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The Economy, Markets Start to Turn

Published on: Mar 18 2021

The U.S. economy is stronger than many people realize, and growth is likely to accelerate. That affects stocks, bonds, gold and more. Parts of the economy were hurt badly by the pandemic and continue to struggle.

Other sectors of the economy, however, held their own or even surged during 2020. The focus on hurting households and businesses means many investors and analysts overlook how healthy the majority of households and businesses are.

The massive stimulus programs exceeded the total income lost during the pandemic. The U.S. savings rate rose to record levels during 2020 because many house-holds saved at least part of the stimulus.

The economy slowed a bit last fall, but growth surged again. Better control of the virus, vaccines, new fiscal stimulus and more gave households and businesses both confidence and cash.

Retail sales increased 5.3% in January 2021, compared to an historic average of 0.3% monthly. That’s the third highest monthly increase on record, surpassed only by the stimulus-fueled spending surges in June and July of 2020. Perhaps more impressively, total January 2021 retail sales were 7.4% higher than total retail sales in January 2020.

The markets have started to recognize the growth.Interest rates on the 10-year treasury bond surged from their August low of 0.55% to a recent high of 1.54%. That’s close to the 1.92% rate registered in December 2019 just before rates started to tumble.

The stronger economy increases inflationary expectations and raises doubts the Fed will stick with its low-interest rate policy, causing interest rates to rise. The breakeven inflation rate on the 10-year treasury bond is a measure of inflationary expectations for the next 10 years.

You can see from the chart that breakeven inflation on the 10-year bond has been shooting higher since late 2020.The Fed’s Chairman Jerome Powell said the central bank plans to keep nominal interest rates low for a while and let inflation rise, but the markets apparently believe the Fed’s commitment will be tested earlier than was expect-ed only a few months ago.

The latest round of fiscal stimulus and the re-opening of parts of the economy as more vaccines are administered are likely to trigger an acceleration of both growth and inflation.

Investors also are shifting away from the sectors of the economy that benefited from the pandemic toward those that were hurt and now are likely to recover.

That’s why stocks, bonds and gold began declining in mid-February. Investors are adjusting their expectations for and the values of all investments.

In addition, there were signs of excess-es in parts of the markets and economy, mostly in stock prices of technology companies, especially small, nascent companies. A number of companies went public despite negative earnings and some-times little or no revenue.

Yet, their stock prices often increased 50% or more shortly after going public. Mean-while, prices of many established tech company stocks assumed earnings and profit margins would continue to grow at recent high rates. Pushing these excesses along was a surge of new, inexperienced retail investors, many of whom use options or other leverage to make their investments.

Some of the excesses already are being wrung out of the markets. Many stocks that were flying high are down 30% or more from their peak prices, and some are down 60% or more. Even so, many still have exceptionally high expectations built into their prices. The excesses aren’t widespread.

We aren’t seeing credit excesses or imbalances, high inflation, or extremely high valuations across the broad stock market. But when a segment of the market reaches unsustainable prices, there is a risk the excesses could spread. Another risk is that the broader stock market can be dragged down when the bubble in one sector bursts.

We protect our portfolios from market excesses and sharp changes in the economy with balance and diversification, plus some tactical portfolio changes. Investors have not needed diversification much for at least 10 years, but it’s becoming important again.

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