Inflation and surging bond yields have replaced COVID-19 as the top risks for investors, but economists caution against overlooking the pandemic’s lingering hazards.
Higher than expected inflation and a possible “tantrum” in the bond market now top investors’ list of the market’s biggest “tail risks,” according to a monthly survey of money managers put out by Bank of America on March 16.
It was the first time in a year that the pandemic was not the top risk for investors in the monthly survey. Roughly three-quarters of money managers polled said either inflation or a spike in bond yields were now the top market worry keeping investors awake at night.
The survey was released at a moment of relative peace for stocks, at least in terms of volatility. The Chicago Board Options Exchange Volatility Index fell below 20 this week, levels the index has not fallen to since February 2020. The index — the market’s so-called “fear gauge” — is a measure of stock market volatility expectations based on S&P 500 index options.
The recent surge in government bond yields has already weighed on the tech stock rally and fueled speculation of a policy shift from the Federal Reserve. Meanwhile, the economy’s expected resurgence from the pandemic has also triggered worries of roaring inflation for the first time since the end of the financial crisis of 2007-2008.
“We’re headed for very strong growth in the second half of the year,” said Peter Cardillo, chief market economist with Spartan Capital Securities, in an interview. “Inflation is on the horizon. It’s just a matter of time.”
But while inflation and rising bond yields are inarguable market risks, investors could be overlooking market conditions in place even before COVID-19 took over the world, said Peter Cecchini, founder and chief strategist at AlphaOmega Advisors, a research and consulting firm.
For one, he said, earnings and cash flows were not growing before the pandemic and loan growth had contracted in 2019. At the same time, stocks have gotten historically expensive over the past year, rising to valuations at levels not seen since the dot-com bubble burst.
On March 15, the S&P 500’s 12-month forward price-to-earnings ratio reached a multiple of 22.9x, up from 14.21x a year earlier.
“Valuations are pricing in perfection,” Cecchini said.
In addition, Oren Klachkin, lead economist with Oxford Economics, said investors may be prematurely letting their guard down on the lingering risk the pandemic presents.
“Investors shouldn’t yet be satisfied that COVID has been successfully contained,” Klachkin said in an interview. “While much slower virus spread and accelerating vaccine distribution are encouraging developments, new COVID strains remain a risk. Also, recent moves by several states to reopen raises the risk of rapid COVID transmission.”
Investors, Klachkin said, seem largely unconcerned about the long-term damage caused by the pandemic, particularly the likely lasting harm to the job market.
On March 16, the five-year breakeven inflation rate, a rough measure of the bond market’s view of inflation over the next five years, closed at 2.59%, the highest point since July 2008. The breakeven inflation rate has risen 64 basis points since the start of the year.
But worries about inflation pressure are likely “overdone,” Klachkin said.
“While some inflation is unavoidable due to base effects, fiscal stimulus, and stronger economic activity, uncontrolled inflation is highly unlikely,” he said. “Aside from ongoing pandemic risks, investors should be more worried about the long-term damage inflicted by this crisis, namely on the employment front.”