Why market investors are now confused by the signs of rapid growth

Investors have had no trouble bypassing the death and economic devastation caused by the pandemic last year to drive the market to record highs. An increasingly healthy economy is what makes them panic.

In recent days, the S&P 500 stock index has faltered, suffering its worst weekly performance in a month last week, before rising on Monday, only to fall again Tuesday and Wednesday early in the session. The bond market, too, is showing anxiety, with yields rising sharply as yields in the treasury market have fallen by around 3% this year.

The market conniptions are a direct result of several developments that point to brighter prospects for economic recovery. Vaccines are rising, retail sales and industrial production have been surprisingly strong, and perhaps most importantly, the Biden administration is expected to push its $ 1.9 trillion stimulus package through Congress in the coming days.

“We’ve never seen this magnitude of a budget response before, and the market is struggling to process it,” said Julia Coronado, Founder and President of Macropolicy Perspectives, an economic and markets consultancy. Because the United States has never put so much money into the economy, Coronado said, the market “is wondering what some of the unintended consequences might be.”

One of the obvious consequences should be strong growth. Wall Street economists now expect output to rise nearly 5% in 2021. Such robust growth – it would be the best year for the economy since 1984 – would seem like a good thing for stocks. After all, a strong economy makes it easier for businesses to increase sales and profits, as employment increases and consumers have more money to spend.

But with growth comes the possibility of higher inflation, which in turn could prompt the Federal Reserve to raise interest rates – and that’s what investors are reacting to, with different consequences for the markets. stock market and bond.

When the pandemic began in March, causing widespread panic that led the S&P 500 to lose more than a third of its value in a matter of weeks, the Fed acted to appease the markets and prevent the bottom from collapsing completely. He cut interest rates to near zero and indicated he would keep them there. He also started pumping billions into the markets each month by essentially creating fresh dollars and using them to buy government bonds. These so-called easy-money policies provided a positive wind for the S&P 500, which rose more than 70% between March 23 – when stocks climbed to bottom – and Wednesday.

“Part of the enthusiasm in the market has been that the Fed is going to keep the cocaine going,” said Lisa Shalett, director of investments at Morgan Stanley Wealth Management. “Things are better and better, the less and less the Fed has less and less reason to keep rates at zero.”

The Fed’s moves also affect bond markets, usually through rising and falling yields. In general, government bond yields – which are determined in part by interest rates set by the Fed – broadly reflect investors’ views on how the economy will develop over time. When growth is low, government bond yields tend to be low. (Last year, when the economy fell, they hit their lowest levels ever.) When growing fast, those bond yields tend to be higher.

For now, investors fear that the economic rebound could lead to inflation. Few economists currently see a significant risk of soaring inflation, but investors say the mere possibility of painful 1970s-style price growth could lead the Fed to raise interest rates in order to squeeze the price down. ‘economy.

It would be bad for bondholders. If the Fed were to raise rates, rates around the bond market would rise. Then the price of the bonds that investors currently hold should fall until they produce returns comparable to the new higher market rates.

In the meantime, investors are now demanding a higher return in the form of a higher return on their bonds. Last week, the yield on 10-year Treasuries, the most watched measure of the government bond market, rose at times to around 1.60%.

The interest rate futures market – where investors speculate on how interest rates will move in the coming years – provides a timeline for investors who believe this could happen. Prices there now show a growing chance that the Fed will hike rates in the first quarter of 2023, sooner than the central bank has guided.

And as the Fed has suggested it plans to slow down other elements of its easy money policy before raising rates, investors expect the central bank to start cutting market aid as soon as possible. next year.

Higher rates can be a problem for the performance of the stock market. One reason is that high interest rates make bond ownership more attractive, drawing at least a few dollars out of the stock market. Higher rates can also make borrowing more expensive for businesses, especially smaller ones that have potential but do not have a history of being profitable.

These high-growth companies – Shopify, CrowdStrike, and Zoom Video among them – have performed very well during the recession as their business models have directly benefited from the shift to working from home. But last week they were beaten, and their stocks fell more than 10% each as bond yields soared.

So what should investors do? Analysts have urged them to buy shares of companies poised to benefit from a short-term economic surge. Known as “cyclicals,” these types of stocks include banks and energy companies, whose profits tend to rise during times of faster growth, higher interest rates, and rising prices.

And these are precisely the parts of the stock market that have done best so far this year. For example, energy stocks on the S&P 500 rose more than 30% in 2021 and financials gained more than 14%. This suggests that investors are preparing their portfolios to benefit from an increasingly stronger economy rather than just riding the wave of easy money coming out of the Fed, which many believe could – and should – end.

“You can’t have your cake and eat it too,” said Ms. Shalett, of Morgan Stanley. “And there are times when you don’t need to be in intensive care if you’re cured.”

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