Why are you not more bearish?
Client Question: There is a possible world war going on along with a seemingly never-ending pandemic, inflation is at multi-decade highs, the Fed and other central banks are tightening monetary policy, and the world may lose access to Russian oil and gas entirely soon – why aren’t you massively bearish on stocks, which everyone knows is the high-risk asset class?
Answer: While naturally reserving the right to get more cautious on stocks (we downgraded equities to neutral on Feb. 14th), there are a few reasons we are not more bearish on stocks or the broader economic outlook at the moment.
Rate policy diverging among global central banks
Central bank policy remains a key focus for investors as rates are set to rise in the US this year, with debate about the pace of the rate hikes and balance sheet adjustment ongoing. However, this is not true everywhere, as there have been growing divergences in expected rate policies among the major developed market central banks.
As shown in the chart below of two-year sovereign bond yields for the US, UK, Japan, and Germany (Eurozone), investors are pricing in multiple rate hikes over the next year or two from the US Fed and the Bank of England (BoE): US and UK two-year yields are at or near 1% now, up from around zero for most of the time since early 2020.
Powell testimony adjusts timing of taper, not long-term rate outlook
Fed Chair Jerome Powell testified before Congress on Tuesday alongside Treasury Secretary Janet Yellen, and markets were listening. While many topics were discussed, the markets responded most to Powell’s indication that the Fed may speed up the recently announced tapering plan for the huge bond buying program (“QE”) that has been in place since March of last year. The initial plan for $15 billion/month reductions in bond buying would have brought the process to a close by June of next year, while a faster pace could do so by March. Markets also focused on Powell’s comment that the word “transitory” may no longer be applicable with regard to inflation: “it might be time to retire that word (‘transitory’) and try to explain more clearly what we mean.”
Inflation expectations: markets showing more worry now, less worry later
Inflation remains a hot topic among investors, policy makers, and voters. While there is not a great deal that policy makers (fiscal or monetary) can do in the short term to control inflation (today’s announcements of coordinated releases from strategic oil reserves are mostly a signaling action), there are steps that can be taken on a longer horizon. Monetary policy has historically been the primary lever used to try to manage inflation, though it has arguably been less effective in recent years as it has run into the “zero lower bound” (ZLB) with short-term interest rates. Fiscal policy is likely a more potent lever but historically has not been used as such.
Fed dodging another taper tantrum
The primary news from the Fed meeting yesterday was to clarify the likely timing of reducing and then ending the current QE (quantitative easing, or bond buying) program. Fed Chair Powell indicated that (barring any big surprises) the tapering would begin at the next FOMC (Federal Open Market Committee) meeting in early November and aim to be completed (bond buying would end) by the middle of 2022. This would be a somewhat quicker move to end QE than occurred previously, but markets seem prepared for this and thus unlikely to have a “taper tantrum” again.
What is stagflation and is it making a comeback?
A frequent question lately has been: are we currently in, or about to enter, a period of “stagflation” like the late 1960s and 1970s as a result of COVID and policy responses? Our short answer is no: while inflation may be elevated for a while, growth is currently strong, structural inflation pressures are low, and policy is better now than in the 1970s, making any sustained stagflation conditions unlikely. Below we offer some historical context and our current views.
Inflation is steady on the surface, volatile underneath
Inflation expectations have been a topic of growing interest thanks to the extraordinary fiscal and monetary support in place for much of the last year, most recently the huge $1.9 trillion American Rescue Plan that is currently sending checks out to millions of Americans.
All of this new spending by the federal government, along with the economic recovery permitted by the rollout of COVID-19 vaccines, is provoking more discussion about whether demand for goods and services will outpace the economy’s ability to produce them and push prices higher.
Bond market making some noise
The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.
Putting the Fed’s balance sheet in perspective
Along with fiscal stimulus, the aggressive support of financial markets by the Federal Reserve (and other central banks) has been a key to the gains in risk assets since April. In our view, stock and bond prices would not be as high as they are if not for the perception that the Fed will step in with additional support if markets get too volatile. This perceived “Fed put” is on top of the ongoing bond buying programs (excluding the immediate post-COVID surge) that are currently running at a rate of about $80 billion per month for Treasuries and $40 billion per month for mortgage backed securities, though some of this replaces expiring bonds.
In case you need a refresher course, it’s all stimulus these days
Much has been made about the divergence between the path of the US (and global) economy and that of the stock and corporate bond markets. Even while economic and earnings growth is historically weak and remains under severe pressure from a rapidly spreading virus, major stock market indices have rallied and are at or near all-time highs. Market valuations based on forecasted earnings over the next 12 months have clearly risen sharply.