Stocks Remain a Prisoner of Interest Rates

  • The stock market is following the bond market like a puppy. Rates down? Buy growth stocks. Rates up? Buy reflation stocks.
  • U.S. growth estimates are rising, but they are falling in other developed markets.
  • Unless something changes, rates are probably going nowhere.

The economic experience in the U.S. compared with Europe and much of Asia is very different. Although there are some risks of an increasing infection rate in the U.S. after Spring Break, a rapidly growing vaccination effort rate is mitigating that risk and confidence is building. Most are very surprised at the resiliency of the U.S. economy and growth estimates are rising. Meanwhile, Europe can’t make up its mind whether to lock down again, or not, and projections for economic growth are headed south. For now, that has helped to at least temporarily reverse the longer term down trend in the dollar.

It has also served to increase the yield spread between U.S. Treasuries and other sovereign (government) debt. The result is that for the first time in several years, foreign investors have the opportunity to pick up yield with a hedged carry trade. (See chart at top of the following page.) Allow us to explain. A carry trade is when investors in one country, sell their currency, buy U.S. dollars, and then invest in U.S. Treasuries in order to earn a higher yield than they could earn at home. Of course, that would expose them to currency risk, but even after hedging out that risk, they can still earn more than at home. That demand should help to keep a lid on Treasury rates in the near term. But be aware that if Europe gets a handle on COVID over the next few months and growth estimates begin to rise there, this dynamic can reverse quickly, which gives the opportunity for upward pressure on U.S. rates to return. Bottom line, we look for interest rates to find their footing after a bone rattling rise over the last few weeks. This improves the chances for a cooperative stock market in the interim as the stock market typically frowns on bond market disruption.

In addition, the yield on the 10 Year Treasury Note is now back at a level in excess of the dividend yield on the S&P 500, which may also bring in some bond buying. (See chart below.)

Can the Infrastructure Lure Finally Catch Some Funding?

  • Infrastructure should be an easy bipartisan issue.
  • How we pay for it is a big sticking point. Getting a bill passed will not be easy.

There are few issues that have been discussed as consistently as infrastructure, but with no meaningful result. Most recently, infrastructure was a key pillar of the Trump agenda, but it went nowhere fast. Now the Biden administration is talking infrastructure too. The question is whether they can succeed where so many others have recently failed.

On the surface, you’d expect infrastructure spending to be a bipartisan issue, and on the surface, it is. As usual, the devil is in the details and so far, no one has been able to convert the theoretical support into real support. Part of the problem is the red/blue divide. If you thought Trump’s defeat would fix this, think again. There is plenty of talk about ‘bringing the country together’ but no one has held out an olive branch to begin that process. A core inability to compromise on what should be done is not a winning strategy.

In addition, infrastructure brings our financial/debt problems right to the front burner. How much is this going to cost, and who is going to pay for it? The $5 trillion of COVID relief passed in the last 12 months is equivalent to almost one quarter of the economic output of the entire country and it has been financed with borrowed money!

While both sides of the aisle can agree that infrastructure would be a good investment, the sticking point will be who pays for it and how that will be accomplished. Biden plans to pay for some of it with tax increases and the rest by borrowing more. Republicans are only going to go so far with additional debt and tax increases could be a non-starter.

We Shouldn’t Worry About Borrowing, When We Are Investing in Our Productivity

At the end of WWII, we had the only industrial infrastructure left standing. Since then, everyone else has rebuilt, while we have done relatively little. We now have the oldest infrastructure and are at a disadvantage. Probably the proper time to talk infrastructure was in the wake of the Great Financial Crisis. Unemployment was very high and the Federal Reserve had hit a limit on traditional monetary policy (i.e., short term rates to zero) to revive the economy. The Fed was, in effect, begging for Congress to begin some fiscal spending – an infrastructure plan would have been ideal. But it did not happen. Now we have many trillions of additional debt and very little to show for it while infrastructure remains a critical need. The problem is that after all the new debt in the wake of the GFC, and now adding many trillions more in response to COVID, we have a potentially insurmountable debt problem. Ray Dalio, of Bridgewater Capital puts it this way in his recent article “Why in the World Would You Own Bonds When…” (see What We’re Reading for the full text of this excellent article):

“There is now over $75 trillion of US debt assets of varying maturities. US Treasury bonds and notes account for $16 trillion of this and US Treasury securities of other maturities account for another $5 trillion. Holders of these debt assets will either hold them until maturity and endure the previously described terrible returns or sell them. Most holders of debt assets believe that they can sell them to get cash and to buy goods and services with. After all, the only purpose of holding financial assets is to be able to convert them into the buying of goods and services. The problem is that, at current valuations, there is way too much money in these financial assets for it to be a realistic expectation that any significant percentage of that bond money can be turned into cash and exchanged for goods and services. If any significant amount tried to make that shift a “run on the bank” type dynamic would ensue. When such a dynamic—which I call a “reverse wave”—occurs there is no stopping it. It has to be accommodated the way it was accommodated in the 1930-45 period and the 1970-80 period (and hundreds of similar periods throughout history) via printing a lot of money and devaluing it, and restructuring a lot of debt and government finances, usually including large increases in taxes.”

This massive level of debt seems likely to make a Congressional agreement on an infrastructure bill much more difficult than it should be, despite the fact that a quick passage would go a long way to getting unemployment back to acceptable levels. Borrowing all the money for infrastructure would appear to be a non-starter for the fiscal conservatives (we use that term very loosely) and problematic at a minimum for the most centrist Democrats. Biden has hinted that tax increases would pay for at least part of the infrastructure plan, but again, the red team appears uninterested in reversing the tax cuts they implemented only a few years ago. We suspect an infrastructure bill will be a tight squeeze through Congress.

For its part, Wall Street is clearly anticipating an infrastructure bill being passed in the near future. Just take a look at the chart (at right) of some big beneficiaries of an infrastructure bill – Caterpillar, Eaton Corp and United Rentals. All are well above their respective pre-pandemic levels with an accelerating trend recently. We surely hope a bill can be passed, but it might not be as certain as the market suggests.