by Liz Ann Sonders, Jeffey Kleintop, Kathy Jones, and Kevin Gordon, Randy Frederick, Charles Schwab & Company Ltd.
How rapidly and for how long will prices rise? That’s still the million-dollar question. Although inflation pressures are clearly present—the Consumer Price Index surged 6.2% year-over-year in October, the biggest jump in 30 years—investors have been uncertain how strong or prolonged these pressures will be. Stock prices have continued to rise, while corporate profit margins reached multi-year highs in the third quarter. Despite the Federal Reserve signaling the beginning of the end of its easy monetary policies, 10-year Treasury bond yields unexpectedly fell.
Meanwhile, regulators approved the launch of the first Bitcoin futures exchange-traded funds (ETFs), a step toward even broader adoption of cryptocurrencies, as the price of Bitcoin surged to a new record high.
U.S. stocks and economy: Is the price right?
Inflation remains the central focus of policymakers and investors. Price pressures have continued to broaden out as the economy has matured since its reopening. At the onset of the reopening, price increases were concentrated in areas such as autos and hotels, but they have expanded into energy, food, and wages—confounding some investors and policy officials who once believed increases would be transitory.
While a return to 1970s-style stagflation is unlikely given strong employment trends today, inflation could remain elevated if wage growth continues to accelerate. Several metrics—for instance, average hourly earnings, the employment cost index, and the Atlanta Federal Reserve Bank’s wage tracker—indicate wages are increasing quickly. Yet growth is still being driven mostly by workers on the lower end of the income spectrum, indicating a healthy labor backdrop.
Wages have accelerated faster for lower-income workers
Source: Charles Schwab, Bloomberg, as of 9/30/2021.
Key to the economy’s ability to withstand higher inflation and wage growth is an increase in productivity. However, nonfarm business sector labor productivity fell 5% in the third quarter compared with the previous quarter (annualized quarter/quarter rate), while unit labor costs surged 8.3%—indicating wage pressures are affecting companies. One quarter doesn’t make a trend, but if productivity expands at a slower rate than unit labor costs, the surge in wages would keep inflation metrics elevated for a longer period.
For now, the long-term trend of productivity remains largely intact, so several quarters of higher labor costs likely are needed for activity to weaken in a structural sense. From the market’s perspective, this hasn’t yet become an issue. The inflation-adjusted (or “real”) S&P 500® index, shown in the chart below, has continued to trek higher. While this signals investors’ confidence, it also suggests stock prices have become quite stretched relative to their long-term trend. In fact, as shown in the bottom panel, equities are nearly double their trendline value—surpassing levels seen just prior to the tech bust in 2000.
Real measure of stocks suggests an overvalued market
Source: Charles Schwab, ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. Data as of 10/31/2021. Past performance is no guarantee of future results.
In addition to the market’s price becoming very stretched relative to both its long-term trend and several fundamentals (such as earnings), some sentiment metrics show that investors have become quite optimistic. For example, we can look to SentimenTrader’s gauge of “Smart Money” (such as institutional investors and hedge funds) versus “Dumb Money” (that is, average individual investors—the term doesn’t refer to intelligence, but reflects that these investors typically don’t have the time, access to data, or teams of experienced analysts that Smart Money has). As you can see in the chart below, Dumb Money Confidence has surged while Smart Money Confidence has fallen sharply. At extremes, this is a contrarian indicator.
“Dumb Money” confidence has surged
Source: Charles Schwab, SentimenTrader, as of 11/10/2021. SentimenTrader’s Smart Money Confidence and Dumb Money Confidence Indexes are used to see what the “good” market timers are doing with their money compared to what the “bad” market timers are doing and are presented on a scale of 0% to 100%. When the Smart Money Confidence Index is at 100%, it means that those most correct on market direction are 100% confident of a rising market. When it is at 0%, it means good market timers are 0% confident in a rally. The Dumb Money Confidence Index works in the opposite manner.
Keep in mind that stretched sentiment (in either direction) itself isn’t a strong enough reason to suggest equities are due for an imminent reversal. Also, it has been partly offset by the recent improvement in the market’s breadth (that is, the number of stocks whose prices are rising versus the number whose prices are falling). A total of 76% and 62% of S&P 500 and Russell 2000 members, respectively, were trading above their 200-day moving averages as of November 8th, up from 69% and 52% at the beginning of October. For now, broad participation is acting as a stronger shield for the market, despite some signs of frothy sentiment.
Global stocks and economy: Inflation barks, doesn’t bite
Market participants had been expecting that the past couple of weeks would reveal surging inflation, putting a crimp on corporate profit margins and enough pressure on policymakers of the world’s major central banks to prompt them to begin to unwind pandemic-era policies. But the barking dog of inflation failed to take much of a bite, leaving stocks to continue the almost daily string of new all-time highs seen in the MSCI World Index.
Despite inflation pushing up costs, corporate profit margins hit multi-year highs for U.S. and international companies in the third quarter, according to earnings reports. While a wide range of costs (materials, energy, transportation, labor, etc.) are up, companies have been largely successful at passing those costs on to customers. Stocks have continued to move higher during the earnings reporting season, as results widely exceeded estimates.
Despite rising costs, profit margins are at multi-year highs
Source: Charles Schwab, FactSet data as of 11/7/2021.
Following the meetings by each of the world’s top five central banks from October 27th to November 4th, policymakers are no longer signaling as much confidence that the rise in inflation will be quick to fade. But they also expressed views that tighter monetary policy may not be effective at taming the current drivers of inflation, and worry that it could prompt a softening of the labor market well before jobs return to pre-pandemic levels. Rather than risk acting prematurely, they appeared to prefer to wait and see, taking their time to unwind their unconventional policies.
- Bank of England: Surprised markets by not raising the policy rate after hinting for months that it would be the first central bank from one of the world’s leading economies to hike rates since the pandemic began.
- European Central Bank (ECB): Although the market’s long-term inflation expectations for the eurozone briefly rose above 2% in October, for the first time since 2014, it was made clear that the ECB isn’t willing to risk its hard-won recovery with an early hike—having learned that lesson in the last cycle.
- Reserve Bank of Australia (RBA): Confirmed it would stop targeting a near-zero yield for three-year government debt but maintained its other two pandemic measures, quantitative easing (QE) and the near-zero policy rate. Pushing back against bets for a rate hike next year, the RBA reiterated its view that conditions for sustainable inflation will not be met before 2024.
- U.S. Federal Reserve: Provided details of its pre-announced tapering of asset purchases but made no comments about the rate hikes next year that the market is expecting to immediately follow the end of bond purchases.
- Bank of Canada: Ended its QE program and indicated the potential for a first rate hike “sometime in the middle quarters of 2022,” even as markets price in a total of four rate hikes with the first beginning early next year.
Two key messages for investors: (1) policymakers are not afraid to push back against market expectations, and (2) the “normalization” of policy rates could take longer than the market had believed. Due to hikes by other (not major) central banks, the blended policy rate for the Group of 20 (G20) countries is about a third of a percentage point above its low. The path higher may remain slow even as inflation appears to be persistently transitory, helping support stock market gains.
G20 policy rates on slow trajectory
Source: Charles Schwab, Bloomberg data as of 11/7/2021.
Fixed Income: Bond rally defies expectations
Bond yields have fallen sharply in the past few weeks, despite the Federal Reserve’s tapering announcement, rising inflation, and ongoing strong economic data. Ten-year Treasury yields (which move inversely to bond prices) are back below 1.5%, a significant drop from the 1.7% high seen in mid-October.
10-year Treasury bond yields have fallen
Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX). Daily data as of 10/8/2021. Past performance is no guarantee of future results.
For the past few months, there were growing concerns that central banks were failing to keep up with rising inflation and might have to hike rates sharply to catch up. However, recent policy moves appear to have calmed those fears. In the United States, the Fed announced its plans to gradually end its bond-buying program between now and mid-2022. While the Fed is still officially in easing mode as long as its balance sheet is expanding, the signal tapering sends is that the ultra-easy monetary policy is going to end. It isn’t the same as tightening, but it is the first step in that direction.
As markets are forward-looking, signs that the Fed is pulling back on its easy policies may be reduce inflation concerns. As we have noted in the past, 10-year Treasury yields have often moved up during periods when the Fed was expanding its balance sheet and declined when it ended. So, what’s likely coming next?
1. Higher real interest rates. Despite the recent rally in the bond market, we believe there is still room for yields to rise. The economy looks poised to continue growing at a strong pace, fueled by consumer spending and business investment. Job growth and wages are picking up, corporations are flush with cash to invest, and banks have money to lend. Moreover, both monetary and fiscal policy are still supportive. Although inflation pressures are likely to ease from current high levels as the economy rebalances, we expect it to remain above the Fed’s 2.0% to 2.5% target range in 2022.
Moreover, “real” yields—that is, adjusted for inflation—are still very low relative to economic growth and our optimistic outlook. Yields are likely to move higher as the market recalibrates to stronger economic growth and less central bank support.
Real yields are at historically low levels
Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX). Daily data as of 11/5/2021. Basis points (bps) are a common unit of measure for interest rates; one basis point is equal to 1/100th of 1%, or 0.01%, Past performance is no guarantee of future results.
2. More volatility. In addition to higher yields, we expect volatility to increase in the riskier segments of the fixed income markets, such as high-yield and emerging-market bonds. Less central bank buying means there will be less liquidity to spread around the markets. Also, as yields on risk-free bonds rise, investors may demand higher yields to hold bonds with greater credit risk. From a long-term perspective, we view the potential rise in Treasury yields as an opportunity for investors to extend the duration in their portfolios in 2022.
Another step forward for cryptocurrencies
Cryptocurrencies have exploded in popularity over the past few years, despite (or because of) their extraordinary price volatility. Last month, a Bitcoin-related ETF launched and gained nearly 5% on its first day of trading on volume that exceeded 24 million shares—the second-most highly traded ETF debut ever. The ETF holds Bitcoin futures contracts,1 not actual bitcoins. This is an important factor to be aware of because futures involve transaction costs, roll costs2 and contango3 costs, all of which could contribute to underperformance or a large tracking error versus Bitcoin spot prices. (For more on Schwab’s perspective on cryptocurrencies, please visit www.schwab.com/cryptocurrency)
The Securities and Exchange Commission generally has been skeptical of cryptocurrencies, with chairs expressing concern that the product is too volatile, that investor protections are inadequate, and that regulations are insufficient. The agency has rejected multiple applications for ETFs that invest directly in Bitcoin, but took a more lenient view of ETFs that invest in cryptocurrency futures because the futures markets are already regulated by the Commodity Futures Trading Commission.
If you’re considering investing in cryptocurrencies, you should keep the myriad risks in mind, including that the traded value of cryptocurrencies have been volatile, the market isn’t very transparent, transactions are irreversible, consumer protections are minimal or nonexistent, and regulators haven’t clarified their approach to monitoring them. We suggest that investors who want to be involved in cryptocurrencies treat them as a speculative asset primarily for trading with money outside a traditional long-term portfolio.
1 With a futures contract, the investor agrees to buy or sell the underlying asset (in this case, Bitcoin) at a specified price on a specified day in the future. If on that day the asset is worth more than the agreed-upon price, the investor makes money; if the asset is worth less, the investor loses money.
2 Rollover cost is calculated as the percentage change between futures contract price for the next month and the futures contract price for the current month contract.
3 Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity.
Copyright © Charles Schwab & Company Ltd.