Earlier this month marked the 1-year anniversary Covid-19 first hit American shores. While the pandemic has affected everyone to varying degrees, we can all agree that everyone’s life is a bit different today than it was a year ago. Signs of normality are appearing, and it is fitting that this pandemic is coming to an end as Spring approaches.
As we get closer to the end of the 1st quarter, I would like to share our thoughts on several market related “hot topics” that have garnered a lot of attention as of late. As per previous notes, I will use the question-and-answer format below.
Q: Do you still maintain confidence in your 2021-year end S&P 500 Index target of 4,300-4,600?
A: Yes, we do. Reinforced by yesterday’s signing of the $1.9 trillion dollar stimulus package known as the American Recovery Act will add more fuel to the equities markets in the short run. Although, another round of stimulus to this magnitude is not without risk -inflation being the primary concern.
Q: How do changes in interest rates effect the economic recovery?
A: In March of 2020, during the height of the market sell off, the Federal Reserve (Fed) was forced to step in and add liquidity to bond markets. They did this by becoming a buyer of U.S. Treasuries, Corporate and Municipal bonds. This action (although not widely publicized) stemmed the bond market sell off and marked the bottom of the equity selloff.
In addition, the Fed introduced emergency interest rate accommodation and cut rates to zero. The Federal reserve has various tools to speed up or slow down the economy -very much like the gas pedal on a car. Low rates support economic growth but having rates too low for too long can be detrimental to the economy and cause overheating. In a healthy economy, interest rates need to be higher than where they are today.
However, if rates rise too quickly it can snuff out the economic recovery by causing businesses and individual consumers to pause on potential investments such as buying a home, car, or other large purchases. So, to answer the question, rising rates (which is the period we are headed into now) are not necessarily a hindrance to the economic recovery but rather the velocity of interest rate increases need to be monitored and kept in check.
Q: What happens if rates do rise too quickly?
A: This is the biggest challenge facing the Federal Reserve right now. Currently, the Fed is anchoring short term rates at zero but does not control Intermediate or long-term rates -market supply and demand does. The Fed is allowing market rates to rise for now as the committee knows rates need to move higher as the economy recovers.
In addition, as rates rise, frothiness, excessive risk taking by market participants is being stamped out which also benefits the recovery. However, if rates rise too quickly in the future the Fed can start buying intermediate to long dated U.S. Treasuries artificially pushing rates back down. This technique has been used successfully in the past and was given the name “Operation Twist” in 2011.
Q: Over the last couple of weeks the NASDAQ Index and/or “tech stocks” have experienced a sell off due to rising interest rates. Why?
A: The NASDAQ Index consists of 3,300 companies. A large majority of those companies tend to be younger companies, have disruptive business models and are growing their revenue streams faster than the market average. Younger companies tend to rely more on borrowed capital as they build out their business supporting future growth. In addition, they tend to have higher price to earnings multiples or (P/E Ratios) which is one way to measure valuation of a company. The P/E ratio tells an investor what price they are willing to pay today for a company’s future earnings. When rates rise, it can/potentially eat into future earnings of the company -hence the sell off on the NASDAQ Index over the past couple weeks as the market interest rate on the 10-year treasury increased by 50 basis points or .50%.
It’s important to understand, that this is classic academic/economic theory, and the real word doesn’t always follow along. Don’t worry, just because rates increased by .50 basis points, we’re not inclined to sell our Apple, Microsoft, Amazon, Qualcomm or even our highest multiple stock holdings such as ZOOM, DocuSign, Nvidia or AMD.
Normal is approaching—or at least the post-pandemic version of normal—and it’s looking pretty good. Stocks and bonds are both telling us we have a lot to look forward to as the economy moves closer to a full reopening. COVID-19 still presents risks of course, and stocks may be due for a pause after such a strong run. But ultimately, we believe the backdrop of improving economic growth, supportive fiscal and monetary policy, rebounding corporate profits, and improving COVID-19 trends will be a favorable one for stocks over the balance of the year.
We wish you a great Friday evening, an enjoyable weekend.
As always, please reach out to us with any questions or comments you may have regarding your specific situation.
Jaran Day Chief Investment Officer
Griffin Dalrymple, CFP®, Chief Strategy Officer