Investors had no trouble gliding past the death and economic devastation wrought by the pandemic last year to drive the market to record highs. An increasingly healthy economy is what is making them panic.
In recent days, the S&P 500 stock index has wobbled, suffering its worst weekly performance in a month last week, before rising Monday, only to dip again Tuesday and in early trading Wednesday. The bond market, too, is showing anxiety, with yields rising sharply as returns in the market for Treasury bonds have fallen roughly 3% this year.
The market conniptions are a direct result of several developments that point to the brightening prospects of economic recovery. Vaccinations are rising, retail sales and industrial production have been surprisingly solid, and perhaps most important, the Biden administration is expected to push its $1.9 trillion stimulus plan through Congress in the coming days.
“We haven’t seen this scale of fiscal response before, and the market is struggling with how to process that,” said Julia Coronado, founder and president of Macropolicy Perspectives, a markets and economics consulting firm. Because the United States has never before pumped so much money into the economy, Coronado said, the market is “questioning what some of the unintended consequences could be.”
One clear consequence is expected to be strong growth. Wall Street economists now expect output to rise by nearly 5% in 2021. Such robust growth — it would be the best year for the economy since 1984 — would seem like a good thing for stocks. After all, a strong economy makes it easier for companies to boost sales and profits, as employment rises and consumers have more money to spend.
But growth brings with it the possibility of rising inflation, which in turn could prompt the Federal Reserve to raise interest rates — and that’s what investors are reacting to, with different consequences for the stock and bond markets.
When the pandemic started in March, causing a wide panic that led the S&P 500 to lose more than one-third of its value within weeks, the Fed moved to soothe markets and prevent the bottom from falling out completely. It cut interest rates to nearly zero and signaled it would hold them there. It also began pumping billions into the markets every month by essentially creating fresh dollars and using them to buy government bonds. Those so-called easy-money policies provided a tailwind to the S&P 500, which rose more than 70% between March 23 — when stocks scraped bottom — and Wednesday.
“Part of the enthusiasm in the marketplace has been that the Fed is going to keep the cocaine going,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. “The better and better things are, the less and less rationale the Fed has for keeping rates at zero.”
The Fed’s moves also affect the bond markets, usually through rising and falling yields. In general, yields on government bonds — which are determined partly by interest rates set by the Fed — broadly reflect investor views on how the economy will do over time. When growth is weak, government bond yields tend to be low. (Last year, when the economy tanked, they touched the lowest levels on record.) When growth is fast, those bond yields tend to be higher.
At the moment, investors are worried that the economic rebound will cause inflation. Few economists currently see a significant risk of runaway inflation, but investors say that the mere possibility of painful 1970s-style price growth might drive the Fed to raise interest rates in order to tamp down the economy.
That would be bad for bond owners. If the Fed raised rates, rates around the bond market would climb. Then, the price of bonds that investors currently hold would have to fall until they produced yields that were comparable to the new, higher rates in the market.
In expectation of that, investors are demanding a higher return now in the form of a higher yield on their bonds. Last week, the yield on the 10-year Treasury note, the most widely watched measure of the government bond market, jumped to roughly 1.60% at times.
The market for interest rate futures — where investors speculate on where interest rates might go in the coming years — provides a timeline for when investors think this might happen. Prices there now show a rising chance the Fed raises rates in the first quarter of 2023, earlier than the central bank has guided.
And since the Fed has suggested that it planned to slow down other elements of its easy-money policy before lifting rates, investors expect the central bank to start cutting back on help for the market as soon as next year.
Even though the Federal Reserve chair, Jerome Powell, and other Fed officials have recently talked down the possibility that the Fed will reduce its support for the economy anytime soon, the yield on the 10-year Treasury note continues to hover above 1.40%. That is far higher than where it ended 2020, at 0.92%.
Higher rates can be a problem for the stock market’s performance. One reason is that high interest rates make owning bonds more attractive, coaxing at least some dollars out of the stock market. Higher rates can also make borrowing more expensive for companies, especially smaller ones that have potential but lack a track record of profitability.
Such high-growth companies — Shopify, CrowdStrike and Zoom Video among them — have fared incredibly well during the recession because their business models benefited directly from the move to working from home. But last week, they were battered, and their stocks each tumbled more than 10% as bond yields soared.
So what should investors do? Analysts have been urging them to buy shares of companies poised to benefit from a near-term surge in the economy. Known as “cyclicals,” these kinds of stocks include banks and energy companies, whose profits tend to rise during periods of faster growth, higher interest rates and rising prices.
And they are precisely the parts of the stock market that have done the best so far this year. For instance, S&P 500 energy stocks are up more than 30% in 2021, and financials have gained more than 14%. This suggests that investors are preparing their portfolios to benefit from an increasingly strong economy rather than simply riding the wave of easy money flowing out of the Fed, which many believe could — and should — come to an end.
“You can’t have your cake and eat it, too,” said Shalett, of Morgan Stanley. “And at certain points you don’t need to be in the ICU if you’re healed up.”
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.