Investors have had no problem getting over the death and economic devastation of the pandemic last year to push the market to record highs. An increasingly healthy economy is causing them to panic.
For the past few days, the S&P 500 stock index has fluctuated, posting its worst weekly performance for a month over the past week, before rising on Monday to falling again on Tuesday and early trading day. The bond market is also concerned, and yields are rising sharply as government bond yields have fallen roughly 3 percent this year.
The market ties are a direct result of several developments that indicate better prospects for economic recovery. Vaccinations are on the rise, retail sales and industrial production have been surprisingly solid, and perhaps most importantly, the Biden administration will be pushing its $ 1.9 trillion stimulus plan through Congress in the coming days.
“We have never seen this level of fiscal reaction and the market is struggling to process it,” said Julia Coronado, founder and president of Macropolicy Perspectives, a markets and business consultancy. Because the United States has never pumped so much money into the economy, Ms. Coronado said the market “is questioning what some of the unintended consequences could be”.
A clear consequence is likely to be strong growth. Wall Street economists now expect production to grow nearly 5 percent in 2021. Such robust growth – it would be the best year for the economy since 1984 – seems like a good thing for stocks. After all, a strong economy makes it easier for businesses to grow sales and profits because employment increases and consumers can spend more money.
However, growth brings with it the potential for inflation to rise, which in turn could cause the Federal Reserve to raise interest rates – and investors are responding to this with different consequences for the equity and bond markets.
When the pandemic started in March and sparked a major panic that caused the S&P 500 to lose more than a third of its value in just a few weeks, the Fed sought to calm the markets and prevent the bottom from falling completely . It cut interest rates to near zero and signaled that it would keep them there. It also started pumping billions into the markets every month, essentially creating fresh dollars and using them to buy government bonds. This so-called easy money policy provided a tailwind for the S&P 500, which rose by more than 70 percent between March 23, when the shares bottomed out – and Wednesday.
“Part of the buzz in the market was that the Fed will keep the cocaine going,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. “The better and better things are, the fewer reasons the Fed has to keep rates at zero.”
The Fed’s movements also affect bond markets, usually through rising and falling yields. In general, government bond yields, driven in part by the interest rates set by the Fed, largely reflect investors’ views on how the economy will perform over time. When growth is weak, government bond yields tend to be low. (They were at their lowest recorded levels last year when the economy recovered.) When growth is fast, these bond yields tend to be higher.
Currently, investors fear that the economic recovery will lead to inflation. Few economists currently see significant risk of runaway inflation, but investors say the mere possibility of painful 1970s-style price growth could cause the Fed to raise interest rates to dampen the economy.
That would be bad for bondholders. If the Fed were to raise rates, rates around the bond market would rise. Then the price of bonds that investors currently hold would have to fall until they generate returns that are comparable to the new, higher interest rates in the market.
In anticipation of this, investors are now demanding a higher return in the form of a higher yield on their bonds. Last week, the yield on the 10-year Treasury bill, the most widely observed metric in the government bond market, rose to around 1.60 percent at times.
The interest rate futures market – where investors speculate about where interest rates could go in the coming years – provides a timetable for when investors believe this is possible. Prices there now show a rising chance that the Fed will raise rates in the first quarter of 2023, earlier than indicated by the central bank.
And since the Fed has proposed slowing other elements of its simple monetary policy before rates hike, investors expect the central bank to cut aid to the market as early as next year.
Higher interest rates can be a problem for the stock market’s performance. One reason for this is that high interest rates make bonds more attractive and draw at least a few dollars out of the stock market. Higher interest rates can also make borrowing more expensive for businesses, especially smaller businesses that have potential but lack a track record of profitability.
Such high-growth companies – including Shopify, CrowdStrike, and Zoom Video – did incredibly well during the recession as their business models benefited directly from moving from home. But last week they were beaten, and their stocks each fell more than 10 percent as bond yields rose.
So what should investors do? Analysts have urged them to buy stocks of companies that can benefit from a short-term surge in the economy. These stocks, known as “cyclical” include banks and energy companies, whose profits tend to rise during times of faster growth, higher interest rates, and rising prices.
And it is precisely these parts of the exchange that have given the best so far this year. For example, the S&P 500 energy stocks were up over 30 percent in 2021, and financial stocks were up more than 14 percent. This suggests that investors are preparing their portfolios to capitalize on an increasingly strong economy, rather than simply riding the wave of simple cash flow from the Fed that many believe could and should end.
“You can’t have your cake and you can’t eat it,” said Ms. Shalett of Morgan Stanley. “And at certain points you don’t have to be in intensive care when you’re cured.”