- Ten Year Treasury as a Market Indicator
- Is Inflation a Flash in the Pan?
- Is the Growth Cycle Fizzling Out?
Last month marked a significant mile marker on the road to reflation as the CDC announced updated guidance for fully vaccinated individuals. For the first time since the start of the COVID-19 pandemic, those who are fully vaccinated are no longer required to wear a mask in a majority of settings. In addition, the number of new cases in the US has fallen to levels not seen since the very beginning of the crisis in March 2020. While it is too early to declare that the COVID-19 pandemic is “over,” we are certainly moving closer to things being back to normal.
One of the main themes we have been discussing over the past 8 months has been the consequences of economic reflation. Normalizing the COVID pandemic plays a big part in the reflation process as businesses can now operate with fewer restrictions. Expectations for economic growth going forward remain strong, so much so that many are worried about the possibility of inflation starting to pick up. The narrative is playing out almost exactly as many had expected, except there is one area of the market that is stubbornly refusing to acquiesce.
The chart above depicts two measures of inflation (consumer 5 year expectation in light blue; market implied 5 year inflation in orange) and the 10 year Treasury yield in purple. What you will notice is that while both measures of expected inflation are moving higher, the 10 year has started moving lower since about the middle of March.
Why Do We Care?
Normally, and especially in this market, stocks garner all the attention. Mainly this happens because the potential for return is almost always higher on the equity side and at the end of the day, investors are drawn to that excitement. But stock investors should be taking very keen interest in what is happening right now in the bond market because yields are sending a message that all might not be well with the reflation narrative.
We have reached a critical point in the economic cycle where lower comparisons for a majority of economic and inflation indicators will no longer be compared against the COVID lows. In our last Town Hall webinar, we touched on how the base effect can skew the numbers to appear better/worse than they actually are, on a percentage growth basis. While the headline might proclaim incredible growth rates, it’s all relative to the time period being measured. That leaves us with two probable scenarios going forward.
The first is simply a continuation of the original reflation thesis. The economy will continue to re-open and growth will accelerate. Job growth will improve as a reduction in unemployment benefits will encourage more workers to enter the workforce. Supply chain backlogs will slowly improve but not at a pace that is fast enough to hold inflation in check. The 10-year yield will finally accept that inflation is here to stay and will eventually move higher. Value sectors such as energy, financials, industrials, and materials should continue to be the top performers.
The second scenario is one where growth begins to sputter, the inflation narrative turns from fears about higher inflation to concerns about slower growth and arguments about whether or not we have already passed peak inflation. In this scenario, value sectors would come under pressure as earnings expectations are revised lower. This could also allow the Fed more time to think about raising interest rates, turning a slowing economy into a positive for stocks.
Either way, the next few weeks will be important in determining the direction of both the economic narrative and the market. We have now gone almost 6 months without a 5% correction for the S&P 500, and while not unprecedented, it is longer than normal. With expectations high and volatility low, some complacency is starting to build again. However, market technicals and internals remain positive while economic reports remain sufficient, despite the contrary action from the 10-year yield. We are either entering the end of the beginning of the economic recovery or the beginning of the end of the reflation narrative. For now, we are still believers in the former, while starting to prepare for the latter.
Weekly Focus – Think About It
“Truth is confirmed by inspection and delay; falsehood by haste and uncertainty.”
Performance last week for the four major asset classes were:
- U.S. Stocks – Russell 3000 (IWV) – Gain of 0.60%
- Developed Foreign Markets (EFA) – Gain of 1.05%
- Emerging Markets (EEM) – Gain of 2.04%
- Fixed Income (AGG) – Gain of 0.26%
(Note: performance is based on the change in price plus dividends)
Last Week’s Headlines
- 559,000 new jobs were added in May, shy of consensus expectations but almost double the gain seen in April.
- Wage growth remained strong in May, up .5% and the third-strongest month-over-month gain during the past year.
- The number of job openings increased to 8.1 million while total unemployed moved lower to 9.3 million, showing signs of a labor market that continues to improve.
Eye on the Week Ahead
- Much attention will be on the CPI and PPI reports as investors try to gauge inflation levels and how that could affect markets going forward, while Retail Sales will provide an update on the health of the consumer
If you have questions about the recent market conditions, please contact a member of HCM’s Wealth Advisory Team:
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