Last week’s market action was dominated by interest rates. Treasury yields rose throughout February, at an accelerating pace that peaked on Thursday as 10-year yields briefly exceeded 1.6% intraday. The trend finally broke on Friday, with 10-year yields pulling back to around 1.4%, but interest rate volatility remains high. The CBOE Interest Rate Volatility Index (which measures implied volatility on interest rate swaptions) closed the week just shy of 78, the highest level in the past 3+ years outside of a few days in March of 2020. See the Chart of the Week for details.
The high levels of interest rate volatility are being driven by inflation concerns and questions about the forward path of Fed policy. These concerns were a headwind for stocks last week, particularly longer duration equities like large cap tech and emerging markets. Nearly all sectors in the S&P 500 finished the week lower, the lone exception being energy stocks which continued to perform well thanks to rising oil prices.
Economic news last week was positive (perhaps too much so for rates markets). The Conference Board’s Leading Economic Index and its Consumer Confidence Index both registered sequential gains, while initial and continuing jobless claims both came in lower than expected. And there was more good news on the virus front, as the FDA issued an emergency use authorization for Johnson & Johnson’s single-shot vaccine.
Albion’s “Four Pillars”:
*Economy & Earnings – The New York Fed’s Weekly Economic Index estimates real-time GDP growth to be -3.3% y/y. Growth is expected to be modest early in 2021, and pick up in the second half of the year.
*Equity Valuation – at 22x forward earnings the S&P is certainly not cheap, and long-term valuation metrics like CAPE (cyclically adjusted P/E ratio) suggest that compound annual returns over the coming decade are likely to be in the single digits. That said, lower equity returns may be justified in the context of ultra-low yields on alternatives like bonds and cash.
*Interest Rates – Rates remain low by historical standards despite recent volatility, supporting equity valuations and lowering borrowing costs.
*Inflation – After staving off deflation early in the pandemic, the Fed has communicated tolerance for short periods of above-target inflation. A cyclical bump in inflation may occur in 2021 as pent-up demand is released, testing the Fed’s resolve, but we do not expect higher inflation to persist.