The Bond Market Has Its Say

February started out as more of the same, with equity markets hitting new highs on the biggest rally in three months. Corporate earnings generally beat (lowered) expectations while the “meme stocks,” most prominently GameStop, took a step back from center stage.

The economic news was, on balance, positive throughout the month. The Bureau of Labor Statistics reported that 49,000 new jobs were created in January, dropping the unemployment rate by 0.4% to 6.3%. Retail sales rose 5.3% in January, following three months of decline. It was the biggest jump since last June. Industrial production climbed 0.9%, and oil prices rose. (; 2/17/2021)

Coronavirus infections trended down as the pace of vaccinations continued to pick up. By the end of month, Bloomberg was reporting that more than 245 million doses of the vaccine had been administered worldwide, including over 77 million in the U.S. The Biden Administration’s $1.9 billion Covid-19 relief proposal continued to move through the House in spite of Republican opposition and was passed in a Saturday session on February 27. It now awaits the verdict of the Senate.

In sum, the growing sense of optimism expressed by the markets generally found support in the data and in real world events. Stocks reflected this in the month’s early going. While all three major stock indexes were up over the first couple of weeks, there was particular exuberance among small cap investors as reflected in the performance of the Russell 2000, which outperformed the S&P 500 by the widest margin in nearly two decades, climbing 15% and setting 10 closing records year to date through February 19.

This was, analysts said, a vote of confidence on the economy.

This time it’s different?

It’s generally unwise to characterize anything about the markets as “unique” or “different,” and that may again prove to be the case. But it’s been more than 100 years since the world experienced and then recovered from a pandemic so it’s at least safe to say that these events are not within living memory.

There are other anomalies to consider: for the past year, the Federal Reserve has kept interest rates at historically low levels, and, according to the most recent testimony by Fed Chair Powell, plans to continue to do so until “substantial progress” is made towards the twin goals of low unemployment and inflation levels in the 2% range. Government spending has been at record highs with trillions more on the way. While it’s an outlier, the Atlanta Fed’s GDPNow model was predicting 1Q GDP growth of 9.5% as of February 18, 2021, a level more associated with emerging markets countries than with the G-7.

That there is a higher level of uncertainty than the norm coming out of last year’s pandemic-induced recession is understandable, given these circumstances. But on balance, all of this was viewed as positive for stocks, until it wasn’t.

During the week of February 15th, the bond market fired a warning shot over the bow of the optimists. Yields on 10-year treasuries surged from 1.265% on Tuesday of that week (Monday was a holiday, President’s Day) to 1.34% on Friday. Stocks fell, led down by the tech-heavy Nasdaq.

This helped to reignite the “reflationary” debate, which continued into the month’s final week. Yields on the 10-year pushed higher, briefly topping 1.5% before settling back down around 1.4%. Equity markets first fell and then rose on testimony by the Fed Chair, but took a more decisive move downward the following day, with the Dow dropping 553 points, or -1.7%, the S&P 500 -2.3%, and the Nasdaq -3.1%.

The struggle with valuation

There were other worries. A quick Google search of the words “stocks are overvalued” pulls up 4.87 million mentions over the past 30 days, so it’s safe to say that the issue of valuation was certainly on investors’ minds. Everyone from Bank of America to Warren Buffett’s righthand man, Charlie Munger, expressed their concern over the course of the month.

But of course no one can really predict the short term direction of the market. Longer term, interest rates clearly matter, as do corporate earnings. But a normalization of rates driven by an improving economy is not necessarily bad for stocks. At the same time, many believe corporate earnings are set to improve, FactSet for one reports that the estimated earnings growth for Q1 now stands at 21.8%, which, if realized, would “mark the highest year-over-year earnings growth reported by the index since Q3 2018.” (FactSet, Earnings Insight; March 5, 2021)

It would be nice to report that we’re in for a lengthy period of non-inflationary growth, and it may be that we are. The growth part appears to be baked in as the economy opens back up and billions of dollars find their way into the pockets of consumers. The impact this has on price levels – and bond prices – remains to be seen. This dynamic is likely to lead to higher levels of volatility in both bonds and stocks as the year goes on. Investors should prepare their portfolios accordingly.

Related: Does the Jump in Treasury Yields Signal the Reemergence of Inflation?