February 25, 2021
Despite the recent weakness in equities, Raymond James CIO Larry Adam expects positive stock growth over the next 12 months.
Equity markets were weak on Thursday as the three major U.S. indices and all S&P 500 sectors were in negative territory. There were three main reasons for the weakness in equities: rising Treasury yields, inflation concerns and stretched technicals.
Rising Treasury yields
Longer-duration bond yields continue to move higher, as the yield on the 10-year Treasury has increased 100 basis points since August and is now at the highest level since February 2020. The sell-off in bonds was exacerbated in Thursday’s session as the 7-year Treasury auction saw the weakest demand on record. Rising Treasury yields raise concerns that the current price-to-earnings multiple – the highest since 2000 – may be overextended.
Additionally, the move higher in interest rates brought the 10-year Treasury yield above the S&P 500 dividend yield for the first time since December 2019.
As a result of record accommodative fiscal and monetary policy, improving economic activity, supply chain bottlenecks and base effects, investors are beginning to price in rising inflation expectations for the near future. Rising inflation has brought concerns that a sharp acceleration in price pressures may lead the Federal Reserve to either taper its quantitative easing purchases or raise interest rates earlier than the expected 2023 timeframe.
Following the strong start to February and the best start to a bull market in the post-WWII era, technicals for the S&P 500 had moved to stretched levels. The 14-day Relative Strength Index (RSI) neared overbought territory last week and the equity put/call ratio declined to the lowest level on record.
Volatility is part of the fabric of the market and not uncommon, particularly after the market’s impressive run since the pandemic lows on March 23 of last year. Despite the weakness in equities over recent days, we remain optimistic on equities for a few reasons.
Rates Rising for the Right Reasons
While the pace of the increase in rates has been eye-opening for investors, rates are rising for the right reasons. Mobility indicators (TSA screenings, hotel and restaurant bookings) and real-time activity levels are consistent with our view that economic growth is likely to accelerate in 2021, and there is building evidence of upside to our economic forecasts (2021 U.S. GDP forecast: 4.5%).
While improving economic growth will likely lead to higher inflation relative to the recent depressed levels, it is not our view that we are entering a period of hyperinflation. In fact, the expected modest uptick in inflation should be considered healthy as it’s a sign of the economy healing and it gives companies the ability to adjust prices higher. Historically, core inflation between 1% and 3% (which is the range around our 2021 core inflation expectation of 2%) has provided a positive backdrop for equity outperformance. Inflation at these levels has historically produced above-average equity returns.
Rate move may be overdone
While momentum may push yields slightly higher in the near term, technicals within the fixed income market are extremely stretched. The 14-day RSI for the 10-year Treasury bond price has reached its lowest level since 2016, suggesting that recent weakness may be overdone and poised for a reversal.
We also see a limited sustainable rise in yields going forward. A decline in interest rates, or even a moderation in the overall pace in the rise of yields, would be a positive for the equity market. The market can absorb a 10-year Treasury yield at 1.50%; we’d grow more cautious at 1.75% and more alarmed if yields move above 2%. The caveat: these are moves that would hamper the market in the near term if the surge in rates continues unabated. Longer term, higher rates could be absorbed if corporate earnings continue to grow at a healthy pace.
If interest rates do rise further, we’d expect the Fed to take action to limit the rise. The Fed is cognizant of how rate-sensitive the U.S. economy is.
Sell-off not filtering through to other risk assets
While equities did move sharply lower on Thursday, other risk assets such as the credit sectors of the bond market remain resilient. Spreads across the entire credit spectrum (e.g., investment grade, high yield, emerging markets) remain near cyclical lows, and commodities (both copper and energy prices) continue to move higher. The resilience in these sectors suggests that weakness has been largely an equity story, and that the fundamental economic backdrop remains supportive of risk assets.
Pullbacks are not unusual
While the pace of price appreciation in the current bull market may have brought some complacency for investors, pullbacks are common and a natural and healthy occurrence. The S&P 500 typically experiences more than three 5% pullbacks, on average, in a given year. It’s also important to recognize that the S&P 500 is less than 3% off the record high set on February 12. The index remains technically sound and above both its 50- and 100-day moving averages.
Overall, the trajectory for equities should be higher over the next 12 months as the fundamental backdrop (e.g., improving economic activity, reopening of the economy, accommodative fiscal and monetary policy and strong earnings growth) remains supportive of the equity market. We would use pullbacks as buying opportunities within favored sectors.
All expressions of opinion are those of the Investment Strategy Committee and not those of Raymond James & Associates, Inc. and are subject to change. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance is not indicative of future results. No investment strategy can guarantee success. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risks including the possible loss of capital. The Standard & Poor’s 500 Index (S&P 500) is an index of 500 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion. It is not possible to invest directly in an index. 50-Day moving average: is a stock price average over the last 50 days which often acts as a support or resistance level for trading. 100-Day moving average: is a stock price average over the last 100 days which often acts as a support or resistance level for trading. 200-Day moving average: is a stock price average over the last 200 days which often acts as a support or resistance level for trading. S&P 600: S&P SmallCap 600 seeks to measure the small-cap segment of the US equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. US Treasury securities are guaranteed by the US government and, if held to maturity, generally offer a fixed rate of return and guaranteed principal value. Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Further information regarding these investments is available from your financial advisor. Material is provided for informational purposes only and does not constitute a recommendation.
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