Economic Monitor: Appreciate the Beauty, But Mind the Beast

BY: Mark Drachenberg

In keeping with last month’s Disney-movie-themed post, this past month's economic performance can be likened to another of the studio's timeless classics: Beauty and the Beast. As I'm sure you're familiar, the tale is about a beautiful young lady (in this case, herd immunity from coronavirus) who falls in love with a beast (we'll discuss what this may be in a moment) that is actually a haughty, but dashing, prince who's had a curse placed upon him – one that's lifted by her devotion. Too much of a reach? Well, read on and decide.

The beast, I would argue, comes in the form of economic stimulus. While some may help those that need it, too much could lead to inflation and market turmoil. We want our tale to end with a celebration, rather than a disaster, but no matter the circumstance, we want to be able to navigate the markets safely and appropriately. 

February saw the markets recover from their January doldrums. Equity indices all powered ahead and were led by mid- and small-cap stocks, which returned 6.80% and 7.65% for the month. The only negative on the board belongs to the Barclays US Aggregate Bond Index, which posted a return of -1.44% for the month. Year-to-date, the story is similar, with mid- and small-cap stocks leading the way at 8.41% and 14.42%, respectively. Last year’s big winner, the NASDAQ, is showing more pedestrian returns, as the index was up 1.01% in February and has gained 2.47% on the year.

Volatility has returned, as the yield on the 10-year U.S. Treasury pushed higher to approximately 1.50%. This increase of approximately 0.50% over the past couple months has stoked fears of inflation and the possibility that the Fed could alter its easy-money policies sooner than anticipated. The economy continues down its path to recovery and growth, but the recent volatility reminds us to be mindful of fundamentals. 

In recent weeks, we saw a flare up in rates that reminded many of theTaper Tantrum of 2013. Back then, many feared the Fed was going to put the brakes on its quantitative easing efforts. This time, the fear of inflation and rising interest rates – largely due to the amount of fiscal and monetary measures already in, or coming to, the economy – led to a sell-off in bonds. Much of the financial press has pointed to the rise in yields and inflation, helping to stoke those fears.

In fact, many have stated boldly that inflation is the (emphasis mine) biggest risk to investors. I think that overstates things slightly. The biggest risk is not inflation itself, but excessive or runaway inflation. Any inflation erodes purchasing power over the long term, but a little inflation, such as near the Fed target rate of 2%, can have its benefits. Businesses, over time, can raise prices somewhat, increase profits, pay better salaries and benefits, and provide higher returns to shareholders.

Excessive inflation, however, erodes purchasing power faster and creates an environment in which salaries cannot keep up with rising expenditures, causing demand to fall. Fueling this fear right now is the potential harm that excessive stimulus will do to the economy. Few argue that some stimulus has been good for the economy and has helped many weather the storm, but too much of a good thing can, and will, lead to higher prices and rates at some point. A rapid rise in inflation and a corresponding rise in interest rates has the potential to end the party and could cause the economy serious problems.

The question is, however, are we there already? Or will the latest stimulus package push us to that point? Who knows? Arguments are being made for both sides of the equation, but it will be some time before we have the answers. No one can argue, though, that there are not risks out there. For now, the beast has calmed down and is being kept at bay; however, keeping an eye on it is well worth one’s time.

Investors have reason to be optimistic – at least in the short term. Earnings will continue to be strong, and forward guidance should be positive as well. Additional stimulus will help keep businesses running and create demand from consumers. Tax increases are likely pushed to 2022, at the earliest, and the Fed’s policies will likely continue into 2022, too. All of this adds up to a growing economy (most GDP estimates run between 4.5% and 5% for this year), and that is beneficial to stocks. I think the following quote from a recent piece put out by First Trust should make equity investors feel good for now:

Eventually the bull market will come to an end. Maybe it’ll be the much faster money growth translating into persistently high inflation and interest rates, perhaps tax hikes will go farther and be more damaging than we think. Perhaps, some exogenous factor like a mutant strain of COVID forces another shutdown. Perhaps, perhaps, perhaps. (words theirs, emphasis mine)

But the market is still undervalued (they project the S&P 500 to hit 4200 by the end of the year), the Fed is easy, stimulus will boost the economy and borrowing from the future, and COVID data are very positive. We would never say that anything is certain, or that a correction won’t happen, but the stock market is nowhere near bubble territory. (Taken from First Trust Monday Morning Outlook February 16, 2021)

While beauty can still dance with the beast, she should keep her eyes open. After all, he is still a beast!

We have said, and continue to believe, that the first half of this year, particularly the first quarter, will see periods of heightened volatility as news of the virus ebbs and flows, and inflation and interest rates adjust. As such, we will look for opportunities to take advantage of valuation disparities, diversify, and still provide downside protection. We are here and available to discuss your portfolio or any other issue you may have. Please email me or call us at (608) 826-3570 to discuss your situation and options. We look forward to speaking with you.

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