You're Gonna Need a Bigger Tantrum
Wednesday, 3/10/2021 09:01
Even so, 'jam tomorrow' stocks are struggling...
WHILE the UK was distracted by last week's budget, things have been going a bit pear-shaped over in US markets,
writes John Stepek at MoneyWeek magazine.
It's a continuation of the same problem we saw in February.
Bond yields are going up, because investors think that the recovery will be better than expected. In turn, that will put pressure on the Federal Reserve to raise interest rates or tighten monetary policy in some way.
Markets were hoping last week that Fed boss Jerome Powell would say something to calm them down. He tried. But at this stage, just talking isn't quite enough.
The tech-heavy Nasdaq index in the US has now entered correction territory. It's down 10% since its most recent high, which came less than a month ago, on 12 February. The S&P 500, less reliant on tech, is down about 5% over the same period.
Over here in the UK, by contrast, the FTSE 100 is down by about 2% over the same period (though it peaked for the year back in January, since when it has fallen by about 4%).
What's going on? Well, it's what we've been discussing for a while now. Markets expect the economy to rebound hard now that we have vaccines and the global economy should re-open before the end of the summer and hopefully be well on the way to "normal" before the end of the year. As a result, they're expecting prices to go up too. And if the recovery is strong enough, inflation might even become an issue again.
That's all great news for the economy and for the "real" world. But it's a bit trickier for the financial realm. If the economy is stronger, then central banks would normally be thinking about raising interest rates a bit. That's not good for those markets which have become extremely expensive on the assumption that interest rates would stay low forever.
The worst-hit assets have been "long duration" plays, or what I'm constantly calling "jam tomorrow" stocks.
Tesla, for example, is down by nearly 30% from its highest point this year. The electric-car maker is a stock whose valuation is predicated on hopes and dreams of a glorious future. But because that future is so far away, any change in the discount rate (the number you use to adjust the value of future earnings) has a much bigger effect on the present value of those future earnings than on some boring oil pumper like Exxon, say (you can read more about the mechanics of this in my earlier piece here).
So when Jerome Powell, the head of the Federal Reserve had a chat with the Wall Street Journal last week, the market was hoping that he'd say something reassuring, about how he wasn't planning to even think about raising interest rates until and unless inflation was really going for it and America was at full employment.
The thing is, that's basically what Powell said. "We will be patient. We're still a long way from our goals."
But the market still sold off. Why? Because he wasn't specific enough.
Investors want the Fed to put a number on all this. They want to know that the Fed will act to keep rates down within certain parameters. In effect, investors are starting to price in earlier tightening than they'd previously expected. And that can't help but have an effect on stocks (and bonds) that had been priced for a longer period of ultra-loose money.
Really, what they want is for the Fed to make an explicit commitment to something like yield curve control (where the central bank says that it simply won't let long-term government bond yields rise above a certain rate). But the Fed hasn't done that yet, and because the market is starting to believe that inflation will be higher than the Fed expects, they don't think the Fed will hold out.
And the reality is that the bond market – I mean, you could call them "bond vigilantes" if you wanted though it's a little melodramatic – will probably keep pushing yields higher until either investors decide that they've gone far enough for now (ie that they're pricing in all the inflation they expect) or the Fed decides that enough is enough.
What's likely to drive that? At the moment what we're seeing is a shift from one sector of the market to another. As is clear from the figures above, the Nasdaq is having a tough time, but other markets aren't doing too badly. Value is beating growth. Oil stocks are rallying hard in the face of full-on ESG adoption. The market is doing its usual thing – tipping the boat over just as everyone was looking over the side.
If this continues to simply be a rotation, the Fed may not need to even get involved. The problem is if it starts to spread to the financial plumbing. For example, maybe bond investors – normally the sober ones at the party – will panic and decide that it's actually just been one big bubble and start selling hard rather than simply driving yields back up to "sensible" levels. I mean, there's been a sniff of panic in the air recently – if that goes full blown, then the Fed might react.
Or of course, stocks might fall hard. That's a distress call that central banks have previously struggled to ignore. As Eoin Treacy notes on FullerTreacyMoney.com, "with the S&P 500 down less than 5% from an all-time peak, the Fed has no incentive to act. When it is down 10% or even 20%, then we will see how sanguine the Fed is."
In other words, we need to see another tantrum before the Fed feels justified in acting. While we wait for that, I'd just keep an eye on your watchlist, see if anything you want to buy becomes available more cheaply, and invest when it does. And I'd stick to the plan of value over growth, investing in energy stocks and financials, and opting for international over the US.
For more on all this (we've been talking about it for a while after all) make sure you subscribe to MoneyWeek.
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