Why Is The Stock Market Going Down When The Economy Is Heating Up?

Kevin Grogan, managing director of investment strategy for Buckingham Wealth Partners explains the dissonance between a faster than expected market recovery leading to market challenge. We cut through the headlines to talk about why the stock market is going down when the economy is heating up!

Transcript

Tim Maurer:

Well, Tim Maurer back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Kevin Grogan, managing director of investment strategy for Buckingham Wealth Partners. Kevin, there seems to be something strange going on in the markets because we’re hearing about economic improvement and we’re seeing market volatility and some headlines seem to be suggesting that some of the challenges the market is having are actually due to expectations of a faster economic recovery than we first expected. Is this true and what the heck’s going on out there?

Kevin Grogan:

So it is true, and particularly within fixed income markets, we’ve seen some pretty impressive and quick changes in the levels of interest rates over the past two or three months or so. That has caused market volatility in other segments of the market. Then while this might not be immediately intuitive, it can impact different areas of even the stock market differently. So as you think about a growth company, so that is a company that people are buying with the expectation that at some point far into the future, their business results will be much greater than what they are today. Sort of the classic example in today’s environment would be Tesla. So you couldn’t justify what the price is today based on the number of cars that they’re selling today, or the amount of revenue that they are producing today.

Kevin Grogan:

But people are bidding up the price in an expectation of cash flows far out into the future. So if you would kind of think about Tesla as a bond, it would be a very long duration bond, meaning you’re expecting cash flows out of 10, 20 years from now. So when rates move up in the fixed income space, that means prices come down and you see bigger price movements for the longer duration fixed income securities. We’re seeing some of that in the equity markets as well, where growth stocks have been impacted by rising rates.

Tim Maurer:

All right. But what is the fear in an economy that’s getting better faster than we expected? How could that possibly be a bad thing?

Kevin Grogan:

So in general, it isn’t a bad thing. So what you tend to see when an economy is expanding is that you see rates move back up, and I think that some perspective is in order here. So certainly you see headlines about how rates are moving up and that we should all be concerned about debt levels. I think there are some good reasons for concern, but right now the yield on a 10-year Treasury isn’t higher than where we were to start 2020. You don’t even have to go back that far. You just have to go back to pre-pandemic and rates still aren’t back where they were. They’re approaching back where they were 15 months ago, but they’re not quite there yet.

Kevin Grogan:

So it isn’t as if yields have spin out of control, but it has moved a lot in a short period of time. So to close out 2020, the 10-year treasury yield was at 0.9%. Now it’s at 1.7%. That’s a pretty big move in just a couple of months. You don’t typically see that. In fact, the last time you saw yields move this much was when they came down about a year ago at the beginning of the pandemic. So you’re sort of seeing things kind of cycle back to where we were 15 months ago, along lots of different dimensions, not just in finance and economy, but in folks’ everyday life.

Tim Maurer:

Sure. So is the concern there, Kevin, that if the economy heats up too fast and interest rates rise too much, we could be dealing with an inflation type of situation where the prices of costs of goods are rising too quickly?

Kevin Grogan:

Yes. You have seen that to some degree in markets as well. So you can look at a market estimate for inflation by looking at the difference in yield between a nominal treasury and the yield on a treasury that is adjusted for inflation, and the difference between those two yields is the rough estimate of what the market might expect for future inflation. We have seen that tick up quite a bit, particularly over the next, call it, five years or so. We’ve seen breakeven inflation rates around 2.5% for the next five years. But interestingly, you get out to six, seven, eight, nine, 10-years and inflation expectations are down a bit if you look at what the market is expecting.

Kevin Grogan:

So to sum up, market is expecting a good bit of inflation here over the short to intermediate term, but then kind of coming back down to around 2% over the next 10 years or so. So I think that it is, I think, a reasonable expectation as you see the economy start to recover. We could see some inflation, and I think there is risk for inflation to go higher than 2%, 2.5%. So that’s why at Buckingham, we do tend to think that some allocation towards inflation protected securities does make sense as an insurance policy against inflation not spinning out of control, but moving up higher than the 2%, 2.5% of what the market is expecting.

Tim Maurer:

And by inflation protected securities, you referring to TIPS?

Kevin Grogan:

I’m referring to TIPS, right. So the way TIPS work is that they’re the principle of the bond to adjusts with inflation, looking at that CPI.

Tim Maurer:

All right, but let’s put this in perspective, Kevin. You talked about the 10-year Treasury yield being at what? 1.9% right now? Now it might’ve gone up a lot over a relatively short period of time on a proportionate basis, but in the grand scheme of things, is this actually a high rate for the 10-year Treasury at a whopping 1.9%?

Kevin Grogan:

So it’s currently at 1.7%. [crosstalk 00:06:16]. I know, I know. What’s 20 basis points among friends? But no, it’s not high relative to history. So if you looked through most of history, a 10-year Treasury would yield closer to, say, 5%. So we’re still much, much lower than what we’ve seen historically. So while rising rates certainly aren’t helpful here in the short term, because as I mentioned earlier, as rates move up, prices come down on the bonds that are within an investor’s portfolio. I think on net it’s very good news for retirees because that means higher expected returns on their fixed income, which is helpful. As you think about a diversified portfolio, you’ll want some of that in safe, fixed income. And when it’s yielding, now that it’s yielding 1.7% instead of 0.9%, that makes a meaningful difference in how much a retiree can spend.

Tim Maurer:

For sure. But then we’re also seeing this impact the equity or stock markets, right? My finance 101 class back in college taught me that that stocks are probably what you want to own in an inflation rich environment in order to outpace inflation. So why would stocks be getting hurt by seeing interest rates rise in the bonds? Is it just because now bonds look more attractive and people are moving out of stocks into bonds?

Kevin Grogan:

So I think that’s part of it. So there is this school of thought that says when cash and fixed income is yielding almost nothing, there is no alternative except just to pour money into stocks. Anecdotally, we’ve certainly seen that to some degree with some investors that we speak with who say, “I’m just fed up with where fixed income rates are. I’m going to move into stocks or alternatives or other risky assets to help generate higher returns on what I can get in fixed income.” Now that fixed income yields are a bit higher, that’s likely part of the explanation, although it’s probably not all of it. So we certainly see people moving out of equities back into fixed income, but then there’s also this phenomenon that I talked about earlier, where a good number of companies in the market today are being bid up based on cash flows that are far out into the future. So when rates move up, the value of those cash flows move down, and so that’s part of it as well.

Tim Maurer:

Phenomena indeed. Well, thank you so much for explaining that phenomenon, Kevin, and thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com, by emailing your question to question@askbuckingham.com, or just click in the corner of the screen and the video will take you directly to the website where you can put in your question. Remember that there are no dumb questions, but unfortunately there are plenty of poor and misleading answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm and allow you to apply what you’ve learned in pursuit of good decision-making. So please, follow us and, by all means, Ask Buckingham.

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