- The Fed is a worthy opponent against the economic force of the pandemic on security prices.
- Lower interest rates explain the strength in the stock market.
- Volatility will mirror the uncertainty of the impact of the pandemic.
- Looking ahead, we ponder higher inflation.
The U.S. stock market rose over 20% in the second quarter despite the fact that the pandemic is still with us and the number of infections is rising in many places. The most common question we get is why is the market so high? Here’s our take.
The Federal Reserve and Lower Interest Rates
COVID-19 has knocked the economy off its rails prompting the Federal Reserve to embark on an array of emergency actions. Those actions have reduced interest rates. Intuitively it might seem the Fed is no match for a pandemic. We’ll show the power of the Fed or at least the importance of discount rates. Along the way it will become clear why the stock market can seem so detached from the economy.
The following chart shows the decline in the interest rate on a 30-year U.S. Treasury bond and how it has ranged from about 2.25% to 1% .
Stocks and bonds are worth the present value of their future cash flows. The concept of present value is that a dollar in the future is worth less than a dollar today. How much less is a function of interest rates. Future dollars are discounted to arrive at their present value. The rate at which the future values are discounted is called the discount rate. When the discount rate drops, the value of future cash flows rises. For example, at a 6% rate, receiving $100 one year from now would be worth about $94 today. At a rate of 5%, the present value would be about $95 or about $1 more.
The pandemic has been negative for the economy, causing revenues to fall which leads to lower profits and smaller cash flow payments (dividends and share buybacks) for investors. The Fed has intervened to lower rates. By itself, this is positive for bonds and stocks. So which impact is stronger?
Imagine investing in a stock index fund. Dividends over the next year are projected to be $2 and will grow at 4% annually. Let’s further assume that investors discount the future dividends at a 6% rate. A simple and classic valuation model prices the fund at $100. If the discount rate falls by 1% to 5%, then the value of the fund would double. Changes in interest rates, which are influenced by the Fed, have a huge impact on security prices. We use this example to make the point that the Fed’s power is immense. Hence the aphorism “Don’t fight the Fed.”
Volatility will Mirror the Pandemic
In the other corner we have the pandemic. How much of a drag it will exert on the economy and corporate profits remains to be seen. To estimate the pandemic’s power, let’s consider the same valuation model under a few different scenarios. What if the pandemic causes investors to delay cash flows by a year? Instead of paying $2 over the next year, the fund pays nothing and then pays $2 the year after. From then on the cash flows grow by 4%. In that scenario, the fund would be worth $100 in one year (not today). If we discount that to today, the value would be about $94 or 6% less due to the pandemic. If the pandemic causes investors to delay cash flows by 2, 3, 4, or 5 years the value of the fund would drop (from $100) by 11%, 16%, 21%, or 25% respectively. These are significant differences and stock market volatility will continue to mirror the uncertainty of the pandemic.
The point is that the Fed’s influence on rates is a powerful offset to the drag of the pandemic. More generally, stock prices can rise in the face of diminished growth expectations if discount rates fall enough. That’s our explanation for stocks appearing to be disconnected from the economy and why stock prices seem high given seemingly deteriorating economic conditions.
Stock markets are less volatile than they were earlier in the year but more volatile than they have been over recent years. We hope we’ve made clear the large impact changes in interest rates and growth expectations have on stock values. As long as the pandemic causes greater uncertainty we expect volatility to remain elevated.
Future (Higher?) Inflation
We’ve been pondering what markets will do after the pandemic. Wharton professor and author of “Stocks for the Long Run”, Jeremy Siegel, has some interesting opinions. He is calling for rising interest rates and rising inflation over the next several years. His views are based on the increase in money supply engineered by the Fed and the stimulus from the Federal government. He makes an excellent point that today’s stimulus is different from that in 2008-2009. Then the money sat on the balance sheets of banks and did not find its way into the real economy. This time, the money is finding its way into the real economy.
The market does not seem to agree with the professor. The market expects a 1.3% inflation rate over the next 5 years and 1.5 over the next 10 years based on the difference between nominal and inflation-protected Treasuries. We’re of the opinion that such predictions are difficult to make. The Fed could raise rates and quash inflation as it did under Paul Volcker in the early 1980s at the risk of creating a recession. Inflation has not been present in recent years because we’ve seen increased supply in energy and production. We are of the opinion that future unexpected inflation is a risk. A risk of unexpected inflation is not the same as a prediction of unexpected inflation. If our opinion does not change then at some point we will likely add inflation hedges to our portfolios.
We remain unwavering in our view that investors should commit to an investment allocation based on long term return expectations, their willingness and ability to take risk, and their financial goals.