The Summary
- The roller-coaster ride continued last week as investors digested higher rates, a commitment from the Fed to keep easy money flowing, and no commitment from the Fed to arrest the rise in rates. It is widely believed that there is some level of rates and/or market selloff where the Fed would step in to “stabilize” markets. This means that there is likely some floor to market selloffs so long as the Fed is committed to maintaining their current policy.
- Wednesday morning we get a read on inflation. The consensus is that inflation sits right around 1.4% (annualized). A print much higher than this expectation would likely send markets reeling. Thursday is initial and continuing jobless claims, which are also important. The expectation is for 4.22 million continuing claims and 725,000 new claims. Again, if the jobs market is improving faster than expected that would likely be bad for markets. Both inflation and employment are central to Federal Reserve policy and since that policy is generally driving markets, major changes in the data could lead to major changes in policy, which is a net negative for financial markets hooked on easy money.
- I still see the Fed as being very supportive, despite the recent worries to the contrary. Recent market volatility, in my view, is likely to be short-lived and provides a good entry point for investors with cash to deploy. That said, there are some adjustments to portfolios investors should consider given the rise in interest rates. Current clients have already seen those adjustments, and I am, of course, always happy to discuss what those are!
The Details
Market news and commentary has been dominated by the Federal Reserve the past few weeks (I lump inflation in with the Federal Reserve). Since the story of the Fed is largely a story of changes in liquidity, I spent some time over recent months trying to better understand the role of liquidity in market pricing. The high-level results of that analysis were recently published at the CFA Institute’s blog.
In a nutshell, when you add cash to the marketplace, investors will pay a higher price for the exact same investment. Conversely, when you remove that cash from the marketplace, investors pay lower prices. Neither of these pricing effects have anything at all to do with a change in the fundamentals of an investment, they are entirely driven by the relative liquidity of investors operating in the market.
While this may seem obvious, it is not the traditional view of markets.
I have been mildly surprised by the reaction of various money managers to the actions of the Federal Reserve. Traditional value investors have been frustrated at the absurd expansion in stock valuations. Growth-oriented investors—the main beneficiaries of Fed policy—have taken a few victory laps, while macro-oriented investors, like Ray Dalio’s Bridgewater Associates, realized quickly that their fortunes are intimately tied to Fed policy. Last year, in fact, Dalio quickly called on the Fed to “go big” in their efforts to salvage the Covid-striken economy. Coincidentally, his fund was down 20% at the time (and has recovered in the wake of the Fed’s actions).
The point is, liquidity matters differently to different investment styles. For growth-oriented investors, the massive expansion in liquidity has been a tailwind driving increased valuations. Value-oriented investors, however, have experienced a marketplace that does not reward well-run companies nor punish poorly-run companies. Recent liquidity flows have created winners and losers.
But things change often in markets. As Bob Dylan said, “for the loser now will be later to win… for the times they are a changin’.” In times like today, mental flexibility and an ability to adjust quickly can be the difference between achieving your goals or not.
Chart of the Week
We have some historical examples of how markets react during rising rates. In 2013, we had the “taper tantrum” wherein the 10-year US Treasury moved upward 1.35 percentage points in the space of about four months. In this week’s chart, we look at how this move affected markets, and how the current year compares.
In May 2013, the 10-year US Treasury began to move slowly upward (bottom panel in the top chart below). Note that it took almost a month before markets began to readjust. From its peak in mid-May, the S&P 500 (top panel in chart below) fell about 6% over the course of a month. It rebounded strongly, rallying 8% in July, only to fall another 4.5% into September. As the 10-year US Treasury stabilized, markets recovered strongly, rallying 6% through September 2013. After another quick downswing, the S&P moved steadily higher afterward.
This is all eerily similar to recent market moves (bottom chart). Since January 2021, the 10-year US Treasury yield has moved from about 1.0% to 1.6%, and is expected to continue its climb. As in 2013, it took a solid month for markets to realize this move was here to stay. Similar to 2013, there have been moves down and back up.
Of course, the moves in 2013 took 4-6 months, and we are only about 3 months into the current move. As in 2013, I would expect to see continued volatility in stocks, but with a general trend upward. And while history doesn’t repeat itself exactly, it does tend to rhyme—It looks like 2021 is going to rhyme with 2013.
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