The Fed is in no rush to remove support, and it wants the economy to be running at full speed. How should investors position for strong growth and higher interest rates?
Our Top Market Takeaways for March 19, 2021.
Market update
How strong is too strong?
Investors have been hungry for an update from the Fed, and an update they got. At its latest policy meeting this week, the Fed reaffirmed it’s sticking to its accommodative stance by planning to keep policy rates at or near zero through 2023, despite boosting projections for growth, inflation and employment.
According to the Fed’s updated projections, core PCE (its preferred measure of inflation) is expected to be above 2% for the next three years (2.2% in 2021, 2.0% in 2022, 2.1% in 2023), and the unemployment rate is set to fall to 3.5%. But despite these strong economic conditions, the Fed is planning to keep the policy rate at zero. The message? The Fed is in no rush to remove support, and it wants the economy to be running at full speed.
This is even more meaningful when you realize how much has changed since the last time the Fed put pen to paper on its projections. Since last December (the last Fed forecast release), two major stimulus deals amounting to nearly $3 trillion have been inked into law. Meanwhile, in the United States, the vaccine rollout has accelerated and virus transmission has been declining. Consensus expectations for GDP growth have moved from 3.9% to 5.6% (we think it will be even higher). Bond markets have taken notice. U.S. 10-year Treasury yields are 80 basis points (bps) higher on the back of expectations for higher growth and inflation.
But when does strong become too strong? That is the question markets seemed to be asking themselves this week, as bond yields continued to make pandemic-era highs. 10-year Treasury yields hit 1.75% for the first time since January 2020, and 30-year yields climbed to 2.5% for the first time since 2019. Several popular measures of the yield curve (shown below) are now at their steepest in over five years. Markets are expecting inflation to average 2.55% over the next five years, a rate that hasn’t been seen since before the Global Financial Crisis. This suggests to us that bond markets are asking for more return to compensate against the larger range of possible inflation and growth outcomes.
This chart shows the difference between the yields on 2- and 10-year Treasuries, as well as the difference between 5- and 30-year Treasuries from January 3, 2014, to March 18, 2021. The chart shows that the difference in yield between 2- and 10-year Treasuries declined steadily from 260 bps on January 3, 2014, to -1.39 bps on August 30, 2019, before increasing again rapidly and reaching as high as 153 bps on March 18, 2021. The chart also shows that the difference in yield between 5- and 30-year Treasuries declined steadily from 219 bps on January 3, 2014, to 20 bps on July 13, 2018, before increasing again rapidly and reaching as high as 157 bps on March 18, 2021. The chart shows that both yield curves today are at their steepest levels in five years.
Meanwhile, stocks fell from record highs, with big tech and growth stocks experiencing the brunt of the decline. The tech-heavy NASDAQ lost -3% on Thursday—the index is now -8% below all-time highs. Other high-fliers, such as the ARKK ETF (-5.8%), solar energy (-6.6%) and SPACs (-3.4%), suffered. In a strong economy, growth is not as scarce, so the premium investors are willing to pay for growth is deteriorating. Meanwhile, energy stocks lost over -4% as oil plunged amid concerns over demand in Europe (where the vaccine rollout is lagging and a new wave of lockdowns is hurting mobility).
On the bright side, financials gained. A strong economy and higher interest rates tend to mean higher bank profits.
Our take: We aren’t caught up in yesterday’s messy trading. The S&P 500 is only -1.5% below all-time highs (and up ~+70% over the last year), earnings expectations continue to move higher, and spending on travel and hospitality is surging, indicating that pent-up demand from households is there. In the words of Marlo Stanfield, from HBO’s The Wire, the markets have “one of them good problems”: growth that is set to be the strongest in decades. They just may need some more time to acclimate to the new environment.
Spotlight
Key takeaways from the Fed meeting
At their March meeting, Jerome Powell and the FOMC reiterated their commitment to not raise rates until they see actual data that suggests 1) the economy is at maximum employment, and 2) inflation is averaging 2% over time. The Fed wants a strong economy. We think this bodes well for risk assets over the medium term, and it also underscores our view that investors’ least favorite asset should be cash. Here are our top three takeaways from the meeting, and what it means for you.
1. Jerome Powell and the Fed are keeping the FAITh. The Fed formally adopted its flexible average inflation targeting framework (FAIT) last September. There are a lot of nuances, but the most important implication for investors at the moment is that the Fed will no longer raise rates just because it believes inflation will come. Rather, it will wait to hike until inflation has been actually rising at a 2%+ pace on a consistent basis and until the labor market has reached maximum health. The latest economic projections from the central bank demonstrate its resolve to be patient even as the economy improves. The Fed is an investor’s friend, but cash is not.
2. The unemployment rate alone isn’t enough to determine if the labor market is healthy. Powell consistently cited the employment-to-population ratio (how much of the country’s working age population is actually employed) and the labor force participation rate (how much of the workforce is actually active) as equally important indicators in determining maximum employment. Further, the labor force measures must be inclusive. To illustrate, the employment-to-population ratio for Black workers has collapsed by 5.5 percentage points versus 3.3 percentage points for White workers. It seems like the Fed is focused on fostering more equity in the labor market before tightening policy to slow growth down.
This chart shows the employment-to-population ratio for Black and White Americans. The chart shows that the employment-to-population ratio for White workers rose from 57% in January 1975 to 65% in April 2000, before dropping to 59% in December 2009 in the wake of the Global Financial Crisis. The metric rose slowly from there to 61% in February 2020 before collapsing to 52% in April 2020 due to the COVID-19 crisis, but has since rebounded sharply back to 58% in February 2021. The chart also shows that the employment-to-population ratio for Black workers rose from 50% in April 1975 to 61.4% in April 2000, before dropping to 51% in July 20011 in the wake of the Global Financial Crisis. The metric rose sharply from there to 59% in February 2020 before collapsing to 49% in April 2020 due to the COVID-19 crisis, but has since rebounded back to 54% in February 2021. The chart shows that the recovery in the employment-to-population ratio for Black workers has lagged that of White workers.
3. Assets that are sensitive to growth look set to outperform. The Fed wants a rapidly improving labor market and inflation above 2% on a more sustained basis. It tends to get what it wants. So what should an investor do to position for a strong economy and higher long-term rates? Consider:
a. Getting out of excess cash. Inflation-adjusted cash yields are deeply negative. Said another way, investors aren’t earning anything, and are actually losing purchasing power, by sitting in cash.
b. Investing in cyclical equities to balance growth exposure. As the economy heals, assets exposed to improving growth stand to benefit. Financials, next-generation vehicles and companies that will benefit from increased mobility are some ideas.
c. Avoiding long-duration core fixed income. We don’t think the rise in interest rates is over. Longer-dated interest rates (think longer than five years) can continue to move higher from here as the bond market prices in a stronger economy. To us, that means investors should keep with a shorter duration tilt, at least for now.
Culture
March Madness!
It’s 710 days later and the Big Dance is back. The NCAA Men’s March Madness Tournament tipped off last night with the play in games. Congrats to Texas Southern, Drake, Norfolk and UCLA for punching their tickets. The Women’s Tournament starts on Sunday. We are wishing all the student athletes the best on their quests to cut down the nets in Indianapolis and San Antonio. For the record:
- Men’s Final Four: Alabama (roll tide), Illinois, Gonzaga and Texas Tech
- Women’s Final Four: UCONN, Maryland, Texas A&M and Stanford
All market and economic data as of March 2021 and sourced from Bloomberg and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice
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