Rising Inflation Expectations, Rising 10-Year Treasury Yields (Reason To Worry Or Not?)

Last week the S&P 500 rallied 4.3% after a quick downdraft at the end of January and into the first week of February that zapped gains on major indices for the year and sent the S&P and the Dow into corrective mode (down 10% from recent highs), albeit briefly.

That rally from early February lows made for the biggest S&P weekly gain in more than 5 years and got the stock indices back in the black for the year (+1.0% YTD for the S&P 500 through Feb. 21st). The 3 major indices (S&P, Dow & Nasdaq) have now gained back nearly half of their losses from earlier in the month.

The February 5th drop of 1,175 points for the Dow was the largest single-day point loss ever, but in percentage terms that was a -4.6% decline, one that doesn’t register in the top 100 largest single-day losses.

It seems as if a lot of records are being broken as of late, except at the winter Olympics. It looks like the U.S. haul of 37 medals in 2010 in Vancouver will stand. We’re at 19 in PyeongChang as I write this (Feb. 21st evening). In the end, hopefully we appreciate witnessing exciting competition by great athletes regardless of their nationality as the modern Olympics’ aims are for “better world through sport practiced in a spirit of peace, excellence, friendship and respect.”

I won’t speculate on the rationale for lower overall medals for U.S. Olympians but as for the recent equity market sell-off it’s mostly tied to inflationary expectations which feeds through to interest rates, particularly those on the 10-year Treasury note, the most popular debt instrument in the world.

For borrowers, the 10-year is the benchmark for fixed-rate mortgages and the pricing of other credit assets (such as corporate bond rates which trade at a spread over Treasury yields). Overall, think of the 10-year as a gauge of domestic economic growth.

With a tight labor market showing some wage growth and a recent higher-than-expected consumer price inflation (CPI) report, we’re seeing upward pressure on interest rates. Those types of inflationary signs ultimately work their way through to companies as cost pressures, thus potentially hurting profit margins – that’s when stocks start to get roughed up.

Right now, the 10-year Treasury yield is near 2.94%, up from 2.41% at the beginning of the year (a 22% rise).  Some investors like to look to technical measures as a red line be it 3.0% or 3.5% or 4.0% on the 10-year Treasury as the magical switch to reduce their stock exposure.

As we’re starting to flirt with 3.0% on the 10-year, I don’t see it as the indicator to jump ship from one’s longer term goals (one that probably entails having a fair amount of stock exposure). All in all, rates steadily rising isn’t necessarily a bad thing.

As corporate earnings go up, stocks go up, interest rates go up, and bond yields rise. It’s all OK if it’s in balance. It’s a 3-legged stool – corporate earnings, interest rates (influenced by inflation expectations), and investor sentiment (demand for stocks and the ability/willingness to put money to work). Investors need this trinity to work. Similarly, your own body – physical, mental, and spiritual/emotional well-being – needs to be in-sync to feel at your best.

Fourth quarter 2017 earnings have wrapped up for the most part (with 80% of the companies in the S&P 500 reporting, according to FactSet). FactSet calculated the blended earnings growth rate for the S&P 500 is +15.2%. If 15.2% is the final number for the quarter, it will mark the highest earnings growth since the third quarter of 2011 (+16.8%).

We continue to see positive corporate earnings per share (EPS) growth for 2018. Why? The decrease in the U.S. corporate tax rate due to the new tax law is clearly a significant factor (going from 35% to 21%). Other factors include an improving global economy and a weaker U.S. dollar (which helps U.S. exports). Corporate growth and in turn EPS growth should continue to support share prices. For now, we’re not seeing undue profit margin stress across a large swatch of corporate earnings reports. When we do, it may be time to tactically rebalance one’s investment assets.

So, is the worst over? Is the correction done? Is the market no longer concerned about inflation? Many investors and market watchers may not be so quick to jump back on the bullish bandwagon after such a stunning pullback disrupted one of the most epic market upswings in history; it’s certainly shocking to suddenly see the Dow plunge by more than 1,000 points twice in one week.

My hope is that the market has finally found some balance amid higher inflation, rising rates, and increased volatility. Perhaps this was the long-awaited correction that so many investors said we needed, and now the market can resume its upward trajectory.

What’s the tipping point for investors to step away from equities for higher return that may be available elsewhere? Given recent stock performance as the 10-year has moved closer to 3.0%, I’d speculate that stock bulls will turn worried once rates close in on 3.5% and become outright bearish once rates close in on 4.0%. The catch here is the pace to which we get to these higher yields – a steady move up is fine, but a jump to 4.0% (as an example) by the end of this year on the 10-year would surely be perceived as bearish.

I remain constructive on global stocks given solid growth fundamentals in the U.S. and internationally, but see further gains punctuated by bouts of volatility with higher magnitude than the markets have seen in the past few years. Historically, higher volatility has been able to coexist with upward-trending stocks.

It’s understandable that you may be worried about your investments and seeing the vagary of month-end statement values. If that is distressing to you, let’s talk about your long-term goals, your investment mix, and how I may help you stay on course in volatile times.

Wall Street veterans remind us of the adage, “Trees don’t grow to the sky.” The markets had a well-deserved break, spooked by rising interest rates. Markets go up and down. Over the long run we all know they go up a lot more than they go down. But in these times of market volatility it can be stressful on all of us. The key to managing stress from fluctuations in the market is to ignore the noise.

Disclaimer: Nothing in this article should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my  more

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