Rising Inflation and Rising Interest Rates - A Combo the Markets Haven't Seen in a While
The markets have clearly been spooked by two things of late – rising interest rates and inflationary fears. We’ll focus a lot of our comments on these two issues. It's important to remember that we have been here before, so no need to panic.
• Rising Inflation. Fed Chairman Powell seemed to put the market at ease on Tuesday when he testified before the Senate Banking Committee. The Chairman restated that the Fed has no intentions of changing policy anytime soon and that inflation is not an issue of concern. Au contraire, my dear fellow. AB Inbev (ABI) was the worst performer in the Euro Stoxx Index Wednesday after reporting better-than-expected sales for Q4, volume growth of 2.7%, and revenue growth of 4.7%. Yet, shares were down 5.4% after the report. Why? In the report, AB Inbev reported higher input costs due to inflationary pressures and the company warned of adverse affects on profits due to commodity prices. We saw this last week as the Producer Price Index here in the U.S. increased 1.3% (month-over-month) in January versus an expected increase of 0.4%. The good news – there’s usually a lag between PPI and CPI. A lot of items on the shelf already have built-in costs when inflation was not as much of a concern. Going forward, however, new items on the shelf will likely include the price increase passed on to consumers. At the beginning of the year, adjusted our portfolios for this expectation by adding Commodities (+11.7% YTD) to the models and increasing Emerging Markets (+5.3% YTD). The asset classes that tend to do well during low inflation that is on the rise are below.
• Rising Interest Rates. The interest rate on the 10-year bell weather Treasury bond currently stands at 1.46%. That’s an increase of 55 bps since year-end! As a result, the BBgBarc US Agg Bond Index is down 3.04% for the year. We're not saying the index will finish the year in the negative column, but the return so far is dramatic. Markets have not responded well to rising rates, not so much a function of the actual basis points, but more of a function of the length of time it’s been since rates rose this much. Despite the increase, there are still opportunities. In both of the past periods where interest rates rose more than 150 basis points (2012-2014 and 2016-2018), equity markets ultimately finished higher when the full rate increase cycle was complete. The graph below shows which asset classes do well in a rising rate environment and have a low correlation to the 10yr Treasury. Not to toot our own horn again, but we adjusted our portfolios at the beginning of the year to include High Yield Bonds (+0.1% YTD), Bank Loans (+1.2% YTD), & added to Convertibles (+4.1% YTD). But, we also have to look at equities in relation to rising interest rates. The 2nd table below also shows which equities do well during a full rising rate cycle. The interest rate issue is a little bit complicated because we are still recovering from a pandemic and if states re-open, pent-up demand may be a dynamic that delays the effects of interest rates in the short-run. In our sector rotation portfolio, we are over-weight to Basic Materials, Energy, Financials, & Industrials which have all performed well during rising interest rates. We are under-weight in Communication Services, Health, & Utilities which have not done so well during rising interest rates.
• The Economy and the Virus. The good news is that the economy is improving, overall, despite the spookiness of rising interest rates. So far this week, Pending Home Sales is the only piece of negative news. Chicago Fed Activity showed a considerable increase, Weekly Jobless Claims came in 100k lower than expected and last week’s number was revised lower. Consumer Confidence, Home prices, and New Home Sales all improved month-over-month. The 1st revision of 4th quarter GDP came in a little less than expected (4.1% vs 4.2%), but did inch higher from the 1st print of 4.0%. The virus numbers continue to recede. Cases are rising in only 3 states. Hospitalizations are down 60% from the Jan 6th peak. In fact, hospitalizations from COVID represent less than 0.02% of the overall population of the United States. With cases declining and vaccinations going up, the chances of hospitals being overrun are diminishing every day. Speaking of vaccinations, the FDA approval of Johnson & Johnson’s vaccine is expected tomorrow and several states are likely to get the first doses of the vaccine over the weekend. This will considerably speed up the percent of the population that has been fully vaccinated. The vaccination rate had declined last week due to the winter storms that rocked the South-Southwest. This week, vaccinations are back up to 1.5 million shots daily, with 45.2 million people having received at least one shot and 20.6 million fully vaccinated.
The $1.9 trillion stimulus package is set to go before the House very soon and could be sent the President next week. While the market would probably cheer the stimulus, we’re not really sure it would make a dent. It has been estimated that only about 10% of the bill is projected to actually go to people/businesses affected by the pandemic. The rest, as is typical with Congress, is filled with other pet projects unrelated to COVID. As we’ve shown before, the graphic below tells us that fully re-opening New York, L.A., San Francisco, Boston, Chicago, Philadelphia, and Washington D.C. would bring $5.3 trillion in goods & services back into the economy – much more valuable to overall economic health than a few stimulus checks.