Stocks struggle through a volatile week

Last week was what I would call a “Rip Van Winkle” week. Set in the colonial days of America, Rip Van Winkle is the story of a man who, sick of his wife, decides to go for a hike in the mountains with his dog. He meets a group of strange men who offer him an unusual drink, causing him to fall asleep. When he wakes up, he realizes that more than 20 years have passed, and that he slept through a tumultuous time: He missed the Revolutionary War, in which many of his friends were killed.

Why was I thinking about this story last week? If investors could have taken an extended nap at the beginning of last week, they would have woken up on Friday night with the S&P 500 Index and Dow Jones Industrial Average actually posting a gain — and they would have slept through some major volatility in between, including a significant sell-off.

Some fear that the Fed will be forced to raise rates

Last week was a very difficult period for investors, full of anxiety and fear that the Federal Reserve (Fed) will be forced to raise rates because of rising inflation, and that view led to the rise in the 10-year US Treasury yield. There is concern that the Fed may be losing control of interest rates on the long end of the yield curve.

This should come as no surprise, however — the reality is that it’s very difficult for a central bank to control the long end of the curve. While the Fed can try to reassure investors that it won’t raise the federal funds rate, markets can still have doubts, and that’s what we saw last week. The sell-off was exacerbated by the interview with Fed Chair Jay Powell last Thursday. Some market participants expected Powell to announce that the Fed would use yield curve control tools such as “Operation Twist” to control rates on the long end. However, that did not come to fruition and market participants registered their disappointment.

Stocks were hit by a mid-week sell-off

The problem is that when there is a significant rise in the 10-year yield — especially quickly — it can often cause a re-rating of stocks. And that’s exactly what happened last week, when we saw a rather dramatic sell-off in stocks over several days. This is what we should expect when economic growth prospects improve, raising concerns about inflation as well. Rates were adjusting to improving economic growth prospects, and stocks were simply adjusting to the rise in rates. While adjustments can be difficult in all facets of life, not the least of which is markets, an adjustment signifies a transition — it is temporary by nature. I think of it as a short period of indigestion as stocks get acclimated to higher rates.

We saw the mirror image of this last year at this time. Last February and March, we also saw a significant and rapid adjustment in markets — but to deteriorating economic prospects. In early February 2020, the yield on the 10-year US Treasury bond was 1.65%.¹ However, as COVID-19 spread and the economic outlook dimmed substantially, the yield on the 10-year adjusted to the new economic reality, plummeting to 0.54% on March 9, 2020.² The S&P 500 Index, also adjusting to the new economic reality and its potential impact on earnings, closely followed that drop, beginning its plunge in mid-February and only bottoming later in March when the Fed intervened.

The good news is that we are only back to levels where we were before the pandemic. And if we look at past periods of rising 10-year US Treasury yields, we generally see increases in stocks during the same period. That’s what we’ve historically seen when rising yields are fueled by accelerating economic growth and improving corporate earnings (not significant inflation). But at the same time, there can often be a rotation in leadership.  

If we look at Wednesday’s sell-off, two of the most cyclically sensitive sectors posted gains and drove the S&P 500 Index and Dow Jones Industrial Average to end the week higher: energy and financials. In fact, in the last month, the S&P 500 Index’s performance has been disappointing, but energy and financials have posted double-digit gains. Again, this is to be expected given the magnitude of the potential recovery. Those sectors that are most cyclically sensitive should be expected to outperform. Typically smaller-cap stocks outperform larger-cap stocks. In other words, I believe this is not a time to abandon stocks, but to understand which sectors and areas of the market could be poised to benefit. There is a lot of disruption going on in various areas — so it is definitely a place for active management, in my view.

We’ve continued to see good economic news

Since writing last week’s blog, I’m even more encouraged about the near-term future for the global economy.

• In the US, the Biden administration announced it was moving up its timeline for vaccinations — it now anticipates having enough doses to vaccinate all American adults by the middle of May.  
• US real gross domestic product (GDP) growth forecasts continue to be revised upward and could be as high as 8% to 10% this year given the likelihood that the new stimulus package gets passed.
• China set a 2021 GDP growth target of more than 6% with expectations of creating 11 million new jobs this year.³ There were expectations that China might choose not to release a target, as it did for 2020. But China clearly feels confident enough about its economy to release this forecast — which, by the way, is well below consensus expectations of approximately 8% GDP growth for 2020.⁴
• I’ve been talking a lot about my expectation that there will be a big surge in consumer spending given pent-up demand and elevated household savings in a number of countries. However, I believe a substantial rise in capex spending is also very likely, given the certainty created by COVID-19 vaccines.

Also, I think it’s important to stress two things:

• I don’t expect inflation to become “problematic,” to quote Fed Chair Jay Powell. Yes, there could be an increase in inflation as the economy re-opens, but I expect it to be very transitory. There are a number of reasons to believe inflation will be benign, including that there is significant labor market slack that will take time to improve, and that there are longer-term structural forces that will continue to exert downward pressure on inflation, including demographics and technological innovation.
• I think it’s likely that the Fed will act if the yield on the 10-year US Treasury rises rapidly from here and creates disorderly markets. Last June, the Fed considered monetary policy tools that could accomplish yield curve control but decided such action was not needed in the current environment. However, the minutes from that July meeting leave the door open to future use if the environment merits it: “… many participants judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly. A couple of participants remarked on the value of yield caps and targets as a means of reinforcing forward guidance on asset purchases, thereby providing insurance against adverse movements in market expectations regarding the path of monetary policy, and as a tool that could help limit the amount of asset purchases that the Committee would need to make in pursuing its dual-mandate goals.”⁵

Conclusion

In periods like these — when the market is fearful in the near-term, but economic trends look positive — I believe it’s time to look for buying opportunities. Understanding what’s driving the current volatility, and how similar historical periods played out, can help investors decide where to look.