There is a lot of market uncertainty right now as concerns of interest rates, economic growth, and inflation all weigh heavily on investors’ minds. Uncertainty and volatility are environments that active management typically outperforms in, and T. Rowe Price outlined the current market climates as well as the potential paths forward from here.
David Eiswert, CFA and portfolio manager at T. Rowe Price, recently wrote a white paper discussing the equity market cycle and where the firm believes markets currently are. Because of economic shutdown, the bolstering of the Fed has led to an environment with little systematic risk, both now and potentially in the future if interest rates remain low and the pandemic continues to improve.
Currently, interest rates are low, asset prices are high, and there is no credit cycle to create pressure and disrupt things. It has given rise to what Eiswert calls “careless risk-taking in financial markets,” and he argues that this behavior type is best approached through active management.
While there is general inflation in the labor market, there is still the question of whether it will become a permanent fixture or if it will increase. “While a degree of labor inflation is a good thing, an escalation would likely necessitate a change in monetary policy that could potentially disrupt the cycle,” Eiswert said. Schools resuming in the fall could play a mitigating factor in balancing labor supply and demand.
Coupled with the general labor market inflation are pockets of “absurd” inflation such as in lumber, DRAM, and used cars, the biggest concern is that these pockets might cause an overcorrection by the Fed in terms of rapidly increased interest rates. This is a scenario where everyone loses as all assets would take a tumble; it’s something that happened on a small scale in December of 2018, Eiswert explains.
Added into the mix are current interest rates, which are historically low. “We are wary of the level of interest rates today and believe that the price of Treasuries represents hedging and risk aversion more than being an accurate indicator of future economics,” said Eiswert. While Eiswert believes that interest rates should be higher, they need to be within reasonable limits so as not to cause serious issues.
Active Management Can Help Thread the Needle
With the pandemic, many of the growth stocks experienced unprecedented gains that didn’t lose momentum even as economic reopening has become increasingly more possible.
“Mega‑cap technology stocks have dethroned consumer staples and utilities as a source of market defensive positioning. We see significant crowding and momentum in some of these areas of growth, especially in SPACs, IPOs, and MEME2 stocks,” explained Eiswert.
It’s a situation that Eiswert believes is “dangerous” and where the benefits of active management can really shine by ensuring that only appropriately priced assets are invested in. T. Rowe Price is preparing for a "Goldilocks" scenario for the path forward, in which there is lower inflation than there is now, coupled with rates that are higher but still maintain a status quo by remaining historically low.
This scenario could be created by the Chinese economy slowing down, COVID-19 cases accelerating from Delta (which would work to slow the economic recovery), and continued improvement to supply chain functionality. In this scenario, the “absurd” inflation goes away and the economy’s growth stabilizes, creating an environment in which stock pickers thrive.
“Our aim is to own stocks where we have an insight about improving economic returns while avoiding stocks that imply unnecessary risks and should be avoided. This is our role as fundamental bottom‑up stock pickers,” Eiswert said.
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