FIVE THINGS YOU SHOULD KNOW
INSIGHTS for INVESTORS
This week has brought some high drama (for finance geeks) around the Fed’s meetings in Jackson Hole (though many are virtual apparently) and what announcements will be made around their plans for tapering bond purchases and other monetary policy moving forward.
While various members had become to indicate, or float trial balloons, regarding more hawkish policy (aka stricter monetary policy) in recent weeks, that appears to be abating as more “dovish” members speak out regarding allowing inflation to run hotter than normal (more on this below from Brian Wesbury).
Analyst Tom Essaye, discussing “The Fed’s Dilemma” summarized the current options for tapering from the market’s perspective as follows:
The “Good Taper.” The Fed begins tapering in December and at $5 billion or $10 billion/month, essentially leaving QE ongoing for most (or all) of 2022. Likely Market Reaction: Risk on. The market is still viewing the Delta variant and COVID spike as a temporary influence, so if the Fed tapered more slowly in response to it that would create an environment where the economic recovery resumes as COVID peaks, but it’d still have the tailwind of QE for basically all of 2022. I’d expect stocks to rally (the S&P 500 could push towards 4,750 or higher as multiples could expand) led by cyclicals and growth/commodities. Treasury yields would rise but not materially given the Fed will continue to buy Treasuries throughout 2022. But I’d still expect the 10-year yield to hit 2% in the coming quarters. The dollar would drop sharply (likely through 92) while commodities would be the biggest winners from this decision (oil and gold should surge on the weaker dollar and higher sustainable inflation).
The “Bad Taper.” The Fed does as expected and begins tapering in December at a rate of $15 billion/month, ending QE in mid 2022. This outcome isn’t really “bad” because it’s already mostly priced into markets, but with COVID cases high again and some rising concerns about growth, the market would be more sensitive to the Fed following this procedure. But as long as the market views the COVID spike as temporary (and it still very much does) then this tapering schedule won’t de-rail the rally. Likely Market Reaction: Not much. Stocks could drop modestly on a knee-jerk “tapering is bad” tantrum, but again this has been widely telegraphed so I wouldn’t expect too big of a move. Defensives and super-cap tech would outperform cyclicals and value. Treasury yields should rise back into the upper 1.50% range on this outcome in the coming months, although again I don’t think the increase in the 10-year yield would be “disorderly.” The dollar shouldn’t move much, as at 93 this outcome is already priced in, and the same can likely be said for commodities (again they are off recent highs, and this is largely priced in).
The “Ugly Taper.” The Fed begins tapering QE in December at a rate of $30 billion/month (or more than $15 billion), ending QE before June 2022. This would be a shock to markets and substantially increase stagflation concerns, because the Fed aggressively tapering QE with the uptick in COVID cases would clearly signal that the Fed is nervous about inflation regardless of the loss of growth. Likely Market Reaction: Pain. Stocks would drop sharply led by cyclical sectors such as energy, materials and consumer discretionary. Super-cap tech, consumer staples and some financials (benefitting from higher rates) would relatively outperform but the entire market would be sharply lower. Treasuries would drop/yields would surge (10-year yield likely towards 2%), as would the dollar (the Dollar Index would rise towards 95). Commodities would be the biggest loser in this scenario and gold would get hit very, very hard.”
As has been the case since the Great Financial Crisis, the Fed’s role for better or for worse has played an outsized role in market sentiment. The fact that they have gotten away with as much experimentation as they have without inflation to date has been a fortuitous break. However, as Brian Wesbury discusses below, in a piece I wanted to share with you, those days are over. Inflation is not only here but continues to accelerate, and as famed investor Jeffrey Gundlach stated this week, may very well come in over 5% for 2021.
The Fed certainly doesn’t want to derail the recovery but weaning the market and investors from perpetual Fed intervention sooner rather than later will be key to not having to “overreact” to inflation in a year or two and create a real issue for both the economy and risk assets.
Key Takeaways - Before I turn you over to the article from Wesbury, I’ll touch on a couple of key takeaways for investors. First, with inflation appearing more structural for the time being, investors will want to avoid being too conservative with their allocations. Cash is losing purchasing power by the day, and with yields almost certain to rise eventually, many parts (not all) of traditionally conservative fixed income are likely a ticking time bomb. Second, and lastly, this doesn’t mean to over allocate to equities as an alternative, but rather serves as an encouragement to find true alternatives from asset classes to strategies to balance the challenges of keeping pace with inflation while not abandoning your true risk tolerance.
As always, we are here to help you with just such challenges.
Have a wonderful weekend,
Tim and the team at TEN Capital
Fed Being Tempted Into SIN
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Narratives get more energy these days because of social media and cable TV, but they've always existed. Back in the 1970s, one narrative was that inflation was not caused by too much money creation by the Fed, as Milton Friedman argued. Instead, it was caused by OPEC or "inflation expectations." And politicians came up with a plan...it proved disastrous.
In October 1974, with inflation running at about 12% (no, not a typo), President Ford announced a plan to "Whip Inflation Now," which was supposed to reduce inflation, not by tightening monetary policy, but by changing consumers' habits. Consumers were encouraged to wear "WIN" buttons.
The good news was that this approach was a more free-market method than the government-enforced wage & price controls imposed under President Nixon. The bad news was that by ignoring monetary policy as the ultimate source of inflation it was destined to fail.
The theory behind the WIN campaign was that inflation was caused by consumers spending too much money, so reducing inflation required consumers to save more and spend less, by, for example, growing their own vegetables, car-pooling, and using less energy in their homes. The idea was that changing consumer spending habits would wrestle inflation under control.
It's easy to look back now and laugh at this absurd attempt to reduce inflation. Alan Greenspan, who worked for Ford in the White House, wrote in his book "The Age of Turbulence" that, at that time, he was thinking, "this is unbelievably stupid."
These days it appears the Fed has come full circle and is trying to create more inflation. We decided to give the campaign a name : Start Inflation Now. And maybe the Fed should print some SIN buttons.
That, in a nutshell is the policy proposal published by David Wilcox, a former influential research director at the Federal Reserve, and David Reifschneider, a former Fed economist and adviser to Treasury Secretary Janet Yellen (who backs the reappointment of Jerome Powell).
In particular, Wilcox and Reifschneider want the Fed to raise its 2.0% inflation target to 3.0%, which would let the central bank run a looser monetary policy. They believe this looser monetary policy would help create more jobs, reduce unemployment, and even reduce racial inequities.
We think consistently higher inflation is a bad idea. Printing more money is not a path to sustainable prosperity. Higher inflation would make business planning more difficult and reduce the "real" (inflation-adjusted) wages of workers, particularly those with the least bargaining power, including lower-income workers.
Nevertheless, we think a higher inflation target is being discussed internally at the Fed. What this means is that even though the Fed is talking about "tapering," it is highly likely to maintain a far easier monetary policy than what otherwise is warranted. Even if the Fed moves toward tapering its bond buying, short-term interest rates will still be near zero. The Fed is still going to be loose even when QE is done.
For now, the Fed still says it expects inflation at about 2.0% next year as well as in the years beyond. We think inflation will be higher than that next year and, if the Fed doesn't explicitly reject the idea of a new higher 3.0% target, may be higher for many years to come.
Money is a contract between government and the people. A stable currency is essential for a stable economy. With the M2 measure of money now 33% higher than it was in February 2020, total spending – prices plus real output -- will end up 33% higher. That doesn't mean a 33% increase in the CPI; after all productivity is growing. But this is more extra money than the US economy has absorbed since the 1970s. We may have more than one book written by advisors in DC today that echo what Alan Greenspan thought back in the 1970s.
Narratives work for political entities in the short-run, but often lead to disastrous outcomes over time. We will be watching the new SIN policy closely in the years ahead.
This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.