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.

What investors can do now

Investors should always remember the tried-and-true disciplines of diversification and periodic portfolio rebalancing—but these are especially important when markets are choppy or possibly near an inflection point. Although calendar-based rebalancing—e.g., monthly, quarterly or annually—is a solid strategy, you might want to consider portfolio/volatility-based rebalancing instead. Under this strategy, you would choose a threshold change—5%, for example—in any asset class as a prompt to rebalance. This can allow you to “stay in gear” during a volatile market environment by potentially adding securities at relatively low prices and trimming at high prices. This is likely to be more successful than trying to anticipate which stocks or sectors will drive leadership over the short term.

For fixed income investors, we suggest keeping the average duration1 of your  portfolio low, but look for opportunities to consider buying higher-yielding bonds as rates rise. We expect 10-year Treasury bond yields to continue to move higher in the months ahead, with 2% the next target. Market expectations for when the Federal Reserve will start raising short-term rates have jumped forward to the second half of 2022 (previously, they were mid-to-late 2023). With the Fed still holding short-term rates anchored near zero, we expect the yield curve to steepen this year, meaning longer-term yields will rise faster than shorter-term yields.

 

1 Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

Next Steps

Important disclosures:

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Investing involves risk including loss of principal.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Diversification, asset allocation, and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. High-yield bonds and lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Commodity-related products carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.

Currencies are speculative, very volatile and are not suitable for all investors.

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