Ally’s image shows article title, “Low Yields, High Anxiety: The Market Reacts to Inflation Fears” with faded stock charts in the background and “Weekly Viewpoint” in the top left corner.

Lately, there’s been a growing concern that the economy could be rebounding so quickly that the Federal Reserve could be losing control.

Those worries boiled over on Thursday, when Fed Chair Jerome Powell said higher inflation could be coming and reiterated that the Fed will likely keep rates low for a while. The S&P 500 fell as much as 2.4%, while the 10-year Treasury yield spiked to 1.55%.

Graph titled ”Inflation Expectations at a 10-Year High” charts the 5-year breakeven rate from 2011 through 2021. Breakeven rates are the difference between nominal Treasury yields and TIPS yields of the same maturity. They show the market’s implied inflation expectations over a set number of years. From 2011 through 2021, the greatest fluctuations occurred in early 2020 with a drop from about 1.75% to nearly 0% before rising to nearly 2.5% in 2021. The rate otherwise does not dip lower than 0.5% or go higher than 2.5%.

Rising inflation and yields may be the stock market’s latest obstacles, but we think they could be signaling a healthy economy ahead instead of something more nefarious.

Here’s what we’re seeing in this latest bout of volatility.

The Inflation Situation

The U.S. economy is back in growth mode and Wall Street economists are projecting 5.5% gross domestic product growth in 2021. The problem? There are fears that rising inflation may be right around the corner.

Powell’s comments were a jolt to investors consumed by the thought of runaway inflation. From a pessimist’s point of view, if the Fed keeps rates low and allows demand to ramp up, we could see a massive increase in prices that could eventually overpower incomes. A $1.9 trillion third round of stimulus could add fuel to the inflation worries, too, even though many consumers and businesses need the help.

We don’t expect inflation to rise to worrisome levels, though. Core personal consumption expenditures (the Fed’s key barometer for consumer prices) grew just 1.5% in January. The Fed is watching for 2% growth, a level core PCE hasn’t stayed consistently above in over a decade. On top of that, parts of the economy (such as the job market) are still healing, and long-term trends like demographics and globalization could keep a strong lid on inflation.

A spike in inflation is a risk we’re watching, but we believe any spike would be temporary as the supply chain adjusts for the pickup in recovery and demand shifts from the goods-producing sectors to the service sectors. Ultimately, there’s a small chance of an inflation scare in our view.

The Yield Tantrum

The 10-year yield has jumped almost 0.5% since the beginning of February. That may not seem like much, but it’s the biggest move in yields since the end of 2016. Investors can get concerned any time a market moves that quickly, and this time around, yields have compounded runaway inflation worries.

Rising yields have gotten a bad rap, and theoretically, they could lead to lower values for future cashflows. But in this context, we think higher yields could be foreshadowing a healthy economic recovery, which could be positive for stocks long-term.

The trend in yields also makes a lot of sense when you compare it to other economic recoveries. Yields tend to rise when the economy is growing, as the improving outlook entices investors out of conservative assets (such as bonds).

Here’s a table of how stocks have performed during the 10-year yield’s biggest monthly gains since 1990.

A History of Yield Tantrums

The 10-Year Yield’s Biggest Months Since 1990

Month 10-Year Yield (End of Month) 10-Year Yield Monthly Change S&P 500 Monthly Change S&P 500 12-Month Return
July 2003 4.41% 0.89% 1.6% 11.3%
April 2004 4.51% 0.67% -1.7% 4.5%
December 2009 3.84% 0.64% 1.8% 12.8%
February 1999 5.29% 0.64% -3.2% 10.3%
January 2009 2.84% 0.63% -8.6% 30.0%
March 1994 6.74% 0.61% -4.6% 12.3%
January 1992 7.27% 0.58% -2.0% 7.3%
November 2016 2.38% 0.56% 3.4% 20.4%
November 2001 4.75% 0.52% 7.5% -17.8%
March 2002 5.40% 0.52% 3.7% -26.1%

Source: Ally Invest, Bloomberg

To put this into context, the 10-year yield is still well below the average of 6.13% since 1970 and 2.24% since 2010.

Today’s stock market could be following the same playbook. Higher yields can cause tantrums in stocks, especially growth stocks that flourish when rates are low. But over the long term, higher yields typically signal a strong economic outlook. Combine that with the fact that yields are still historically low and we’d expect this particular tantrum to calm down soon.

Finding the Opportunities

If you’re looking for opportunity, we’d encourage you to take a glance at sectors that do well in early economic recoveries. Coincidentally, these are also sectors that have been left behind for most of the rebound.

Industrials:  Growth in price-to-earnings (P/E) multiples of globally exposed industrial companies, while elevated, haven’t caught up with the 82% profit growth expected in the next four quarters. Potential benefits for this group could be a hot housing market and residual demand from infrastructure spending, which tends to be a key component of most government stimulus programs.

Financials: Rising yields have been a tailwind for the financials sector that investors have been waiting on for a while. The group could be a key beneficiary of higher rates if banks can earn more on the loans they offer than the rates they must pay on their deposits. Higher consumer and commercial demand in an economy that is recovering more quickly could also boost the sector. Valuations for financials are about in line with its historic average, which compares to a premium for many other sectors.

Materials: Materials stocks, such as chemical companies and gold miners, are valued at 20.1x forward earnings, which is below the market average. The sector P/E ratio has increased 18% over the past year, just about half of the 35% profit growth expected in the next four quarters. A weak U.S. dollar could also benefit the sector by boosting earnings for several multinational materials firms.

The Bottom Line

Change can be nerve-wracking, and the stock market continuously adjusts for change.

Keep calm for now. We don’t think this drop is the beginning of something bigger, especially considering the strong trends in earnings and the economy. This may just be a healthy step back for a market that’s rallied strongly since November.

Callie Cox, Senior Investment Strategist, contributed to this article.


 
Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.