Is the bond market damaging the stock market?

Outlook: The US reports the ISM Feb manufacturing index this morning, forecast to show robust recovery. We wonder if the bigger headline is a speech by Fed chief Powell (and a handful of other Feds) now that the bond market has thrown down the gauntlet. He doesn’t speak until 2:30 pm ET, though.

The bond market is damaging the stock market. Warren Buffett said in his annual report “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future."

The Morgan Stanley Investment Management’s chief global strategist Sharma had a piece in the Sunday FT about the “end of the party” now that stimulus is here. Stimulus will boost inflation and the overheated economy—US GDP up as much as 8%--will nag at the Fed until it raises rates. This sounds suspiciously like Larry Summers, by the way. 

The writer sees stock market speculation by newcomers (13 million of 49 million online brokerage accounts were opened in 2020). “The week after stimulus checks went out in April, trading by middle-class Americans soared.”

And it’s everywhere. “From South Korea to India, individuals bought stocks at a furious pace. The huge winners were large growth stocks, particularly in the US and China. Together they accounted for most of the 2020 market gains worldwide…. Where will all the money go when the virus fades?”

“Ironically, a booming economy may not be good for markets. Savers will become shoppers again. Resurgent demand for leisure travel, fine dining and other services will strain the capacity of industries gutted by the pandemic. The deflationary impact of business closures could give way to the potentially inflationary impact of supply shortages, which are already visible in sectors such as shipping, airlines and semiconductors. The prices of commodities from oil to soyabeans have also been surging of late.

“The bond market is beginning to price in higher inflation, and the prospect of higher yields could suck money out of stocks, which are now much more vulnerable to interest rate swings. Last year stock valuations received an unusually large boost as rates plunged. A sharp rise would deliver a proportionately large shock. Further, the rally was driven mainly by growth stocks — the kind most sensitive to interest rate shifts — and they now dominate many stock market indices.”

Bottom line, higher rates are going to end the bull run “for giant tech stocks in the US and China and move flows towards a new set of countries and industries.” The stock market is not ready for it. “Markets often underestimate the impact of big shifts in the global economy. Rising yields will overwhelm “the rise in earnings during a recovery. The impact could easily end the rally of 2020, leaving markets suffering withdrawal symptoms despite a global economic boom.”

This seems fairly logical and consistent with historical events and of course those who refuse to learn from the past are doomed to relive it, but we still have a problem with that inflation forecast. We haven’t had inflation of any note since 2011, or a decade. The reasons are well-known—cheap goods supplied from Asia and domestically, laggardly wage growth despite notionally low unemployment. Unit labor costs in the US rose 4.4% y/y in 2020. For what it’s worth, unit labor costs rose by more in China (6.5% and in Mexico (4.82%), according to Statistica. 

Now the whole wage-push inflation story is back, mostly because of the debate over the $15/hour minimum wage. We have decades of economists’ papers on why wage-push inflation does not occur inevitably when wages go up and in fact occurs only sometimes, including that labor is only one of the factors of production. This is cold comfort to service providers. Raise the wage of a MacDonald’s worker and to keep the price of a hamburger the same, buy cheaper bread and meat or get a robot. Gee, that provides jobs in the meat, bread and robot industries.

In other words, unit labor costs vary widely by sector but generally comprise only about 20% of the cost of goods sold. If you have to raise wages, you may find equivalent savings in some other input. Labor-intensive industries (as in high tech and information, or precise machine-making), already pay more than the minimum wage. In 2016, the percentage of the workforce earning the minimum wage was 2.3%, falling to 2.1% in 2017 and 1.9% by 2019. That seems to be the most recent data available.

That does mean we won’t get inflation. It means we won’t get inflation from raising the minimum wage, whatever scare stories we hear about lot jobs, store closings, etc. Besides, to speak of inflation arising from new demand or demand diverted from speculation to consumption is to ignore the elephant in the room. That elephant is always in the room, and it’s oil. In other words, demand can wax and wane, but supply is far more rigid, and of all the supply issues, oil is the key one. The data to watch as the year progresses is whether the newly high and rising oil prices restore the US fracking contribution—prices are already over the $45-55 breakeven—and to what extent alternative energy, especially wind, cut into oil dependency.

As for  a new cohort of newbies speculating in the stock market, broadening the base is never a bad thing, although one does tend to think of the advent of online and 24-hour trading in the late 1990’s and the crash that followed. We were commissioned to write a book about it (CNBC, Trading Around the Clock, Around the World). What is different this time that might avert a history repeat?

Bottom line, inflation is not an authentic worry, at least not yet. The bond market is an authentic worry, but it may be reaching the limits of how far fear can take it. The speed of the yield rise is what is scary, not the yield number itself. A level near 1.5% was always expected for this year, just not on March 1. The forecasting tends to be at a sane and reasonable pace, while the real world slaps you in the face. If 1.5% is the ending point, or near the middle of a new range, the stock market can handle that—as indeed, futures suggest already this morning.

It’s possible the bond market will settle down by 2:30 pm when Powell speaks and he can escape talking about it at all, or only in the most indirect way. Thar’s what the ECB did, issuing a marshmallow statement that “it will not tolerate higher yields that risk undermining the economy.” The UK is taking a similar stance, leaving the RBA as the only central bank actually taking action.

The Fed will continue to send out the same message—any rise in inflation will be transitory and not sustained, and in any case, inflation can run hot for a while before the Fed gets its back up. That makes this sudden yield move a flash in the pan. We might get additional tests of Fed resolve, including from the bond vigilantes—we usually do—but the upper edge of the forecast range is still under 2%. The dollar can retreat, if not right away.

Tidbit: Pres Biden signed an executive order calling for a 100-day review of critical product supply chains, including semiconductors, key minerals and materials, active pharmaceutical ingredients and advanced batteries. The order also calls for a longer-term review of fortifying six industry-specific sectors including defense, public health and biological preparedness, communications technology, transportation, energy and food production. Food production? What century is this?

Behind it all is the US lacking the ability to get protective gear and things like ventilators during the height of the Covid hospitalization crisis and needing to get critical supplies from China. The chip shortage and rare earths vulnerability is in there, too. China is not targeted specifically by name, but China is the issue. This is a better way to deal with China risk than insults and tariffs.

Politics: The spineless conservatives at the national meeting over the weekend approved of Trump, who hinted at running again in 2024. One pundit pointed out that he probably will not run, because it’s already clear he cannot win. Trumpism will pass to the next guy even if it’s not Trump himself. Various speakers including Trump himself still assert he did win in 2020 and the election was stolen, for which there is no evidence. Another pundit points out that the sole reason he is still trying to dominate the party is to raise more money, political contributions earning him more than his businesses.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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