Hi there—here is your update!
There has been recent stock market volatility, which may have some investors confused.
One question that we’re facing is why the stock market might fall even if our economy is on the mend and we’re close to having COVID behind us. There are a few misconceptions centered around inflation, interest rates, and valuations. We’re going to dive in and analyze each of these factors and how they tie together.
We’ve seen people blame future inflation as a catalyst for recent market volatility, but we disagree with that view.
In general, if our government is printing a lot of money, we should expect to see inflation. Theoretically, this is true. However, we believe that inflation isn’t a real concern today.
While stock volatility has picked up over the last few weeks, the 10-year breakeven rate has fallen.
The 10-breakeven interest rate is the difference between a US government bond that matures in 10 years and a 10-year US government bond protected from inflation. This is a gauge for the market’s expectation for the average inflation for the next ten years.
For inflation to be the reason for the most recent sell-off, we would expect to see the 10-year breakeven rate spike.
Interest rates have gone up for long-dated US government bonds, like the 10-year US government bond. This is important because many bonds and loans use US government bond rates as a benchmark. Interest rates for short-dated bonds, such as the 2-year maturity US government bond, haven’t moved much.
This steepening yield curve typically means that the market expects our economy to strengthen.
Now we’re faced with this question: if the economy is strengthening, why would stocks sell-off? It has to do with how interest rates impact the valuation of stocks.
A simple way of thinking about this is if interest rates rise, the return you generate from buying a bond and other safer investments becomes more attractive. Riskier investments like stocks look less attractive because if safer investments offer higher returns, why take on risk if you don’t have to?
We believe that long-dated interest rates will start falling, which should be good for stocks. The reason we believe interest rates will fall is due to the Fed’s role in the markets today.
The US government just injected vast amounts of money into the markets to reduce the impact of COVID, and the Fed is not interested in having our fragile economy crumble because of tighter financial conditions caused by rising interest rates. If rates continue to climb, the Fed will likely start buying long-dated government bonds, which will lead to lower rates.
The other tailwind for falling rates is the stimulus bill. We saw personal savings skyrocket with the first wave of stimulus checks and expect to see the same thing happen with this round of checks. When you deposit money into your bank account, banks then take that money and typically buy short-dated bonds. Doing this in such large quantities, due to trillions of dollars of stimulus, forces investors to reach for higher-yielding assets like long bonds.
Guggenheim Partners has expressed a similar view, and they are forecasting that rates can go even lower, potentially down to a negative interest rate in 2022.
We also hear that stock prices have to fall because valuations are too high. This is another viewpoint we don’t necessarily agree with.
Historically, valuation is a poor timing tool, and valuations aren’t too high given how low interest rates are. When looking at valuations today, it’s an exercise of relative returns. When interest rates are very low, which they are currently, it becomes tough to generate high rates of return.
So, if an asset can generate a high rate of return, many people or institutions want to hold that investment. This, in turn, pushes valuations higher. Today, fewer companies can grow fast, so for the companies that can, their valuations will be higher, and in some cases, that is justified.
This isn’t to say that valuations should stay high no matter what, but that in the current landscape, we do not think it’s an issue.
Our goal is to help explain how we see the connection between inflation, rates, and valuation in today’s markets. We believe that it is acceptable to take on risk at this time, but you have to be willing to go through some bouts of volatility.
See you soon,
The Round Team
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