I was told many years ago when I started in this business that it wasn’t my job to predict the future. Our job as investors is to properly and accurately interpret the present. I was also told that wasn’t as easy as it sounded and the current consensus about the state of the world was probably, almost certainly, almost always, wrong. Last week I thought about that as I listened to guest after guest, talking head after talking head tell me that the bond market was selling off on inflation fears. Or that the dreaded bond vigilantes had finally made a comeback, Treasuries going wanting at the 7 year auction as the House of Representatives prepared to pass President Biden’s $1.9 trillion COVID relief (mostly) bill.
It was a neat narrative that explained so much. Bonds were selling off, stocks were selling off, commodities were rallying. It was like the return of the 70s all in one week. The only real problem with it was that, well, it wasn’t true. The market was sending out a message to investors, the financial press, financial Twitter and it was like they were all standing around with their fingers in their ears going “La, la, la, la, la”, I can’t hear you.
It is true that bonds sold off last week. On Thursday, the 10 year Treasury yield at one point was up 18 basis points from its low. That might not seem like much but when the rate starts the day at 1.45% it’s a pretty big move. The sell off accelerated after the 7 year Treasury auction, the results of which showed a distinct lack of enthusiasm on the part of buyers. But to ascribe those moves to a rising fear of inflation required that one ignore a bunch of other markets.
What was more interesting than the 10 year everyone was watching was the 10 year everyone was ignoring – the 10 year TIPS. They also sold off on the day, a quite curious response if the market was actually bracing itself for an inflation surge. The 5 year TIPS didn’t sell off as much though so there is some heightened concern about near term inflation I suppose but we aren’t talking big numbers here. The 10 year breakeven inflation rate finished the week at 2.15% up – oh my! – one basis point from a week ago. Yes, 1/100th of a percent. The 5 year rate finished the week at 2.39% up all of 10 basis points on the week. By the way, none of this should have come as a surprise. I told you two weeks ago my target for the nominal 10 year was 1.4% (we closed the week at 1.45%) and Jeff told you about the inverted TIPS market well before last week’s action. (The inversion refers to near term versus long term inflation expectations). No, we don’t predict the future but we do try to watch what everyone is watching (Keynes beauty contest) and we do listen when markets speak.
What really happened last week was the market’s real growth expectations improved. That’s something I’ve been waiting to see and I’m happy it did even though I own TIPS. The divide between stock market expectations and bond market expectations was about as wide as I’ve ever seen it and that makes stocks very vulnerable to disappointment. To be clear, 10 year TIPS yields are still deeply negative so we’re not talking about anticipating a boom here. But the 10 year at -0.71% is quite a bit better than -1.06%. That is a pretty big change in a short period of time (10 trading days) though and markets are usually more interested in rates of change rather than levels. At least things are moving in the right direction.
Other markets seemed to confirm the rise in growth expectations. Stocks were down but the big down moves were in growth stocks which are highly sensitive to changes in interest rates (thanks to our friends at Knowledge Leaders Capital). Stocks, it should be noted, have in the past performed pretty well in rising rate environments; better growth usually means better earnings. Growth sensitive commodities were also higher on the week while gold was down more than the S&P 500. Again, that’s the opposite of what one would expect if inflation fears were the driving factor. Even the dollar managed a small gain on the week so the US outlook even improved a little relative to the rest of the world.
One thing I can’t say is whether the market’s change of heart about growth will be right or not. I do believe there is some validity to the Soros’ theory of reflexivity, that markets shape the economy rather than the other way round. If the market believes that growth will improve and investors act accordingly, it may actually induce the growth it is predicting. If rising growth expectations steepen the yield curve it could have an impact on lending and bank profitability. If rising growth expectations raise the price of oil, it can cause the industry to drill for more. There are plenty of other examples but I’m not sure how much they apply in the midst of a pandemic. Right now, better growth is probably more a function of the vaccine rollout and whether we can get it done before some new variant puts us back in the soup. I don’t know how to handicap that and neither does the market.
A quick glance at the economic statistics from last week shows why growth expectations were on the rise last week. The data was good and mostly better than expected. Of course, incomes were up 10% because of government transfers which have a shelf life no matter what the MMT crowd believes. And as expected, most of the transfers were saved; the personal saving rate jumped to over 20%. That can be construed as positive too since the expectation is that that savings will get spent down when the virus is past. I don’t disagree with that in the short term but I suspect financial behavior will be quite a bit more conservative on the other side of the virus than it was before.
The Chicago Fed National Activity index is a good, all encompassing indicator of economic health and it came in at 0.66, indicating an economy growing well above trend.
Next week’s calendar is pretty full too with the all important employment report on Friday.
What investors should have learned last week is that diversification does indeed work and it works when you need it most. Stocks and bonds were both down last week but commodities – which are always some part of our portfolio – were up, providing some offset. Another lesson is that you need to pay attention to the trends and not try to buck the market. It has been obvious for months that long term yields were heading higher with short duration bonds outperforming. That’s why the fixed income part of our portfolio has been concentrated in short term bonds since right after last year’s onset of the virus crisis period. Trying to bottom fish in long term bonds burned a lot of people last week and there was just no reason for it.
Markets last week told a very consistent story even if most people weren’t listening. Value outperformed growth with the financial, energy and industrial sectors leading. That is a clear pro-growth shift. One last thing to note and it may be very important. Despite being down, US markets were the clear winners last week as EM stocks – particularly China – got hit even harder. With growth expectations rising the dollar was higher last week and appears to be putting in some kind of bottom here. That doesn’t mean it is about to take flight but stability is a positive sign for growth too. For now, we still have the environment as:
The 3,6,9 and 12 month rates of change for the dollar index are all still down so that’s where we are. But the rates of change are definitely slowing too. And there are some rumbles in EM currencies as we would expect when US rates are rising. But there is nothing yet that points to any kind of crisis except of the self made variety (I’m looking at you Brazil).
Our portfolios shifted to a full weighting in small cap about six months ago and that has paid off handsomely. We added EM stocks to our portfolios last year too which has also worked out pretty well (although that position is now on watch due to the recent firmness in the dollar). We also added a small value position to the portfolios last year. That trend is now accelerating and we upped our small cap value weight last week. But I don’t know if this rotation will persist; there have been a lot of value head fakes over the last few years and this could be one more. But it doesn’t feel that way. We’ll find out over the next few months.