Dovish Fed policy powered the 12-year bull market that was interrupted briefly by the 2020 lockdown. But it’s worth recalling that equities suffered steep corrections when Standard & Poor’s downgraded U.S. Treasurys in 2011 and again when the central bank raised its fed funds rates to a modest 2.5% in 2018. Equities generally dislike bond market volatility.
The only experience two generations of professional and retail investors have had with a rising interest rate environment, never mind rising inflation, are the few miniscule rate hikes by Fed chairs Greenspan, Bernanke, Yellen and Powell, Cuggino says. “Who knows how they will react if interest rates quickly move up and to the right?” he wonders.
There are other reasons besides the massive debt binge that could cause rates to spike more than people expect. The pandemic has disrupted supply chains, and some companies are now willing to pay marginally more to those vendors they perceive as more secure and stable.
Northern Trust’s Browne says this is a scenario that financial markets are only starting to reckon with. He cites a recent University of Michigan inflation expectations survey finding that participants expect prices to rise 3.1% over the next year and 2.7% over a five- to 10-year period.
Cuggino notes that the Fed is telling the market to expect “transitory,” not extended, inflation. Going up against last year’s depressed second- and third-quarter lockdown economic data, that’s a given.
He hopes the Fed is correct, but the Permanent Portfolio funds are cautiously planning for a more extended period of price hikes. “If you don’t get substantial economic growth, you could get stagflation,” Cuggino argues. “Inflation is a difficult thing to manage surgically. Market rates could decouple from the Fed’s wishes, especially longer rates. Be careful what you wish for.”
Fed Chair Jay Powell has repeatedly stated that the central bank is willing for a while to let inflation run at higher rates than the U.S. has experienced in the last decade. But it’s not even clear how long Powell will remain in his job, since his term expires in February 2022.
“Someone else could be in his seat when it comes time to raise rates,” Weisman says. That individual could be even more dovish than Powell.
Weisman expects yields on the 10-year Treasury to keep rising from the 1.73% rate on St. Patrick’s Day, though he won’t put a figure on it. The Bank of America Securities survey found that large institutions think many bonds would be more attractive than stocks if the yield hit 2.5%.
Two demographic narratives are likely to dominate the complexion of the recovery. One is that many millennials are in much stronger financial shape than they were exiting the financial crisis. They are starting to buy houses and have acquired a taste for equities. Already, they are the largest demographic group in a fast-changing labor force. Whether or not they remain more energetic savers than previous generations remains to be seen.
Baby boomers are also a wild card. For the better part of two decades, the fastest-growing segment of the work force has been people over 60 years old.
But today the average boomer is over 65 and starting to place stress on entitlements, particularly Medicare. It’s unclear how hospitable the labor market will be to older workers in times of disruption and exponential change.
Finally, there is the Biden administration’s plans for taxes. The economy and equity market managed to withstand a 39.6% tax rate on ordinary income on Americans earning incomes over $400,000 under President Clinton (then it was $250,000) and during President Obama’s second term.
But Biden’s aides have proposed raising the investment income tax to the same rates as ordinary income. Details have yet to be spelled out, but the impact for retirees living off their investments could be significant.
Orlando of Federated Hermes notes that markets got a taste of this last September and October when it became apparent Biden was likely to win. The S&P 500 fell 10% during those two months, but tech stock indexes tumbled 20% as investors with huge unrealized capital gains in these shares headed for the exits.
With the narrowest of margins conceivable in Congress, it’s uncertain whether Biden could push through all his tax proposals. But his stimulus bill adds another $1.9 trillion to a federal budget already running a $2.3 trillion deficit. That isn’t stopping Orlando from predicting that the S&P 500 will finish the year at 4,400, more than 10% above where it stood in mid-March.