How much economic growth is too much?

Uncertainty continues to reign in the markets but now investors are grappling with a classic problem – how much economic growth is too much?

Investors need a strong economy to drive corporate earnings and justify higher stock prices, but they don’t want things to move too fast out of fear this will lead to significant inflation. The knock-on effects are what keeps them up at night, including the potential of higher interest rates that could negatively impact future earnings growth.

Kevin McCreadie, CEO and CIO of AGF Management Limited, believes that’s why markets have been so jittery over the past two weeks. He said: “Even though central banks haven’t touched their overnight lending rates in months, bond yields have risen dramatically since the start of the year – again, because investors are worried about inflation and because they anticipate tighter policies from the U.S. Federal Reserve and global counterparts to cool things off.”

The Fed kept interest rates at the lower bound yesterday and continued to project near-zero interest rates at least through 2023, despite upgrading their U.S. economic outlook and the mounting inflation worries in financial markets.

The decision came on a volatile day for investors, however, with Treasury yields surging ahead of the announcement. At the subsequent press conference, Powell said: “The strong bulk of the committee is not showing a rate increase during this forecast period”, adding that the time to talk about reducing the central bank’s asset purchases was “not yet”.

This reponse is unlikely to quell investors’ fears over inflation but whether those concerns are justified is a tough one to answer. McCreadie said it’s hard to imagine that investors would be worried about too much inflation when huge swaths of the global economy are still getting back on their feet and some countries, like Canada, remain in lockdown to some degree or another.

He said: “Yet, if there’s been a constant throughout the rally off the March bottom last year, it’s been the fact that equity markets are well in front of the economic recovery. From that respect, then, it makes sense for investors to have already begun the process of pricing in higher inflation even though it’s not a guarantee and, if it does happen, may still be months away from taking hold.

“Of course, all of this is prefaced by the massive stimulus efforts of governments and central banks around the world over the past year. Perhaps never has fiscal and monetary policy been this accommodative at the same time, and the amount in play continues to grow following the latest US$1.9-trillion package that was approved in the United States earlier this month.

“It’s given this – and also the fact that savings rates have risen dramatically due to the lockdowns of the past year – that many believe an increase in consumer prices to be inevitable once the pandemic is fully under control.”

But does that necessarily mean higher rates? Bond markets obviously believe so but the Fed made it clear last year that it is now more willing to let inflation run hot than it would have been in the past. McCreadie believes this means it may not, therefore, be as quick to raise rates as some investors might be expecting.

He added: “Based on our research, stock prices suffer the most when the 10-year U.S. Treasury climbs 40 basis points or more in less than a month, but they do much better when the increase is less drastic.

“More specifically, before this year, we found that 10-year yields have risen by more than 15 basis points in a month more than 45 times over the past 20 years, but during those months, the S&P 500 Index was negative only 11 times and, in six of those periods, yields were already greater than 4% or well above where current yields lie.

“In other words, rising bond yields don’t always have to be negative for stocks, but they are a problem when not contained and the pace at which they rise as the global economy continues to recover will continue to have a huge bearing on the Fed’s next move and on how equity markets perform.”