Charting the Market's Path Ahead: Three Charts to Watch
It was a rather quiet week, allowing the markets to continue to be towed by the economic recovery outlook. In what has become a common refrain, stocks hit new record highs as the S&P 500 posted a 2% gain for the week1. While this bull market is still quite young, it's already logged some significant mileage, returning 87% in just over a year1. This raises several key questions:
- Where will the fuel come from for the next leg of the market's journey?
- At what speed will the market travel?
- What potential potholes lay ahead?
No bull-market path is perfectly predictable, but we do think there are key signposts that provide signals of progress. In terms of the questions above, here are three key gauges to monitor:
1. Improving labor-market conditions will supply the fuel.
The chart above illustrates that falling unemployment can be good for the stock market as bull markets correlate to lower and falling unemployment and bear markets typically see a rise in unemployment.
- The unemployment rate has fallen nearly 9% over the past year. On one hand, this is tremendously positive. Previously, the largest decline in unemployment since WWII was 6.5% from October 2009 to February 2020. On the other hand, this reflects just how much damage the pandemic did to the labor market. Unemployment is still 6%, a level which is historically elevated. Weekly initial jobless claims rose last week, though they remain in a broader downtrend. This indicates to us that the near-term improvement in employment conditions won't be completely smooth, as vaccine distribution and regional/industry restrictions proceed unevenly.
- With consumer spending accounting for roughly 70% of U.S. GDP, we think employment trends will be a powerful tailwind for the economy ahead. We expect the unemployment rate to decline throughout the year, driven by accelerating job gains spurred by the reopening of economy. March added 916,000 jobs, the strongest gain in eight months. We think even stronger monthly gains will be experienced this year as a rebound in the service sector (including travel, hospitality and leisure) takes shape.
- In the past 40 years, when a descending unemployment rate breached 6%, it continued to decline, on average, for another 50 months. Moreover, the average gain in the stock market over the next two years was 22.7%, reflecting the important influence an improving labor market has on a growing economy, and what a growing economy then means for equity-market performance.
2. The stock market has an open road ahead, but it will advance at a slower speed.
Source: FactSet, S&P 500 Index, past performance is not a guarantee of future results
With rates rising in the near term, the S&P 500's earnings yield advantage over the 10-year rate has been narrowing.
- The earnings yield on stocks (corporate profits divided by the price of the S&P 500), relative to the 10-year Treasury rate, currently sits just below 3%, the lowest level since 20181.
- This is the result of two trends: 1) a rise in interest rates, with the 10-year Treasury yield currently sitting near the highest level since January 2020, and 2) rising stock prices, which have outpaced the rate of earnings growth over the past year.
- The downward trend in the earnings yield relative to bond yields signals that investors are receiving less compensation for taking the risk of seeking upside appreciation from equities, as compared to the safety of Treasury yields.
- We don't think this is signaling that the bull market is running low on gas, but we do think this implies more moderate returns for equities as we advance. And we doubt the gains of the past year will be replicated in the year ahead. However, we do expect earnings growth to accelerate meaningfully this year, and we expect longer-term interest rates to rise at a more gradual pace. This should help reverse the downward trend in the earnings yield.
- The earnings yield reached similar levels in January and October of 2018, followed by strong performance from the market in 2019.
3. Policy potholes ahead: Fed rate hikes will matter more than corporate tax hikes.
Source: FactSet, FRED
Tax rates over time have been largely range bound with a downward trend while the Fed Funds rate saw a rise in the 70's to combat inflation and then followed a prolonged period of a downward trend.
- While the progressing economic recovery will be behind the stock-market wheel this year, fiscal and monetary policies represent potholes that will frequently appear in the headlights.
- President Biden's proposed $2 trillion infrastructure bill is the latest iteration of the fiscal-policy response, which would push pandemic fiscal stimulus above 30% of GDP, by far the largest in U.S. post-war history and well ahead of current levels among other global developed nations.
- Accompanying tax hikes are included in the initial bill in an effort to produce revenue offsets to blunt the impact on the federal deficit. We think the proposed hike in the corporate tax rate from 21% to 28% will spark some indigestion in the equity markets.
- We'd note a few key takeaways:
- This tax hike is far from a done deal, and we would not be surprised if Washington negotiations center on a slightly lower number than 28%.
- Even with the hike, corporate tax rates have been much higher in the past. The corporate rate was above 50% for much of the 1950s and 1960s, a period of economic prosperity. The average annual return for the stock market over those two decades was 13.4%1. The rate was 35% from 1993 to 2017, and stocks gained an average of 9.7% per year over that stretch1.
- The corporate tax rate was raised in 1968 and 1993, with the market delivering an average total return of 10.5% in those years.
- On the back of a strong economy, earnings growth should be robust this year and next, which means a tax hike won't fully undermine the bull market. However, a corporate tax hike shouldn't be dismissed, as we would anticipate it to trim the earnings growth rate next year. In a market in which fundamentals are favorable and expectations are optimistic, tax hikes could cause periodic market volatility.
- We think the rate that poses a greater risk to the expansion is the Fed's short-term policy rate. As the chart shows, it's been anchored at 0% since the beginning of the pandemic, and we expect it to remain there for some time to come.
- Phases of monetary-policy tightening (Fed rate hikes) restrict financial conditions and tend to initiate economic and market downturns when policy becomes particularly restrictive. The Fed reiterated last week that it intends to maintain accommodative policy settings to foster a lasting economic expansion.
- We suspect that higher inflation readings this year will raise the market's anxiety level over the timing of the Fed's pivot toward tapering its stimulus. We don’t expect inflation to run too hot for so long that the Fed is forced into that this year, but the higher inflation readings will be a source of volatility, nonetheless. Fortunately, we think Fed policy will remain more helpful than hurtful for some time, with rate hikes unlikely to occur in the coming year.
Craig Fehr, CFA
Source: 1. Morningstar Direct
Weekly market stats
|Dow Jones Industrial Average||33,801||2.0%||10.4%|
|S&P 500 Index||4,129||2.7%||9.9%|
|10-yr Treasury Yield||1.66%||0.0%||0.7%|
Source: Morningstar, 4/11/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.
The Week Ahead
Important economic data being released this week include an inflation update, retail sales growth, and manufacturing production.