I’ve got some good news for you.
After a year like the last, I know that just a smidgen of good news sounds awfully tantalizing, so let’s cut right to it: The yield on the 10-year bond has been increasing.
You’ve probably got some confetti in your desk drawer (who doesn’t, right?) so take a moment to toss some of it in the air to create a small celebration just for you. Savor this moment.
Maybe the global increase in bond yields isn’t a thrilling prospect, what with a life-threatening pandemic eroding our sense that we might ever achieve something akin to normalcy again, but know this: rising bond yields might be a sign that at least one thing is getting back to normal, the economy.
The rising 10-year interest rate will likely not be fantastic news for some bond investors because many bonds lose value as interest rates rise. But now that rates have hit a twelve month high, we might cautiously assume that upbeat investor expectations and optimistic corporate earnings estimates are having a positive impact on the economy.
As you are cleaning up the celebratory mess you’ve just made on your desk, remind yourself that the reason for your confetti-strewn workspace is that the positive feedback loop of private sector confidence and a stronger economic outlook seems to have begun.
Inflation Fears Inflated?
As the politicking over the next COVID-relief package intensifies, much will be made of the possible inflationary impact of so much government spending over such a short period of time. The next relief package, as you’ve undoubtedly heard by now, comes with a $1.9 trillion price tag, and this is hot on the heels of the nearly $4 trillion spent in relief packages over 2020 ($3 trillion in March 2020 and another $900 billion later that year).
While the bond markets seem to be sketching out an optimistic story for the US economy, some investors worry that an overheated economy could pressure the Federal Reserve into raising rates earlier than planned, which would effectively trigger the sprinkler system and clear out the party.
The Big Bank Prognosticators
Today, at least, some big banks are not raising alarm bells about the risk of inflation too high above the Federal Reserve’s current target of 2%.
UBS economist, Alan Detmeister, believes that the bill’s effect on inflation will “likely be small” with price growth rising gradually over the coming years while Goldman Sachs’ Jan Hatzius also believes inflation risk to be limited.
Contrast these perspectives with that of the head of US Economics, Michelle Meyer, who suggests that the question isn’t whether or not the economy will overheat, but rather to what extent.
Bank of America projects GDP growth at around 6% in 2021 and 4.5% in 2022, which is stronger economic growth than we have had for many years, and passage of the next relief bill could push the difference between maximum potential GDP growth and actual GDP (output gap) to its highest point since 1973.
And Deutsche Bank’s Chief International Strategist, Alan Ruskin, notes that inflation often lags growth by up to two years, which would suggest that any inflation indications seen today may not reach fruition (or become a threat, depending on your position in the market) until 2022 or later.
Inflation and the Markets (or What This Means for You)
Historical analyses are never to be mistaken for investment advice or even predictive indicators, but certainly investors would do well to consider how higher inflationary environments have impacted various asset classes.
If this sort of thing piques your interest (and why wouldn’t it?) then the 48 years from 1970 to 2017 can hold some clues for us.
Using the median level of inflation over that time of 3.26% we can reasonably qualify the first 24 years of the period as a high inflation and the last 24 years as a low inflation period.
Tracking the returns of various asset classes after accounting for inflation, “real returns,” shows clear indications of winners and losers in either high or low inflationary environments.
Asset Classes During Low Inflation
The second 24 years of the period saw the following asset classes perform quite well in the low inflation environment: Small Cap US Stock (11.44%), Large Cap US Stock (10.8%), Real Estate (10.3%), Non US Stock (8.67%), and US Bonds (4.27%). US Bonds performed better in the low inflation environment relative to the high inflation environment, so I would consider that “out performance.”
It is easy to understand why companies that can borrow money at lower interest rates might perform better in low-inflation times (Large Cap and Small Cap Stocks), and Real Estate as an asset class also benefits from the same principle.
Poor performers over that same time period were commodities (-4.03%) and US Cash (0.41).
Asset Classes During High Inflation
Now take a look at asset class performance in a high inflationary environment during the 24 years starting in 1970. Commodities lead the pack by far with an average annual growth rate of 15.13% and US Cash outperforms (1.33%) while most other asset classes show much slower growth, Real Estate (7.86%), Small Cap US Stock (6.26%), Non-US Stock (5.21%), Large Cap US Stock (4.7%), and US Bonds (3%).
What To Do?
I can’t tell you what to do about all of this because I don’t know your specific financial situation, of course, but I can tell you that in 2003 and 2009 corporate earnings early in these recoveries rebounded considerably. Consensus forecasts, as noted by Société Générale, show a 30% rise in earnings for companies in the international index and a 40% increase for emerging markets.
If these forecasts are correct, then equities might have further to climb before inflation, if it takes hold even modestly, could eliminate some of those gains.
Anthony M. Conte is managing partner at Conte Wealth Advisors based in Camp Hill. He can be reached at [email protected]
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