Inflation Fears Rise and, With Them, Concern Over Possible Action from the U.S. Federal Reserve

Feb 26, 2021 | Nick Scholte


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But is it a realistic concern for 2021? I'd argue "no".

To my clients:

It was a down week for North American stock markets with the Canadian TSX falling 1.8%; the U.S. Dow Jones Index falling 1.8%; and the U.S. S&P 500 falling 2.5%.

Inflation fears and coronavirus concerns dominated market sentiment this week. Let’s begin with coronavirus first…

After a period of 42 straight days of decline, improving covid case trends stalled this week. The question is why? Does it owe to a rising prevalence of the more transmissible variants that are now spreading in both the U.S. and Canada? Does it owe to the natural ebb and flow in human behavior I wrote about last week whereby the tendency is to begin relaxing personal precautions as the covid outlook improves? Were there delays in reporting previous infections owing to severe weather conditions in certain parts of the U.S., and the current modest rise in cases is merely playing “catch up” with previously unreported cases? My opinion is that it’s probably a combination of all three of these possible causes. So might there be a new mini-wave of infection upon us? Possibly, yes. But I don’t think we are on the cusp of a significant 4th wave in the U.S.. The reason being is that now there are seven U.S. states where the sum of the number of previous infections + vaccinations has reached 60% of the population – the threshold of herd immunity. As vaccinations continue to roll out, the number of such states will progressively increase. Of course, given the slower pace of vaccine roll out here in Canada, the situation is somewhat more problematic in our home nation. That said, barring a vaccine-immune covid variant cropping up, the trend is uni-directional (to the good). Further, the U.S. remains the proverbial “dog” wagging the Canadian “tail” and improving economic conditions in the U.S. should fuel market optimism which will at least partially be felt in Canada also. Bottom line: covid is not gone as a concern, but the overarching trend (despite the stall this past week) remains favourable.

Further to this point, because of the favourable overarching trend in covid cases (despite the current stall and possible mini-wave up), economic optimism is ratcheting up.  Significantly.  With it, so too are inflation expectations.  Corresponding to these inflation expectations, there was a significant rise in U.S. bond yields, with the 10-year yield surging past 1.5%. While the absolute yield of the 10-year bond is still low by historical standards, the proportional move the past week or so has been very significant. It speaks to the expectation that the economy is set to surge in the second half of 2021 (as I’ve also written about in recent weeks, and likewise communicated in my annual reviews ongoing with clients) and that the Federal Reserve may be forced to begin raising rates sooner than they’d like. Rising interest rates often inspire bouts of market weakness, and that is one of the main causes of this week’s declines…

… but here is the thing: the Federal Reserve, under the Chairmanship of Jerome Powell, has been explicit in stating that it will not be raising rates any time soon. FURTHER, the Fed has also made clear that it will be willing to tolerate significant stretches of inflation running at over their target rate such that the average rate of inflation meets its 2% target. With inflation running significantly under 2% for several years, the math required to average 2% or more suggests that inflation would have to surge well past the 2% target AND be sustained in order to trigger rate increases from the Fed. I don’t realistically see this as a 2021 event.

Therefore, this week’s market volatility (read weakness) is, in my view, a transitory event. I’ll be watching eagerly for further weakness next week to again add more equity (i.e. stock) to client portfolios and push the stock weighting further into overweight territory.

That’s it for this week. All the best and stay safe,

Nick

Nick Scholte, CIM, FCSI

Vice-President & Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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