As of March 16, 2021
- We believe interest rates are rising for the right reasons and are not a cause for concern.
- Signals point to modestly rising inflation, which could prove to be temporary.
- Stocks tend to perform well in the early innings of an economic recovery.
Stock prices have faced headwinds recently from rising interest rates and concerns about inflation pressures. However, like the Federal Reserve, we believe any near-term rise in inflation could be transitory. An aging population and technology innovation often act as deflationary forces in the economy over time and, historically, help keep inflation in check.
With that said, we believe the U.S. economy is entering a reflationary environment, which is typically good for stocks. Reflation is when inflation is rising but not aggressively enough for the Federal Reserve to tighten monetary policy. Signals that point to modestly rising inflation levels this year include:
- Acceleration of COVID-19 vaccine distribution
- Massive fiscal and monetary support
- Improvement in economic conditions
- A stronger pace of corporate profit growth
- Pent-up consumer demand
- Higher commodity prices
- Easy year-over-year comparisons due to COVID-19 lockdowns last year
The reflationary environment is likely to persist for much of the year. Notably, the newly passed $1.9 trillion stimulus package could spur additional spending/growth across the economy. That could cause inflation pressures to further build over the coming quarters.
But if rising inflation proves to be a temporary phenomenon and the Fed remains accommodative (which we believe should be the case), stocks most likely could look through the pressure.
Interest rates are now well off their March 2020 lows and have aggressively risen over recent weeks. In our opinion, bond yields at the start of the year were less reflective of the likely near-term path for growth and inflation. As such, the bond market has quickly reset to stronger growth expectations.
Simultaneously, the dividend yield for the S&P 500® Index has fallen from 2.8% in March 2020 to 1.5% currently. With risk-free interest rates now close to yields on stocks and if rates continue to rise, income investors may choose to put their next marginal dollar to work in bonds.
However, at what level interest rates find equilibrium is up for debate. Market pundits have highlighted a 10-year U.S. Treasury yield near 1.5%, 1.75% or north of 2.0% as pressure points for equities. In our view, equity prices may see more difficulty with rising rates if the pace of change quickens unexpectedly. Rates are rising for the right reasons, yet they are low and should remain relatively low this year. Overall, this is positive for stocks and is confirmation of the reflationary environment taking hold. In part, the growing competition between bonds and stocks — from an income perspective — has caused stock volatility to rise.
While higher interest rates may not affect the economy this year, they may influence asset prices when used to discount future corporate earnings/cash flows. Mainly among high-growth, high-momentum companies, higher interest rates could cause future cash flows to look less valuable over time. On the margin, however, small changes in risk-free rates used to price future cash flows can be meaningful.
Over recent weeks, the bump upward in rates has caused more price dislocations across the Information Technology sector and other high-growth areas that led markets higher in 2020. Conversely, cyclical-value areas are experiencing fewer disruptions from rising rates. This is because the earnings expectations are priced on a near-term economic recovery — which is less dependent on fluctuations in rates.
We believe most stock investors may be worrying about rising interest rates and inflation within the context of what the combination implies for central bank action. Here, modestly higher interest rates and inflation are unlikely to lead to tighter monetary policies this year.
Below are main considerations to keep top-of-mind as we move through the coming weeks and months.
- Economic growth and corporate profits are on pace for a strong year, and we believe that’s the No. 1 story moving forward. Combined with incredible monetary and fiscal tailwinds, we believe stocks have a fertile environment to drift higher.
- Stocks have a long history of performing well during the early innings of an economic expansion. The S&P 500 Index is positive 87% of the time over a one-year period when the U.S. economy is growing.
- Consider short-term price pullbacks as an opportunity to put sidelined cash to work or rebalance portfolios.
- Maintain a preference for high-quality, cyclical-value stocks.
- While high-quality growth stocks could face additional pressure from rising interest rates, treat the circumstance as a longer-term buying opportunity to add or take new positions in well-established secular growth trends.
Don’t lose sight of your risk appetite. While we prefer equities over bonds and favor the setup for stocks this year, a smart investment approach always incorporates a contingency plan for the unexpected. Cash, bonds, defensive stocks and alternative investments may offer a less desirable return in a reflationary environment, but they can help mitigate risks if the script doesn’t go as planned.
Data source for indices and sector graphs: Morningstar Direct, as of March 8, 2021.
Past performance is not a guarantee of future results.