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The Fed’s preferred inflation gauge—the Personal Consumption Expenditures (PCE) Price Index—hit the wires Friday morning, showing inflation ticked up from 1.4% y/y to 1.6% February.[i] That is below the Fed’s 2% target. But if we have learned anything in our many years of covering economic developments, it is that this won’t do a thing to quell inflation chatter. Many still think rapid inflation is inevitable as more businesses reopen, especially with fiscal stimulus talk picking up again. This week, we have seen a fair few pieces arguing we are seeing the initial signs of this, which we think makes it worth a look at what is—and isn’t—inflation. Mind you, we don’t think rising inflation is inherently a risk for stocks, which have actually done quite well during such spells in the past. Trouble generally stems from the Fed being too late to rein in prices and then over correcting, an event we think defies prediction. Still, having a better understanding of the supposedly inflationary news today can help you keep a level head when making portfolio decisions, so off we go.
First off, what the heck is inflation, really?
Glad you asked. Inflation is a general rise in prices across the entire economy. Inflation measures use broad baskets of goods and services in hopes of capturing broad trends accurately. These include the aforementioned PCE index as well as the Consumer Price Index (CPI) and private-sector gauges like MIT’s Billion Prices Project. At any time, some items in these inflation baskets will rise while others will fall, but those outliers cancel each other out and let the broader trend emerge.
Investors have a lot on their plate these days, from tax season to stories of investing opportunities promising big returns—including the newest fad, digital art. All the noise can be overwhelming, and, unfortunately, ne’er-do-wells will seek to exploit honest folks’ emotions. To help you shore up your defenses, your friendly MarketMinder Editorial Staff has round up examples of illicit activity garnering financial headlines recently—and has some tips on protecting yourself.
Watch Out for the Pump and Dump
Stories of huge investing successes may tempt some to chase big returns, leaving them susceptible to a common investment scam: the pump and dump. This scheme often involves shares of tiny companies that trade for less than $5 a share—also known as penny stocks. These thinly traded securities usually trade on over-the-counter (OTC) markets rather than major stock exchanges. Some were caught up in January’s Reddit frenzy, hence the heaps of attention now.
One year ago today, global stocks hit bottom. They had fallen -34.0% since their high on the previous February 12, pricing in the strict lockdowns and resulting deep economic contractions across the US, Europe, Australia and the rest of the developed world.[i] The very next day, economic data would start registering that contraction courtesy of IHS Markit’s flash purchasing managers’ indexes (PMIs) for services and manufacturing. But stocks were already looking further ahead—they had priced the flood of bad news to come and were already looking forward to reopening and recovery. On paper, the steep rally over the past year is a new bull market. But as we will show, we think stocks are acting as if last year’s record-fast decline was the eighth correction in the bull market that began way back on March 9, 2009. That has two key forward-looking implications, as we will discuss.
A helpful way to see the past year’s uniqueness relative to other new bull markets, in our view, is to look at stylistic leadership. Usually, value stocks beat growth in a new bull market’s first stage. Value companies usually have shakier credit and rely on bank lending, making them extra-vulnerable in a bear market’s panicky final stage. Investors fear these companies won’t survive the recession and associated tighter credit conditions and punish them disproportionately. But they usually bounce just as fast in the new bull market, thanks to gutsy bargain-hunters seeking big returns in unfairly punished, economically sensitive firms and turnaround opportunities. This history, coupled with vaccine enthusiasm, is why the vast majority of pundits—and a record-high share of fund managers—expect value to beat growth for the foreseeable future.
But as Exhibits 1 – 3 show, the last year has looked much more like the typical aftermath of a correction that occurs late in a bull market than it does a new bull market. Exhibit 1 shows the past 12 months, with growth leading out of the gate and still ahead cumulatively, despite some countertrends. That looks nothing like Exhibit 2, which shows growth trailing over the first year following the prior two bear markets (again, with some countertrends). But it looks an awful lot like Exhibit 3, which shows the corrections occurring late in the 2002 – 2007 and 2009 – 2020 bull markets. In all three, growth led out of the gate and cumulatively over the full 12 months, with—yes—countertrends.
During value’s bursts of outperformance since vaccine news broke last November, talk of the so-called reopening trade—a market rotation from industries that benefited from the lockdowns to those that suffered—has frequented headlines. So it is presently, as value categories enjoy another moment in the sun. Many, many investors see this as lasting. But markets tend to anticipate widely watched factors like this. Today, fairly few seem to acknowledge just how much reopening is already reflected in stock prices. In our view, a tour of charts of the most reopening-related categories should give proponents pause and raise the question: Exactly how much reopening is left for markets to weigh?
The reopening trade essentially presumes increasingly widespread vaccinations will drive investors to dial up expectations for profit growth among the industries hardest hit by lockdown. Those are generally economically sensitive value stocks. But, more specifically, we refer to the Airline industry, Hotels, Restaurants and Leisure firms and the Energy sector. The lockdowns designed to quell COVID’s spread devastated all of these. All would likely benefit from reopening in a major, major way relative to growth-oriented firms—some of which were COVID winners.
But here is the thing: Pretty much everyone knows that. In investing, anything widely expected is likely already reflected in stock prices to a very large degree. So, with that, consider Exhibits 1 – 4, which plot the cumulative percentage change in global value stocks and each of the three categories noted above since 2020’s pre-pandemic market peak.
10-year Treasury yields inched up again Thursday, closing above 1.7% for the first time since early 2020.[i] With this move, Treasury yields erased their pandemic plunge, which one might rationally call another indication of the economy’s returning to normal. But reason seems to be in short supply, as we have basically seen two schools of thought among pundits. The first argues rising long rates mean big inflation looms, dooming us all if the Fed doesn’t tighten monetary policy. The second, seeing higher inflation as a desirable sign of burgeoning demand, doesn’t acknowledge the strong correlation between long-term interest rates and inflation. Instead, they worry rising long rates amount to premature tightening, dooming us all if the Fed doesn’t intervene with more bond buying under quantitative easing (QE) to tamp rates back down. In our view, both camps are making the same central error: presuming low long-term rates are indeed loose monetary policy.
The reason that thesis is off base, in our view, is the same reason long rates correlate with inflation: Long rates’ role in monetary policy stems from the yield curve. Steeper yield curves have a long, long history of getting money moving. They motivate banks to lend, which pumps more money through the economy, driving faster growth and, as a byproduct, inflation. For the yield curve to be steep, long-term rates must be well higher than short. If long rates are only mildly above short rates, the flatter curve doesn’t do enough to encourage banks to take the risk of lending. Banks borrow at short rates and lend at long rates, with the spread their profit on new loans. Smaller profits mean less reward for taking risk, which discourages lending. That means slower money supply growth. Less money flowing through the economy drags down growth and inflation. (An inverted yield curve, with short rates above long, is generally contractionary and deflationary, but that is a topic for another day.)
With this in mind, let us examine the amusing irony of both schools of Fed watchers. The first school wants the Fed to slow QE down or end it, encouraging higher long-term interest rates. They miss that this would, all else equal, steepen the yield curve and lead to the faster inflation they want to prevent. That outcome would fulfill the goal of the second school. But they would rather have the Fed buy more long-term bonds—which would flatten the yield curve, slow growth and inflation and, in the end, make the first school happy. And that, folks, is the weird place most analysts have reached: Each side’s chosen monetary policy prescription would only worsen their perceived problem.
Editors’ note: MarketMinder is politically agnostic. We favor no party nor any politician and assess political developments solely for their potential market impact.
Political change of any kind can stir big emotions. Hope for change! Or fear of the same. In markets, the latter is a powerful factor possibly driving up uncertainty. Hence why we think gridlock is golden for stocks. If governments can’t pass much legislation, they can’t create winners and losers via new regulations, taxes or industrial policies. That clears the horizon for companies to plan and invest without having to worry big changes down the road will zap those investments’ profits. Happily for markets, gridlock is 2021’s biggest political theme, and political developments this week in Europe—Germany’s regional elections and the Dutch general election—gave it another boost.
Dutch voters elect gridlock. Again. After Wednesday’s vote, the Netherlands looks set for another inactive, multiparty coalition government—one unable to enact material legislation. Prime Minister Mark Rutte’s center-right People’s Party for Freedom and Democracy (VVD) won the most seats, 35 of Parliament’s 150, boosting their existing plurality by 2. This likely returns Rutte, who has served since 2010, as premier. In second, the center-left, pro-European Democrats 66 (D66) party gained 4 seats for a total of 23. Coming in third, Geert Wilders’ far-right Freedom Party lost 3 seats, taking 17.
Editors’ note: MarketMinder is politically agnostic, favoring no party or politician in any country. We assess political developments solely for their potential market impact.
Scotland holds elections for its semi-autonomous, devolved parliament on May 6, and with the Scottish National Party (SNP) polling well despite a scandal embroiling its current and former leaders, independence chatter is once again running hot. The SNP is reportedly planning to table legislation laying the groundwork for an independence referendum before the election even takes place, likely guaranteeing tough rhetoric dominates the campaign—and driving uncertainty afterward if the SNP wins an outright majority. In our view, it is far too early to assess the probable election results. But even if another independence push gets going, it should have only a limited impact on UK equities.
The independence drive has loomed large over Scotland for over 20 years and dominated the devolved parliament before 2014’s referendum. That vote, in which 55% of Scottish voters elected to remain in the UK, supposedly settled the issue for a generation. Nonetheless, here we are discussing it again, just six years later, thanks to Brexit.
If you have glimpsed at a financial news site lately, you have probably heard the one about price-to-earnings (P/E) ratios being at their highest level since the Tech Bubble, allegedly signaling stocks are full of hot air and ready to smack investors with a reality check. We have long held the view—backed by a mountain of data—that no level of P/E is inherently good or bad for stocks. While spiking P/Es can indicate euphoria, that is a statement about the rate of change, not the level. Even then, it is important to use the most relevant P/E and look at both halves of the ratio. Today, that analysis shows us stocks aren’t presently overvalued, but also that it is important to keep rational expectations.
Much of the coverage we have encountered focuses on the S&P 500’s trailing P/E ratio—price divided by the last 12 months’ earnings. This figure jumped from 17.06 when stocks bottomed last March 23 to 27.76 on January 8 before inching down a bit. Meanwhile, through yesterday’s close, the S&P 500 had returned a whopping 80.4% since the low. Those factoids are driving the vast majority of the stocks are overvalued chatter. But they are an incomplete look, because they ignore the denominator, earnings. A ratio can rise one of three ways: The numerator can rise, the denominator can fall, or both. The latter is what happened with P/E ratios over the past year. Stocks rose, but S&P 500 earnings per share fell -11.2% last year overall, with drops in all four quarters—and huge falls in Q2 and Q3. That helped pump trailing P/Es.
The problem with using this as a forward-looking indicator is that stocks look ahead, not backward. They aren’t pricing in earnings over the past 12 months. Stocks took care of last year’s earnings drop when they suffered history’s steepest, fastest bear market in February and March 2020. At this point, for stocks, depressed earnings are a heaping load of duh and shouldn’t factor into a forecast, in our view. When you purchase a stock, you are buying a share in its future profits. So what matters from here is whether stocks are overvalued relative to future earnings.
In a telling sign of just how hyper-focused people are on bond markets right now, one of this week’s most-watched events was … Treasury bond auctions. Usually, the Treasury’s debt sales to its regular customer base of banks and institutional investors don’t garner much attention. Success is usually a foregone conclusion, making them more dog bites man than man bites dog for news editors. But two weeks ago, a sale of 7-year Treasurys attracted the lowest demand since 2009. (Never mind that bids totaled just over twice the amount on offer.) That supposedly bad auction triggered some fear, contributing to yields’ recent uptick, and making this week’s three auctions much-watched events. The last one happened today and—spoiler alert—it went great, which we think offers a couple of lessons for investors.
The first of this week’s festivities was an auction of 3-year notes on Tuesday, which attracted demand of 2.69 times the amount on offer at a median yield of 0.32%.[i] Wednesday’s offer was a 10-year note, which was similarly oversubscribed with a bid-to-cover ratio of 2.38 at a median yield of 1.47%.[ii] Rounding out the pack was Thursday’s sale of less-plentiful 30-year bonds, which attracted bids for 2.28 times the amount on offer an a median yield of 2.23%.[iii] All were nicely above the 2.04 bid-to-cover ratio at that supposedly disastrous 7-year auction two weeks ago.[iv] They were also right in line with their trends over the past eight months since yields bottomed last August. That suggests to us that the panic-inducing auction was an aberration and investors are very, very happy to buy US bonds.
The surface-level takeaway here is that Congress’s multiple debt-financed COVID relief bills aren’t denting demand or visibly inducing concerns about Uncle Sam’s creditworthiness. Even with the recent uptick, yields remain near generational lows, keeping that new debt affordable. Think through that 30-year auction—the Treasury will be paying 2.23% on that tranche of debt until 2051. That is a wonderfully long time to lock in low funding costs.
As vaccine distribution becomes more widespread, many economists are becoming increasingly optimistic about economic growth. One factor underlying the excitement: Households are sitting on a massive pile of savings. Some see this as dry powder that will power an economic recovery for a long time to come. But households are unlikely to spend all these savings, and we think sentiment toward this alleged mountain of pent-up demand is a key place to watch for frothy expectations.
According to a recent Bloomberg analysis, households worldwide have accumulated $2.9 trillion in new savings since the pandemic hit, with the US comprising about half that amount ($1.5 trillion) as personal savings rates soared.[i] While the government’s direct household payments have contributed, the stockpile also reflects a lack of spending, particularly on services and travel, due to COVID restrictions.
Now, with economies poised to reopen more fully as vaccines roll out, some see these savings as jet fuel for economic growth. One research outfit estimates that if households ran down built-up savings in full, GDP could grow 9% in 2021.[ii] In that scenario, GDP would be about 5% higher than its pre-pandemic 2019 level.[iii] While possible, that extreme outcome seems a wee bit unlikely to us—especially since US GDP ended 2020 only -3.5% below pre-pandemic levels, and growth slowed in Q4 as the post-lockdown snapback ran its course.[iv]