Global investors have seized on the idea that the Federal Reserve will keep interest rates low as inflation rises. But they still need to fully figure out what this means for their portfolios.
On Thursday, the S&P 500 set another record. Markets have been emboldened by upbeat earnings, Covid-19 vaccinations and the Biden administration’s $1.9 trillion fiscal-stimulus plan. But there is a puzzle: Optimism has also pushed up yields on 10-year U.S. government bonds to 1.1%, from 0.9% at the end of 2020, and investors often fear that this makes equities less attractive. Technology giants are seen as particularly vulnerable to rising rates, yet they are leading the charge once again.
An explanation is that inflation-protected Treasurys, or TIPS, haven’t sold off. This means the bond-market gyrations are all about inflation expectations rising well above pre-outbreak levels. In other words, the market is now convinced that, even if the Fed eventually raises rates, it will do so by less than inflation, keeping “real” financial conditions very loose.
For now, U.S. inflation remains low due to the pandemic, but is predicted to bounce back strongly. In the past, traders would have expected the Fed to pre-emptively try to cool the economy—in the immortal words of former Chairman
William McChesney Martin
in 1955, ordering “the punch bowl removed just when the party was really warming up.” Last year, though, officials committed to allowing inflation to run at a higher level for a while before taking action.
Various investment strategies have historically outperformed in periods of “reflation” or higher inflation. Buying gold is the most famous inflationary hedge, but has actually only been effective against sudden jumps in consumer prices—not the upward drift that many see as likely now. Stocks are better than bonds when costs rise, but still suffer as companies cannot always raise prices to maintain margins. Retailers, miners and energy firms tend to do better, whereas technology stocks struggle, as do utilities and other so-called bond proxies.
If the market is wrong and the Fed can’t resist raising real rates as soon as inflation accelerates, traditional portfolio plays may work. But, as behemoth money manager BlackRock has pointed out, if the punch bowl really is glued to the table, some strategies need to change.
The modern investment playbook was developed for an era in which central-bank rate rises and higher inflation went hand in hand. Investors need to start disentangling the impact of the two, which isn’t easy.
Based on market data since 2004, tech and telecom shares have shown they can outperform the market in periods when Treasury yields and inflation are rising, as long as “real” yields remain subdued—as long as, of course, they have convincing growth stories. Conversely, cyclical sectors that are typically favored during economic recoveries could disappoint somewhat. Banks, which are usually believed to benefit from higher rates, may also struggle more than previously thought if inflation-adjusted yields stay low.
More generally, ultralow “real” rates, which are often seen as an ill omen for economic growth, could instead provide some extra fuel to stocks—despite already-expensive valuations and clear signs of market froth. Low real rates help emerging markets, too, by potentially limiting appreciation in the U.S. dollar.
While a return to 1970s-style inflation is unlikely, prices are almost certain to rise faster than normal this year, because they were artificially depressed by the pandemic. If the market is reading the Fed correctly, though, that needn’t stop the party.
Write to Jon Sindreu at [email protected]
Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8