How Much Economic Growth is Too Much for Investors?
Author: Kevin McCreadie
March 15, 2021
The threat of inflation has pushed bond yields higher in recent weeks and put equity markets on alert. But the true risk this poses to stocks remains unclear and will be largely predicated on the words and actions of central bankers over the next few months, says AGF’s CEO and Chief Investment Officer.
Why have equity markets weakened since hitting new highs in mid-February?
Investors are toiling with a classic problem right now. They need a strong economy to drive corporate earnings and justify higher stock prices, but they don’t want the economy to grow too much or too fast out of fear that will lead to significant inflation. And it’s not just the inflation itself that worries them, but the knock-on effects that come with it, including the potential of higher interest rates that could negatively impact future earnings growth. So, that is why markets have been so jittery over the past two weeks. Even though central banks haven’t touched their overnight lending rates in months, bond yields have risen dramatically since the start of the year – again, because investors are worried about inflation and because they anticipate tighter policies from the U.S. Federal Reserve and global counterparts to cool things off.
Is this fear warranted right now?
This is a critical question. It’s hard to imagine that investors would be worried about too much inflation when huge swaths of the global economy are still getting back on their feet and some countries like Canada remain in lockdown to some degree or another. And yet, if there’s been a constant throughout the rally off the March bottom last year, it’s been the fact that equity markets are well in front of the economic recovery. From that respect, then, it makes sense for investors to have already begun the process of pricing in higher inflation even though it’s not a guarantee and, if it does happen, may still be months away from taking hold. Of course, all of this is prefaced by the massive stimulus efforts of governments and central banks around the world over the past year. Perhaps never has fiscal and monetary policy been this accommodative at the same time, and the amount in play continues to grow following the latest US$1.9-trillion package that was approved in the United States earlier this month. It’s given this – and also the fact that savings rates have risen dramatically due to the lockdowns of the past year – that many believe an increase in consumer prices to be inevitable once the pandemic is fully under control. But does that necessarily mean higher rates? Bond markets obviously believe so, but remember, the Fed said last year that it is now more willing to let inflation run hot than it would have been in the past, meaning it may not be as quick to raise rates as some might be expecting. In fact, Fed Chairman Powell recently reiterated the central bank’s intention to keep rates low for longer, saying short-term inflationary pressures caused by supply shortages and bottlenecks during the initial surge in “relief” spending are likely transitory and will eventually give way to more normalized growth.
Is that the sort of communication that can keep bond yields in check?
It helps alleviate some of the concern, but many investors believe the Fed could be doing more to keep the yield curve from steepening, including a new version of “Operation Twist,” in which it sells short-term Treasuries and buys longer-dated bonds. Either way, the key for equity markets is that bond yields rise less aggressively from here than they have over the past few weeks. Based on our research, stock prices suffer the most when the 10-year U.S. Treasury climbs 40 basis points or more in less than a month, but they do much better when the increase is less drastic. More specifically, before this year, we found that 10-year yields have risen by more than 15 basis points in a month more than 45 times over the past 20 years, but during those months, the S&P 500 Index was negative only 11 times and, in six of those periods, yields were already greater than 4% or well above where current yields lie. In other words, rising bond yields don’t always have to be negative for stocks, but they are a problem when not contained and the pace at which they rise as the global economy continues to recover will continue to have a huge bearing on the Fed’s next move and on how equity markets perform.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor to AGF Perspectives.
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