Stock prices and bond yields continue on the path of least resistance: up 

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2021 Outlook:
  • U.S. economy: Getting worse before it improves. 
  • Global economy: Ready to get back to normal—with the help of vaccines.
  • Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
  • Fixed income: A modest-risk overweight with a focus on credit sectors.
  • Equities: Lean toward small caps, emerging market shares and dividend payers.
  • Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.

Quote of the week:

"Courage and perseverance have a magical talisman, before which difficulties disappear and obstacles vanish into air.” – John Quincy Adams

Market risks remain despite a tame inflation outlook

For much of 2020, inflation was hardly a hot topic. The pandemic forced businesses to close and people to stay home. The economy sank into recession. But as the U.S. started to rebound and Congress amped up fiscal spending in the form of relief packages — with a $1.9 trillion deal still on the table — concerns over rising prices began to grab investors’ attention. Small wonder, then, that last week’s consumer price inflation (CPI) data for January was so closely watched.
The numbers, though, were neither memorable nor market moving. Year-over-year headline inflation missed forecasts, coming in at 1.4%, unchanged from December’s reading.4 Core CPI, which excludes volatile food and energy costs, also registered 1.4%.5 On a month-over month basis, headline CPI rose a healthy 0.3% thanks to sharply higher gasoline prices, while core prices didn’t budge.6
Despite these mostly tame results, we believe markets may experience an “inflation panic” sometime this year, akin to the events of early 2018. Then, an unexpected jump in wages closely followed a round of large personal and corporate tax cuts. Investors feared that the Fed, in an effort to forestall a potentially overheating economy, would begin raising interest rates faster than it had planned. (Higher interest rates are the one tried and true method a central bank has for fighting inflation.) Within a few weeks of that wage-growth data, the yield on the bellwether 10-year U.S. Treasury note breached 3% for the first time in more than four years, credit spreads widened and stocks sold off sharply.7​
What might trigger similar inflation dynamics in 2021? The first source could be from “base effects.” This would show core inflation appearing to accelerate simply because weak readings from last spring, in the early days of the pandemic, will be replaced in year-over-year calculations by potentially stronger data as the economy continues to normalize. Although investors may react badly to base-effect inflation by unloading stocks and bonds, we doubt the Fed will pay it much heed, recognizing it as a temporary statistical quirk rather than a true reflection of the economy’s strength.
The second, more likely source of inflation risk in 2021 could come in the form of a sudden, positive shock as the economy fully reopens and demand is restored in hard-hit sectors such as traveling, dining and hotels. A return to commuting as employees head back to the office, which requires energy consumption, would also heat up the economy. This return to “everyday living,” when it eventually occurs, won’t generate long-lasting higher inflation, in our view, since the positive shock would represent only a short-term boost to demand in certain service areas of the economy, and could be accompanied by a drop in demand for goods.
Against this backdrop, we would expect this type of inflation to be largely ignored by central banks and investors alike. In his recent public comments, Fed Chair Jerome Powell has already warded off worries about temporary increases in inflation. He and his colleagues will focus instead on evaluating whether economic conditions have normalized to the point that the Fed should be concerned about a general rise in the level of prices (which is what inflation is, after all) caused by too much demand chasing too little supply across the economy. Historically, such inflation has tended to materialize only when full employment has been reached and wages are rising in a broad-based fashion. And even then, inflation isn’t guaranteed to rise.
So when might the Fed begin to raise its benchmark federal funds rate? “Not anytime soon,” Powell stated at his January 27 press conference, and we agree. Right now, the economy still has plenty of slack. Unemployment stands at 6.3%, up from 3.5% just prior to the pandemic.8 And the labor force participation rate is just 61.4%, versus 63.4% before the outbreak.8​
Meanwhile, core PCE inflation, the Fed’s preferred inflation gauge, measured 1.5% year-over-year in December.9 Only once that rate increases to around 2% do we think the Fed might start to wind down its quantitative easing asset purchases (currently $120 billion per month). And we don’t expect Fed officials to begin discussing a rate hike until core PCE consistently registers 2.5% or higher. We think that’s unlikely to happen until 2023-24.
And because the effects of monetary policy work on a lag, inflation could continue to rise even as the Fed is tightening policy, perhaps hitting 3% by mid-decade. (The likelihood of inflation running out of control by topping, say, 5%, are low.) These moderately higher inflation numbers probably would come in the context of significant increases in real wages, so we don’t anticipate they’d cause economic pain. They could, however, be accompanied by a redistribution of economic benefits from employers to employees.

Things we’re noticing…

Although last week was a mostly quiet one for markets, we spotted a few items worth pointing out. Among them:
  • Investors are still shunning stocks in favor of bonds. Continuing a trend that began back in 2018, investors continue to dump stocks and buy bonds, despite the stock market’s remarkable performance over that stretch. (The S&P 500 is up 50% versus 18% for the broad investment-grade bond market, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index.)10 According to ICI, equity mutual funds and exchange-traded funds have seen outflows totaling $50 billion in the first five weeks of 2021, while fixed income funds have received over $120 billion of inflows.10
  • The 2-year/10-year U.S. Treasury yield curve hit its steepest level since 2017. Investors are convinced that the Fed will anchor short rates for at least a few more years, but that hasn’t stopped yields on longer-dated government debt from gently increasing on expectations for higher growth and inflation.11 
  • Brent crude oil topped $60 per barrel for the first time in a year. As vaccinations kick in, hopes that economic activity will normalize – with more people driving and flying – is likely to boost energy demand, temporarily pushing up oil prices until supply rises, as well.12
  1. Bloomberg, Marketwatch
  2. Bloomberg, Haver
  3. Bloomberg
  4. Haver
  5. Haver
  6. Haver, Trading Economics
  7. Bloomberg, Marketwatch
  8. Haver
  9. Haver
  10. Bloomberg
  11. Bloomberg
  12. Bloomberg
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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