The Upside of Inflation

Friday Reflection | February 26, 2021

Last week we talked about the resiliency of complex systems. Whether financial markets or power grids, short-term impacts and headlines are dire when crises arise; nonetheless these systems work the vast majority of the time. That said, how do these systems handle the onset of more fundamental changes? For example, what happens when financial markets face a paradigm shift from a 40-year cycle of falling interest rates1 and low inflation to an unknown phase that may include rising interest rates and a return of inflation?

These concerns caused the US stock markets to take a step backward this week. The S&P 500 declined by -2.5% for the week, and the technology-heavy NASDAQ index declined by -4.9%. 

In the media, all eyes were on the 10-year US Treasury note, viewed as a barometer of the market’s outlook on interest rates and inflation. Since starting the year at 0.9%, the 10-year treasury has seen its yield climb to 1.46% as of this week, the highest level since before the pandemic. It is human nature to assume a strong trend will continue unabated; investors are concerned about what that could mean for rates. When we instead consider current interest rates in the context of historical averages, we remind ourselves that shifts to a more normal level won’t automatically lead to runaway inflation.

Why Interest Rates Matter

Interest rates are closely watched because they are a key input to the price of stocks, bonds, and real estate. For stocks, interest rates determine how much to discount future earnings, especially for companies in a growth phase. We know the axiom that “a dollar today is worth more than a dollar tomorrow” but that is only true if there is inflation and positive interest rates. Without inflation, a dollar tomorrow is worth the same as a dollar today.

Growth stocks are generally expected to earn the bulk of their profits in the future, including large technology companies that were the darlings of the market in 2020. Those far-off cash flows are discounted back to the present using today’s prevailing interest rates. So when rates rise, those future earnings are worth less in today’s dollars, and a company’s stock price should adjust downward accordingly. Conversely, higher interest rates support companies with stronger current earnings. These upward and downward repricing moves are a sign of a healthy market.

For investors who value stability, the past decade has been difficult because bonds and CDs paid historically low rates. Major banks are currently offering three-year CDs at 0.05%, which most likely means negative returns when factoring in inflation. That is not the sign of a healthy market. Despite the fretting about higher yields on the 10-yr Treasury, it is actually a welcome sign for bond investors. Higher yields mean cautious assets will once again generate more consistent income. This allows diversified portfolios to provide more consistent price growth and better protection against downside volatility.

For the housing market, the story is not the same, but it rhymes. Low-interest rates mean low mortgage rates, which allows buyers to borrow more and bid up prices. The US housing market has been red-hot with the dual tailwinds of low mortgage rates and limited inventory in most major markets. In 2021, this tailwind has lessened slightly, with the average 30-year fixed-rate mortgage in the US jumping from 2.65% in mid-January to just below 3% this week, with the bulk of that gain coming in the past two weeks.2 Rising interest rates can signal an improving employment market and a re-opening economy, and even at 3%, today’s mortgage rates remain favorable for property buyers.

A Vote of Confidence

The Fed lowered interest rates to zero as emergency support for the market last March. The fact that the market is lifting interest rates off of those historic lows is a sign that investors expect a quicker re-opening and normalization of consumer spending. It is, in many ways, a vote of confidence for the recovery.

Recovery has been accelerating faster than expected in many ways. With Q4 corporate earnings nearly complete, 79% of companies in the S&P 500 have reported better-than-expected earnings.3 Earnings rose approximately +3.2% in the fourth quarter. Less than two months ago, strategists were forecasting a -9% decline. A portion of the spending that supported those earnings came from stimulus, but there are also fundamental reasons to be optimistic the economy can transition from stimulus-led growth to organic growth.

There are positive data points giving rise to this belief that prices will be higher in the future. COVID numbers have sharply declined since post-holiday spikes and household incomes jumped more than +10% in January.4 While headlines talk of a shocking onset of inflation worries, for the long-term investor, the current process looks more like a normalization trend. Price volatility will be part of this process, but the upward trajectory for interest rates is a healthy sign for our shared economy.

1 Fed Funds rate reached a high point of 20.61% in June 1981. The current Fed Funds rate is 0.07% as of 2/25/21.

2 Average 30 yr mortgage is at 2.97% for the week of 2/25/21. Freddie Mac

3 Data from Factset.  Earnings Insight published Febuary 19, 2021. Factset.com

4 Boost to Household Income Primes U.S. Economy for Stronger Growth. By Josh Mitchell. Published February 26, 2021.  WSJ.com

Brian Kozel, CFP  

About Brian Kozel, CFP®

Brian Kozel works as a partner and lead advisor at North Berkeley Wealth to help his clients feel confident in their financial decisions.

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This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

By |2021-03-05T14:38:40-08:00February 26th, 2021|