Quarterly Market Outlook: Different Speeds

Economic growth is picking up and the stock market is trending higher, but in a choppy fashion that lately resembles a “bunny” market more than a bull market. Vaccine rollouts in major countries are proceeding at different speeds, and investors are torn between optimism about business re-openings and concern about rising interest rates.

So how fast will the pace be going forward? A few thoughts:

1. Worries about rising interest rates may be premature. U.S. stocks dropped sharply in late February, as a rapid rise in the 10-year Treasury yield spooked investors. Rising interest rates tend to raise the cost of borrowing, which in theory tends to discourage capital spending and to slow economic growth. The speed of the move has been more worrisome than the overall level, as rates are still very low by historical standards. That said, if yields continue to climb as fast as they have during the past six months, it could begin to weigh on economic growth.

2. The days of low bond market volatility are likely behind us. Ten-year Treasury bond yields declined last year as the Federal Reserve kept short-term interest rates low and took other steps to support the economy during the COVID-19 pandemic. However, that same easy monetary policy combined with expansive federal government fiscal policy is now shifting the outlook to higher interest rates. With the prospects for economic growth picking up and the Federal Reserve willing to let the economy “run hot” for a period of time, investors are beginning to demand higher yields to compensate for the risk of rising rates. The recalibration of yields is likely to be a bumpy process.

3. Optimistic investor sentiment calls for more caution, not less. Investor sentiment has been quite frothy lately, a circumstance the recent stock market pullback dented, but didn’t reverse. Extremely buoyant sentiment can be a contrarian indicator, although a negative catalyst usually has been needed to start a reversal. Heightened sentiment may continue to cause bumpy markets.

4. International earnings growth is expected to outpace the U.S. in 2021. Cyclical stocks—such as international developed- and emerging-market stocks—typically do well when global growth accelerates. We believe emerging-market stocks may rebound and rise alongside interest rates, as they have done in the past; they’ll also likely gain support if commodity prices rise amid stronger economic growth, and if the U.S. dollar remains weak.

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