While many indices are hitting all-time highs, underneath the surface there is much more occurring. On June 16 the US Federal Reserve released its meeting minutes that outlined a one year acceleration on the time frame to raising interest rates in the US to 2023, known as the dot plot. Two days later a non-voting member of the Federal Reserve said that he thinks that raising rates in 2022 might be appropriate.

This is much sooner than the 2024 timeline that the markets had factored into their models. The basis for these interest rate increases is inflation, growth and employment.

This caused the markets to quickly adjust and throw what I believe was a taper tantrum.

Oxford Languages defines a tantrum as “an uncontrolled outburst of anger and frustration, typically in a young child.”

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The tapering comes from the gradual reduction in monetary stimulus in the form of bond purchases by the central bank and a pledge to ultra-low emergency level interest rates.

Put the two together and we get market participants who thought the zero interest rates would be here forever and now they have to change their earnings models.

The interest rates in their models discount the earnings and cash flows that companies produce. This brings down asset values.

Let’s break down the US S&P 500 for June 2021 and some of its sectors to see how they reacted.

While the S&P 500 was up 2.2%, some of the sectors saw much more dramatic movements in both directions.

The energy sector was up 4.5% while the financial sector was down 3%. Both utilities and industrial were down over 2% which is odd because they usually run counter to each other. The utilities sector is seen as more defensive while the industrial sector is more cyclical.

The interesting piece about this is the perception of economic growth and inflation with what was already baked into the markets.

What is happening is that we are seeing strong growth with the reopening of the economies. As a result we are seeing very high year over year inflation. Many raw material prices are a lot higher than they were a year ago. Real estate and other financial assets are reflecting strong demand. Economic growth is strong on consumer spending and other measures of production in manufacturing and industrial production. Corporate earnings are also very strong. Provisions for credit losses are being reduced as lenders see less than forecasted defaults on loans.

This is all very normal and healthy growth and inflation. The concern is that today’s inflation when combined with low interest rates and fiscal government stimulus will become a tinderbox for uncontrollable inflation. Uncontrollable inflation is a concern and no one wants to see double digit interest rates.

What happened next was that central banks confirmed that their view is that the inflation is transitory and not lasting. As more economic data was released it confirmed the transitory viewpoint.

This means that long term rates are not likely to rise aggressively.

Instead, with the economic recovery well underway and less need for emergency measures, the central banks may be more inclined to raise short term rates.

This is what’s called a flattening of the yield curve. Short term rates should be lower than long term rates and that gives us a chart going from the bottom left to the upper right. When the yield curve flattens, the spread between short term and long term rates becomes smaller.

This is negative for financials because they borrow on the short end and lend out at the long term. The larger the spread the better. The smaller the spread, the tighter the margins are.

Industrials on the other hand should have done well because of the strong economic growth and lower long term interest costs.

I believe that this is a short term taper tantrum similar to what we saw in 2013. While 2013 saw the market sell-off in bonds and bond yields rose as a result, this time it is the equity market that is largely hanging on edge. We saw a large spike in interest rates in February only to pare back some of those bond losses.

I don’t think the large amount of consumer firepower in the form of cash and available credit, the rise in wealth because of asset prices and still historically low interest rates will stop the markets and create a long term bear market. I believe the markets will remain healthy over the medium to long term. These are very financially accommodative times and a rise in interest rates is not likely to derail this train. Further I don’t see inflation running away and expect it to moderate as we see an initial reopening reaction slow to normal and also work through some of the supply issues in the market.

We are already seeing this in lumber and other areas.

My thoughts upon reflecting on the last month are to stay the course with a bias towards cyclicality, stay short term duration bonds, and look for any pull-backs in the market of 10% to 20% to rebalance portfolios, allowing us to buy more equities.

Until next time,

Trevor Dale

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