FIVE THINGS YOU SHOULD KNOW
INSIGHTS for INVESTORS
Investors remain torn between riding the momentum of the markets, and the fear created by the words “all-time high.” Of course, most of this focus remains on the stock market. However, as we’ve been discussing of late, it’s the “other side” of one’s portfolio that needs the most attention – along with perhaps those outsized cash balances in the bank.
Outside of people’s “feelings” about the state of markets, which don’t help anyone much, the real issue driving the outlook for many assets classes is the interconnected relationship between inflation, interest rates and the path of the Fed’s response to them.
Fund manager Scott Grannis commented on the current state of the market saying “It looks like the bond market is beginning to wake up to the reality of higher inflation. Yields have moved significantly higher in recent days, and inflation expectations are rising. That the stock market is taking this in stride - so far - suggests that higher interest rates are not necessarily bad for the economy. I think we are still in the early innings of the adjustment to higher interest rates. There's a lot more to this story that will play out soon.”
While traditional bonds continue to shudder and move lower as rates rise, equities continue to look past inflation and interest rates due to the continued strength in corporate earnings, +36.2% year over year, that continue to surprise relative to expectations (see next chart).
There is also a belief that even stronger earnings are likely in 2022 as supply chain issues subside and spending (from historically strong consumer balance sheets) is allowed to accelerate. Furthermore, equities should continue to find price support given their attractiveness and yields, as compared to the troubled bond market (see chart below courtesy of Janus Henderson).
It’s noteworthy that this relationship between the stocks and bonds, coupled with the tremendous amount of dollars in the system at present, (see also the following chart from Janus) is a big reason there has been a “floor” of sorts under equities for the last year.
Our view is that inflation is likely to stay elevated through 2022 as the Fed will be slow to act around rate hikes despite their suggestions otherwise given both the dovish nature of its members, but even more importantly because of the mid-term elections. Famed bond manager Jeffrey Gundlach is on record stating that he believes inflation will be above 4% next year.
And while inflation continues to erode purchasing power, the amount of liquidity and corresponding demand should keep the economy on solid footing and lead to more numbers such as this week’s ISM Services Index reading at a robust 66.7 and Manufacturing Index at 60.3 (note for both anything over 50 indicates expansion).
Such a backdrop would continue to put downward pressure on the bond market, but in general provide a positive environment for equities, real estate, and other risk assets.
For those that are interested, I’ve included two great (short) pieces that Brian Wesbury put out this week on the topic of inflation and the Fed.
Have a wonderful weekend,
Tim and the team at TEN Capital
Eyes on the Fed
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Investors will be focused on the Federal Reserve this week and our expectation is that it will finally announce an overdue tapering of quantitative easing. In addition, we expect Chairman Jerome Powell to make it clear in the press conference that he expects tapering to be completed by mid-2022.
Inflation is clearly a problem. The CPI is up 5.4% from a year ago. When October data arrive the year-ago comparison will likely be 5.7%, the largest increase since the early 1990s. Some of this is "transitory," but not all of it, not by a long shot. Housing rents were held down artificially until early September, due to limits on evictions. Once nationwide eviction limits ended, rents escalated in September and we expect more of the same for the foreseeable future. That's important because rents make up more than 30% of the CPI.
Given the likely pace of inflation in October, the "real" federal funds rate (the funds rate adjusted by inflation) is running at about -5.6%. That's a record low, even more deeply negative than the -5.0% in early 1975 and -4.8% in mid-1980, both of which were at the end of recessions, not almost a year and a half into a recovery, like we are right now.
In other words, the current economic environment doesn't just warrant tapering, but rate hikes. Unfortunately, rate hikes aren't happening anytime soon. We wouldn't be surprised by just one rate hike at the very end of 2022, but the start of a hiking cycle could also be postponed until 2023.
First, the Fed is very unlikely to raise rates until after it's done tapering, so that alone delays hikes until at least mid-2022. Second, we think the Fed will be reluctant to start hiking a few months before the mid-term elections.
And third, personnel changes at the Fed will likely give the Fed a more dovish tilt in 2022. There's already a vacancy on the Fed Board, two openings to fill for bank presidents in Dallas and Boston, and we think Trump-appointees Richard Clarida and Randy Quarles will be gone by mid-2022, due to the expiration of their terms as Vice Chairman and Vice Chair for Supervision, respectively.
The problem with monetary policy is that the M2 measure of money is up 36% since February 2020, versus a trend of about 6% annualized pre-COVID. That surge in M2 is like a cow that's been eaten by a snake...gradually moving through. As long as the Fed doesn't regurgitate the extra money, the cow isn't going away, which, in this case, means a devaluation of money relative to goods and services.
That doesn't mean higher inflation forever, but it does mean a prolonged period of higher inflation until the extra M2 is fully digested by the economy.
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
The Federal Reserve today announced the (much-overdue) start to tapering, which means it will continue to increase the size of its balance sheet, but not quite as fast. Starting later in November, the Fed will reduce its monthly pace of asset purchases to $105 billion per month from the current rate of $120 per month. In particular, the Fed will reduce Treasury purchases to $70 billion per month from $80 billion, while reducing mortgage-backed securities purchases to $35 billion per month from $40 billion. And the Fed expects to keep tapering Treasury securities by a further $15 billion per month (in the same proportions) starting in December. At this pace, tapering would conclude in June of 2022, just in time for the market-implied first rate hike in July of next year.
Beyond the wording changes to the Fed statement to announce the tapering timeline, there were also changes reflecting updated views on the economic front. For example, the Fed noted an additional tailwind for future activity as "an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation."
It's also worth noting that the Fed tempered its "transitory" inflation talk. In September, it had little doubt that the drivers of inflation would be temporary, stating the higher prices were "largely reflecting transitory factors." Today's statement hedged that comment, stating these factors are now "expected to be transitory." In other words, their confidence that inflation pressures will ease any time soon is waning.
While pushed in his press conference to comment on rate hike timing, Chair Powell was very intentional not to make any commitments, but implied that if progress meets expectations, a rate hike could likely be appropriate in the second half of next year. As per the usual line, future decisions are "data dependent," and faster or slower growth would shift that timeline. When pressed on if the Fed is starting to fall behind the curve (given that they have been consistently low on inflation expectations up to this point) and how they would react if progress exceeds expectations, Powell simply reiterated that the Fed is prepared to accelerate (or slow) purchases if the data justify it.
At the end of the day, the Fed wanted to get the process towards normalization started, but the path this will follow in the year ahead remains uncertain. There is no reason why QE should still be in effect today; tapering should have started, and ended, a long time ago. In addition, the Fed's forecast on inflation is clearly too low. And with the Fed not raising interest rates anytime soon, inflation is likely to turn out much more persistent than the Fed hopes.