Market drawdowns are never fun. But for all the hand wringing over the current market downturn and the pain in the long-duration trade, let’s not forget that in many ways, this is playing out as we had hoped. It was only one year ago when the first case of the SARS-CoV-2 appeared in my home state of New Jersey. If you had told me then that 12 months later the U.S. economy would produce 379,000 jobs in the prior month,1 the 10-year U.S. Treasury yield would be flirting with 1.60%,2 and the U.S. 10-year inflation breakeven would be over 2.2%,3 then I would have slept much better that night.
Ironically, investors ask in year one, “How can the market be going up if the economy is so bad?” only to ask in year two “Is this getting too good too fast?” Buy the rumour, sell the news I suppose. For rates to surge in year two of market cycles is not uncommon. 1983 and 2010 are prime examples of rates returning to near pre-recession levels,4 causing the market’s advance to pause. In both instances, rates ultimately trended lower.
Consumer demand could lead to short-term inflation
I understand. This isn’t 2010. Neither the U.S. household sector nor the U.S. financial system needs to go through a prolonged deleveraging process. Savings rates are much higher.5 Fiscal support is significantly more sizeable.6 The U.S. consumer is like a coiled spring, ready to unleash our pent-up demand on the economy. Count me in on vacations, restaurant visits, haircuts, and perhaps a few new articles of clothing if asked to return to the office.
Importantly, all that money would be unleashed on an economy without workers returning quickly enough to meet the demand (more on that in a moment). That would be inflationary in the short-term, just as U.S. Federal Reserve Chair Jerome Powell expressed yesterday, and I would expect to see all of the typical inflationary trappings for the market: Rates higher, cyclicals over defensives, value stocks over longer-duration growth stocks, etc. In other words, the reflation trade that all 2021 outlooks predicted.
But deflationary forces persist
However, lest we all become “inflationistas” and run out and buy 1970s-style polyester leisure suits, the inflation story is likely to fade. The increase in growth from fiscal policy in 2021 is temporary — the income replacement provided by stimulus fades in 2022. In addition, there’s likely 10 million un- or underemployed workers ready to ultimately return to the workforce and meet the growing demand.7 If inflation is too much money chasing too few goods, then the response is to produce more goods. This idea that workers won’t return so long as the extended unemployment checks keep coming hasn’t played out in the data. For example, more than half of unemployed workers had returned to the job market before the extended benefits ran out in July, and there was no surge in hiring at the end of that period.8 Finally, the long-term structural forces pushing against inflation—automation, new technologies, aging populations—have not changed.
I believe we’ll be back in a slow growth, benign inflation environment before you know it. As a mentor of mine stated this week, “Don’t fret. It’s still a secular bull market.” The reflation trade may have some legs, but I expect long-duration assets such as technology stocks to be back in vogue before you know it.
1 Source: Bureau of Labor Statistics, Feb. 28, 2021
2 Source: Bloomberg, L.P., March 5, 2021
3 Source: Bloomberg, L.P., March 5, 2021
4 Source: Bloomberg, L.P.
5 Source: Bureau of Economic Analysis, Jan. 31, 2021
6 Source: US Congressional Budget Office
7 Source: Bureau of Labor Statistics, Feb. 28, 2021
8 Source: Bureau of Labor Statistics, Feb. 28, 2021