Here are the top market developments we have been watching in February.
1. Interest rates spiked at the long end of the yield curve. Is it a cause for concern?
Source: treasury.gov
No, as the current level of long term interest rates does not threaten the economic recovery. In addition, the rise in rates may be beneficial as it will help eliminate some froth in equity markets. However, our antennas are up.
Some mean reversion, i.e., a rise, in long term interest rates was justified, since the outlook for economic growth has improved. COVID-19 cases and hospitalizations have declined dramatically since the mid-January peak. A combination of acquired immunity and vaccine distribution will dampen the size of any next wave of infection. In addition, more fiscal stimulus is forthcoming.
That said, the global economy will take years to fully recover from the destruction of capital stock from business shutdowns related to the COVID-19 pandemic. The U.S. economy remains dependent on ongoing shots of monetary and fiscal stimulus to sustain growth. Only a small portion of the fiscal spending is devoted to productive uses, such as infrastructure spending. It is unlikely real economic growth rises sustainably to justify long term interest rates rising much further.
2. Inflation expectations have increased and commodity prices have been marching upward. Could inflation drive long term interest rates higher?
The prices of some goods and services, such as semi-conductors, used cars, and many food items, have risen substantially over the last several months. Commodity prices have also been on the rise.
This chart illustrates the recent spike in the prices of industrial metals and energy. HG1 is Copper futures traded on U.S. Nymex. B1 is Brent Crude Oil futures traded on U.K. ICE.
Yes, higher inflation, if it persists, could easily drive long term interest rates higher. We believe such a scenario is unlikely in the near future. The pandemic has had temporary inflationary effects in some goods and services categories. As for industrial metals and energy commodities, the pandemic’s negative impact on demand suppressed already low prices. However, a rebound was inevitable, even if timing was uncertain, as a few years of muted supply growth had already set the stage for price increases. With most commodities, the cure for low prices is low prices.
For high inflation to persist, structural changes or secular changes are necessary, given the current excess supply of labor and capital globally. We would be more concerned about inflation if the world experienced a sustained global supply shock such as a large expansion of trade restrictions. Alternatively, the U.S. government could create a big demand shock by allowing excess bank reserves to serve as legal tender, igniting money velocity.
3. Fourth quarter 2020 corporate earnings were solid and better than expected
With 96% of the companies in the S&P 500 reporting actual results, earnings grew 3.9% year-over-year according to FactSet. The Materials, Financials, and Information Technology sectors have exhibited the strong earnings growth. Blended revenue growth was 3.2%, led by the Health Care and Information Technology sectors.
Source: FactSet
4. Credit risk remains the risk to the equity bull market
We have highlighted the credit risk factor ad nauseum over the last several months (here, here, here, here, here, here). We are wary of recent speculative frenzies, exemplified by GME (GameStop Corp) and SPACs (Special Purpose Acquisition Companies), and the accompanying increase in financial leverage across the financial system. Debt levels remain too high for our liking across much of corporate America. When there is euphoria, it is often followed by a slippery slope downwards. As investors, we are most comfortable when there is a wall of worry to climb.