recovery phase?
The chart below from Mikael Sarwe of Nordea Market Strategy (via Twitter) provides a good visual of the market’s opinion. As Mikael mentioned “I note a growing consensus … that sticky inflation is a consensus view. I doubt that. If it was, then the US 10-yr yield wouldn’t be 1.6%. Historically, such a low yield has been in line with 1.5-1.7% core inflation, i.e., the bond market believes the transitory story.”
From this perspective, the bond market is pricing in lower sustainable inflation than what the current data is portraying. It follows then that the bond market agrees with the US Federal Reserve that current evidence of higher inflation rates is indeed “transitory”. By these measures, today’s inflation data should not be overly concerning, until it is…
Inflation and Interest Rates
Core CPI y/y & Ten Year US Treasury Yield
Macrobond and Nordea
1985 – May 2021
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