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Stocks close mixed as the 10-year Treasury yield hits highest level in a year

Wall Street has a few prudent principles; the trouble is that they are always forgotten when they are most needed. – Benjamin Graham

The major stock averages were mixed last week as the Dow Jones Industrial Average eked out a modest gain while the S&P 500 Index and the Nasdaq Composite Index were down 0.7% and 1.6%, respectively. The yield on the 10-year Treasury also rose and ended the week at 1.34% (bond prices and yields are inversely related), a move that may have been a catalyst for the weakness in technology stocks that dominate the Nasdaq. Typically, high growth technology companies are most vulnerable to higher interest rates and rising inflation. The yield on the 10-year Treasury is at its highest level over the last 12 months.  While investors are still optimistic over recent Covid-19 data, the rollout of vaccines and the prospect for additional fiscal stimulus, higher interest rates could be problematic for stocks and cause investors to rotate out of stocks into bonds. Most economists expect the economy to rebound strongly as more Americans become vaccinated and forecast gross domestic product (GDP) growth of at least 5% in 2021. If a $1.9 trillion economic relief package is implemented, the economy could run the risk of overheating with higher inflation and higher interest rates, which would increase borrowing costs and put a damper on corporate profits and stock prices. But based on the minutes from the most recent Federal Reserve meeting in January, Fed officials do not share the same concern. According to them, there is still plenty of slack in the labor market as at least 20 million people are currently receiving unemployment benefits. Because the economy is far from where it needs to be and inflation is still below its target of 2%, the Fed believes monetary policy must remain accommodative in the foreseeable future. This means that the federal funds rate will remain at or near zero while the $120 billion security purchases each month will also be maintained. If the stronger economic growth that is forecast over the next few years results in higher corporate revenue and profits, then the economy and the stock market should be able to withstand slightly higher interest rates.

Last Week

Retail sales in January surged over 5%, much higher than expected, with consumers spending their $600 stimulus checks on a broad range of items as every major retail category saw increases. The producer price index (PPI) in January recorded its biggest monthly increase since December 2009. In the 12 months through January, though, the PPI has risen only 1.7%. Housing starts in January plunged compared to numbers in December and the soaring cost of lumber and other building materials were likely the reason for the decline. Strong housing demand, low interest rates and a boom in home remodeling have pushed home prices higher but affordability should slow this growth. Weekly jobless claims were 861,000, the highest level in a month and above estimates of 773,000.

For the week, the Dow Jones Industrial Average edged up 0.1% to close at 31,494 while the S&P 500 Index fell 0.7% to close at 3,906. The Nasdaq Composite Index dropped 1.6% to close at 13,874.

This Week

Leading economic indicators for January are expected to increase slightly and in line with the increase in December, but the rate of growth has slowed considerably in recent months. The second estimate of fourth quarter gross domestic product (GDP) is forecast to match the initial estimate of 4%. New home sales for January should remain strong and be slightly higher than in December. Both the February consumer confidence index and the Michigan consumer sentiment index are expected to show improvement.

Federal Reserve Chairman Jerome Powell will give his Congressional testimony this week and will likely continue to emphasize the need for the Fed to remain accommodative.

The most prominent companies scheduled to report quarterly earnings this week are Ingersoll Rand, Boise Cascade, Cooper Tire & Rubber, Exelon, Bank of Montreal, Toronto Dominion Bank, Home Depot, Lowe’s, TJX Companies, Best Buy, Macy’s, Medtronic, ViacomCBS, Moderna, Liberty Media, Nvidia, Autodesk, Dell Technologies, HP Inc.,, Anheuser-Busch InBev and Toll Brothers.

Portfolio Strategy

Last week’s action in the stock market could be a sign of things to come as the economy picks up steam with a decline in Covid-19 infections, wider distribution of vaccines and the prospect of another huge fiscal stimulus bill. Strong retail sales in January and a higher than expected producer price index were partly responsible for the increase in the 10-year Treasury yield to 1.34%, the highest yield in a year. An improving economy should benefit those sectors that are more economically sensitive and cyclical in nature at the expense of technology stocks and other growth sectors. The technology-laden Nasdaq Composite Index was the biggest loser last week of the major stock averages since technology stocks are most vulnerable to  higher inflation and rising interest rates. But sectors that should do well in an economic rebound, such as industrials, financials, consumer cyclicals, energy, materials and airlines, performed well by comparison. This is known as the reflation trade and it could continue as there are signs that economic growth is poised to accelerate in coming months. With this in mind, the important event this week will be the testimony by Federal Reserve Chairman Jerome Powell before the Senate Banking Committee and the House Financial Services Committee. The Fed has long maintained its desire to remain accommodative but that could change in light of recent inflation data and the move higher in interest rates. The Fed’s preferred measure of inflation, the personal consumption expenditures index, is released on Friday and it could provide clues as to what the Fed’s monetary policy moves might be over the near term.