The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
“Perfection is not attainable, but if we chase perfection we can catch excellence.” – Vince Lombardi
Market tantrums and what to do about them
Interest rates have been volatile in 2021, rising rapidly in the first quarter only to give up most of that increase in the second and, so far, the third. For example, the bellwether 10-year U.S. Treasury yield began the year at 0.93%, spiked to 1.74% on March 31, declined steadily through spring and summer, and more recently began to edge higher again.5 It closed at 1.35% on September 10.6 When bond yields go up, their prices go down. The net increase in yields this year has caused Treasuries to underperform, producing a negative total return (-1.6%) for the year to date.7
Meanwhile, stocks have been in fine form in 2021, with the S&P 500 posting a stellar year-to-date gain of 18.7%.8
Typically, stock prices tend to rise when bond prices are falling, and vice versa. But this year stocks have rallied consistently, almost regardless of how bonds have been performing. This divergence from the norm tells us that the correlation between stock and bond returns has, for now, gotten a bit out of whack. (Correlation measures the degree to which two different asset classes move in the same direction. The more positive the correlation, the more similar their performance.)
A period of modestly weaker or stronger correlations between two or more asset classes isn’t that unusual. But a big spike in such correlations in the context of acute market stress has happened only a handful of times in recent years. In each instance, the resulting short-term losses have led some investors to overreact, making hasty and sometimes ill-advised decisions that deviate from their long-term financial plans.
These periods have come to be known as “tantrums,” conveying the dramatic (and disproportionate) market response. And the reason to focus on them at the moment is that the best-known example, the “taper tantrum” of 2013, occurred the last time the Fed was preparing to wind down a large asset purchase program – just as it is planning to do now.
Indeed, the defining characteristic of a tantrum is that it’s driven by severe market anxiety about looming tighter monetary policy. This generally leads to higher nominal interest rates like the 10-year U.S. Treasury yield and at least a brief period of heightened volatility (i.e., losses) in the equity market.
Since the end of the 2007-08 global financial crisis, there have been three such periods:
- May 2013 – June 2013 (the taper tantrum). The Federal Reserve jolted investors merely by mentioning it expected to begin scaling back its third round of quantitative easing (QE) at some point in the future. Stocks tumbled about 5% over the next month or so, while long-term Treasury yields marched higher over the next seven months.9
- Fourth quarter of 2014. Just as the Fed was winding down QE for good, investors expected an imminent and sharp increase in interest rates, which didn’t come to pass. But stocks dropped 5% in about two weeks.10
- Fourth quarter 2018. Markets were worried that the Fed would continue tightening in the face of a potential U.S. government shut down and a global manufacturing recession caused by trade-related uncertainty. Against that unnerving backdrop, the 10-year U.S. Treasury yield hit a multi-year high even as the S&P 500 began a drop that would ultimately amount to nearly 20% from its October 2018 peak.11How likely are we to see another tantrum before the end of the year? The Fed has signaled that it’s almost certain to begin tapering its current asset purchases in the next few months, but so far, markets have remained reasonably calm. While it wouldn’t be a shock for inflation expectations to fall somewhat and for real interest rates to rise over the balance of 2021, this dynamic is unlikely to be rapid enough to cause significant market stress, unless the Fed makes an error in communication. The Fed, having learned its lesson from 2013, has proceeded with extreme caution as it telegraphs the coming end of quantitative easing and seeks to separate its tapering plans from its eventual pivot to raising policy rates, which is unlikely to occur before 2023.
What might all of this mean for investors and their portfolios?
We’ve learned that diversification by itself hasn’t been enough to help investors overcome negative short-term consequences in a period when both stock and bond prices are falling.
In our view, it’s important to remember that equity market selloffs during tantrums tend to be short-lived, broad and, most importantly, followed by stretches of good performance. Ultimately, the key quality needed during such challenging times is patience. An investment strategy that deploys cash, periodically rebalances and sticks to a long-term financial plan is the best way to navigate through the most uncertain and volatile market regimes.
Why is the U.S. economy losing momentum? It’s not just the Delta variant
Economists generally agree that the once-booming U.S. economy, as well as many economies worldwide, decelerated in August and is likely doing so in September as well. And most think the prevalence of the Delta variant of COVID-19 has something to do with it. So far, the evidence of economic softening has come mainly in the form of survey data: shaky Purchasing Manager’s Indexes (PMIs), which measure manufacturing and service-sector activity, and plummeting U.S. consumer optimism.
Of course, we’ve seen such sentiment-based surveys dip before without a commensurate weakening in the actual economy. That’s why, this time around, the best hard evidence of a material economic slowdown has been (1) August’s disappointing payrolls report (+235,000 jobs created versus forecasts for around +750,000) and (2) July’s tepid consumer spending data despite a larger-than-expected increase in personal income.12
In our view, Delta variant fears are probably not the primary driver of the recent lukewarm spending numbers. In fact, the most virus-sensitive industries have enjoyed the biggest pickup, while the “order-stuff-from-home” segments of the economy have declined. The reason? As a group, consumers tend to rotate their spending away from items that have recently gone up in price (cars and furniture come to mind) and toward things that haven’t — or have, but not to the same degree, like dining out.
Given that consumers are the primary driver of U.S. economic growth, accounting for about 70% of GDP, how might these spending patterns affect the economy? Fortunately, high savings levels and rising incomes, even without the various (and generous) government aid packages, should allow GDP to keep expanding in the third quarter, albeit at a slower pace than in the first (+6.3%) and second (+6.6%) quarters.13 Consumers have the means to spend, gainful employment is widely available and there are fewer restrictions on individual activity than at any time since February 2020.
Of course, this positive backdrop may change. Delta variant cases, hospitalizations and deaths were still surging in many states when last month’s economic data was being collected, and mobility numbers indicate that traffic at airports, for example, has paused or receded. For now, though, the better “slowing” thesis is that consumers are having to make do with little or no ongoing stimulus money. The economic “sugar high” fueled by fiscal policy in the spring of 2021 was never sustainable, nor was it meant to be. But the accumulated savings that resulted should help support demand in the U.S. and other major economies for a few more quarters, if not longer.