Interest rates are rising rapidly, ending a 40-year bond bull market and shifting the economy from deflationary to inflationary. Rising interest rates are replacing COVID-19 as the main factor driving global economies and markets in 2021.
Our September forecast for rising interest rates in our Two Generational Trends Reverse letter is proving to be timely and accurate. With COVID-19 vaccines expeditiously rolling out, the economy is rapidly recovering. Stay-at-home stocks which benefitted from the lockdown are losing their momentum and reopening stocks are rallying with the economic recovery. This growth to value stock rotation is gaining momentum as stay-at-home stocks like the FAANG and large-cap technology stocks are setting up against tough earnings comparisons for the first, second and third quarters of this year. The combination of decelerating earnings momentum and rising interest rates should break the exceptional 24.62% annualized performance of the NASDAQ 100 or QQQ of the last five years.
Social media is increasingly being identified as a key source of political partisanship and social rage by Walter Isaacson and in The Social Dilemma which may cause their boom to slow. Political partisanship has been growing more extreme with the prevalence of social media. The series of charts below from a study by the Pew Research Center shows an alarming and growing divide in the United States that appears to be exacerbated by social media algorithms used by Twitter and Facebook that are designed to increase clicks by enraging readers. The chart series below shows a widening political polarization from 2007 to 2017. This growing polarization could lead to the demise of social media and hurt social media stocks.
The 2021 tech decline will not be as severe as the 83% NASDAQ 100 decline of the 2000 technology bear market, rather this tech decline will be a continuation of the “Great Rotation” from large cap tech and growth stock outperformance to an inflationary cycle where cyclical, commodity and value stocks outperform.
How High Can Interest Rates Go?
Economist Jeremy Segal recently said inflation could end the year at 4-5%. If his forecast proves accurate, the 10-year US Treasury Note yield could rise to the 4-5% range by year-end. This significant 2.3-3.3% increase in interest rates could have a major impact on business and the markets. This 3% rise in rates would lower the “Risk Premium” to zero – a critical cross-market valuation measure not seen since the 1999-2001 tech bubble. Stock valuations could offer no “premium” to justify their ownership over 10-year US Treasury Notes.
To estimate the Risk Premium at year-end, we divided our forward S&P earnings estimate ($196.56) by our year-end S&P 500 price target of 4369. This equates to an earnings yield of 4.48% = $196.56/4369 which, with a 10-year US Treasury Note yield of 4.5%, would lead to a zero Risk Premium. The fourth quarter should see strong earnings momentum with GDP estimates in the 7% range; however, Biden’s proposed higher corporate tax rates will weigh on the market. A lot could happen in the next nine months.
The chart below shows the Fed Model or Risk Premium for the S&P 500. We expect earnings to rise into the fourth quarter, but at that point, interest rates and taxes could stifle the market’s momentum.
Inflation Risk:
The risk the market does not see, is that inflation could return and Federal Reserve Chairman Powell’s assertion that 2% inflation will “be transitory” could prove wrong. If inflation becomes more tenacious than the benign deflationary environment since 2009, 10-year US Treasury yields could rise to 4-5%, significantly changing the global markets, deficit finance, and economic behavior ushering in a new era of inflation winners and losers. With a growing debt service cost on $28 trillion, a rapid rise in interest rates could significantly increase the debt servicing cost of the massive US federal deficit and risk a debt spiral.
Borrowing from Peter to Pay Paul:
Doves argue that technology and outsourcing will keep inflation low and rising rates will not be a problem. Some argue the Federal Reserve will simply increase its purchases of US Treasuries as it has been doing since the Financial Crisis. Unfortunately, international buyers of US Treasuries are buying fewer US Treasuries – about 25% of our US Treasury debt down from 33%. With the debt to GDP ratio of 129% – near historically high levels – the US Treasury’s creditworthiness could soon fall into question. This negative scenario would debunk the Modern Monetary Theory which, US Representative Alexandria Ocasio-Cortez, among others, has argued can finance our significant federal government spending. As my late mother would warn, “borrowing from Peter to pay Paul” is a bad idea.
Inflation and Commodity Cycles:
Many have argued that inflation will never return due to continued technological efficiencies and aging demographics. We are not so sanguine. The history of inflation cycles and asset performance cycles suggest a seismic investment shift toward inflation and commodities could now be underway. The chart below shows cyclical periods of inflation and deflation and the corresponding periods where commodities outperform financial assets.
Commodity prices are rising. Given the massive fiscal and monetary stimulus, inflation appears poised to manifest itself and the Fed is encouraging it!
The chart above delineates the cycles of inflation and deflation since 1887.
The chart above shows commodities versus the S&P 500 is turning up and downtrend lines are being broken. 1995 through 3.31.2021
Investment Strategies and Investments:
We continue to favor economic cyclicals, like energy, including: MLPs such as Enterprise Products Partners, L.P. (EPD), Energy Transfer, L.P. (ET), Magellan Midstream Partners, L.P. (MMP), and MPLX, L.P. (MPLX) and natural gas companies like Antero Midstream Corporation (AM) and Antero Resources Corporation (AR). These energy investments all yield around 9% except for AR.
Banks should benefit from a steepening yield curve and we like Wells Fargo & Company (WFC) and JP Morgan Chase & Co. (JPM).
Cyclical and commodity exposure can be added through select ETFs: Homebuilders should benefit from limited supply – SPDR Homebuilders (XHB), Semiconductors are critical in industrial sectors like automobiles – Van Eck Vector Semiconductor (SMH), and agriculture is benefitting from rising prices – Van Eck Vector Agribusiness (MOO).
After 40 years of declining interest rates, there is a misplaced comfort with duration risk. Bond ownership and maturities should be reduced. Bond yields do not justify their duration risk, yet they are heavily entrenched in the traditional diversified portfolios and financial planning strategies of the last 40 years. We are reducing bond exposure and equity income bond alternatives like utilities.
For our more adventuresome clients, we are buying two inverse ETFs: ProShares Ultrashort Lehman (TBT) is an inverse Treasury ETF that rises when bond yields rise. The ProShares Ultrashort QQQ (SQQQ) is the inverse of the QQQ – Nasdaq 100 Index. The SQQQ rises when the QQQ index declines.
Writing calls against stocks with significant appreciation is an excellent way to reduce total equity exposure with stocks without triggering capital gains.
Conclusion:
We worry about the US monetary system given its record 129% ratio of US debt to GDP and the growing concerns about the Federal Reserve becoming the only buyer of US Treasuries. The casual trillion-dollar spending bills, when the economy is recovering so rapidly, make the US monetary system look like a Three-card Monte game. A market reaction to this excessive spending and the historic deficit could occur later this year.
Currently, the US economy is leading the world out of recession and the dollar is strong with US Treasuries offering competitive yields. When other global economies begin to strengthen later this year, the dollar will begin to weaken, and gold and precious metals and their producers will resume their bull markets.
There will be many opportunities in the stock market this year, but the deflationary bond-friendly dynamics which have helped traditional asset allocation strategies like the 60 40 stock-bond strategy will find its low-risk high return profile of the last 40 years challenged. However, asset allocation that favors higher interest rates and inflation is where investors need to focus.
Happy Passover and Easter.
Tyson Halsey, CFA