Why so much attention on the Federal Reserve and obsession over inflation? Because Central Banks usually end Bull markets and economic expansions when inflation heats up. But, this time it is a little more nuanced than in past cycles. Statements such as, ‘until substantial further progress has been made toward the Committee’s maximum employment and price stability goals’ and ‘Transient’ are open to interpretation.
What we can all agree on is that the economy is recovering thanks to an unprecedented amount of fiscal and monetary stimulation and that the recent spike in inflation and economic growth will recede. So, you can forget about the newspaper headlines and current economic conditions, they’re already baked into equity prices. However, beyond transient there is a wide spectrum of outcomes and possibly a Bear Market lurking.
So, I want to look at where we are today and how the future will contrast to these current conditions and what that might mean for the markets.
Let’s start with the economy. It’s ripping due to pent up demand and the enormous amount of stimulus that was injected by the government and Federal Reserve. Consensus believes that growth in GDP and earnings will peak in the second quarter. The Atlanta Fed expects growth to be 7.9% but that’s a drop from 13.7% in early May and analysts see earnings expanding by over 60%. But, growth is then expected to decline steadily to 2.4% by the fourth quarter of 2022 as some see a ‘fiscal cliff’ as government stimulus fades. Spending will shift from goods to services and there will be tax increases. The Delta variant could push us back towards shut down and auto and home sales are already declining as some fear that the consumer is tapped out. According to Rosenberg Research, whose advice we listen to, consumers bought more in the way of durable goods in the past fifteen months, 30% growth from pre-pandemic level, than they bought cumulatively in the prior six years. Furthermore, the Citicorp Economic Surprise Index has gone negative, meaning that current economic conditions are not meeting expectations, which is quite a contrast to a couple of months ago. Add to these concerns the recent flare up in the Covid Delta variant and slowing GDP in China. If this retraction is truly due to faltering demand, then the economic expansion scenario is in jeopardy, which is the Bear Market case.
Although I buy the slowdown argument, I’m not convinced that the consumer is tapped out. The regional Federal Reserve boards conduct regular surveys and the most recent one showed unfilled orders at a record high and inventories at a record low. So, the slowdown in sales maybe a reflection of supply shortages, not lack of demand. We also have the propensity to spend showing up in a shift from goods to services. Consumers want to travel, attend entertainment venues and go to restaurants. Furthermore, Europe’s economy is now coming around, so we face the prospect of a global synchronized recovery in the second half.
Supporting this is a record amount of savings, which represents latent spending that I’ll quantify later.
Evidence of this mixed message recently became apparent in the fixed income markets as 10 year Treasury yields dropped from 1.74% to 1.25% seemingly supporting the case for a weaker economy. However, this was not confirmed by the spreads between corporate and government yields, which invariably increase during economic slowdowns.
Obviously, everyone favors a strong economy, but they don’t want the inflation baggage that usually accompanies it. Here again we have the transient argument. Most of it is supported by the short-term economic strength factors that most see waning. But the Fed adds other things to this list, such as base effect. This is the difference in prices today compared to the depressed prices during the Covid lockdown. It is accentuated by supply shortages and one time stimulus cheques being spent. Their belief is that the secular forces that have held inflation down such as globalization and technology driven productivity will reassert themselves, and that’s probably true, but there are some big hurdles to overcome.
Let’s start with housing. It is one third of the consumer price index (CPI). It is calculated by imputing what it would cost a home owner to rent his own home, or Home Owners’ Equivalent Rent (HOER). It was up only 2% over the last year but home prices have increased by over 18% in that period and there is usually about a one year lag between home prices and HOER. In 1995, the last time core CPI was above 3%, HOER was 3.5%. Furthermore some of the house price inflation is due to low interest rates, so it draws into question why the Fed is still buying $40bn of mortgage- backed securities each month.
Wages are another factor in the inflation puzzle. The transition crowd says productivity will be enough to offset wage increases and the government says there are still 7.6 million fewer employed than before the pandemic, so we have a surplus. Yet a recent government jobs report known as the JOLTS survey showed 9.21 mn job openings, a record high. Almost equal to the number of people unemployed. So why hasn’t employment improved more? Well, there are a number of reasons. First, many think that people are staying home because the unemployment benefits are higher than what they can earn. Already, 22 states have eliminated a $300 per week entitlement to encourage people back into the workforce. Otherwise, we’ll have to wait until September when the government benefits end for about 3.6 million people to test this theory. If people do return to the workforce, it suggests that the transient economic growth may transition to something hotter than expected. There are others that are staying home, especially women, because they can’t find day care for their children or because schools aren’t open. This too should get resolved in September. One would assume that this could ease wage pressure. However, the fastest wage growth has been in leisure and hospitality, the lowest paying industries and difficult to automate. As an example, Domino’s Pizza is offering some delivery drivers $1000 signing bonuses and $25/hr. There are also significant mismatches by skills, industry and location suggesting continued labor shortages.
The average hourly earnings (AHE) of lower-wage production and nonsupervisory workers (81% of payroll employment) rose 9.3% over the past 24 months through May. That’s twice as fast as the 4.8% increase in AHE for high-wage workers. Prior to the pandemic, AHE was rising 3%. Although forecasts for wages are thought not to be an issue, the Biden government and the Fed are focused on equality and how labor’s share in corporate profits has declined. To accomplish this you need higher wages and some of this will either get passed-on in price increases or you will see a decline in profit margins. Bottom line, the working age population, excluding those over 65, is declining. Baby-boomers on the verge of retirement still account for 6.5% of the workforce. Furthermore, as they age, they create caregiver jobs that can’t be automated or shipped offshore. You also have people that had jobs in leisure, entertainment and hospitality that are committed to career changes to jobs that are more sustainable and less subject to layoffs. This aggravates the jobs/skills mismatch.
So, I don’t disagree that transitional inflation will recede but with wage and housing cost pressure likely to pick up and last longer, the base rate of inflation may be higher than expected. If it isn’t dealt with, it will work its way into expectations and tolerance for further price increases as seen in a Conference Board survey in June where inflation expectations for the next twelve months jumped to 6.7%. Obviously, this debate over the statistics won’t be known until they are published. That won’t do us much good as the market will have already reacted. So, to help anticipate whether inflation is going to be problematic or transient, one has to rely on some economic theory and a lot of it is getting discredited. It’s the basis for my conclusions. But if you’d rather forego revisiting some of your college economics, please feel free to skip ahead.
The ‘Quantity Theory of Money’ was originally set forth by Irving Fisher nearly a century ago and reborn in the ‘60s by Milton Freedman. It is the basis for traditional economic thinking that equates stimulative monetary policy with inflation. Those educated in this thinking have been waiting for a bout of inflation since the first rounds of Quantitative Easing (QE) were introduced during the Financial Crisis in 2008. Because it didn’t happen, many think the theory is no longer valid along with the Phillips Curve that equates labor shortages with rising wages.
However, there is an explanation. Central Banks execute monetary policy through the commercial banks. They do this by buying bonds from the banks which creates free reserves. The banks can then make loans up to ten times the amount of free reserves. However, in the aftermath of the financial crisis, those free reserves simply replaced about $4tn of problem bank loans, and in fact, were not lent out as they soared from roughly $50 bn to $4.5 tn. Therefore, monetary policy was short circuited and there was no impact on Main Street. This time, in the aftermath of the Pandemic Crisis, the Central Banks again engaged in QE but instead funded government treasury issues that were given directly to citizens in wage and other subsidies, thus bypassing the traditional commercial banking methodology. As we have seen, it worked and spending on consumer goods has increased dramatically, not only stimulating the economy but also causing inflation. So, the theory seems to be working and the only debate is whether it can be sustained. However, this hasn’t been a perfect pass through. There has been a short circuit in the form of savings. Total deposits at commercial banks rose $3.5 tn since March, 2020 to $17.1 tn. Furthermore, debt to disposable income has dropped to 85.5% in Q1, the lowest since 1995. So the consumer has firepower almost equal to the size of the economy. Of course, not all of it will get spent as lower income earners will be more likely to consume than higher ones.
This latent spending power is likely to sustain a higher consumption level beyond the actual disbursements by the government and argues for a stronger economy.
Another thought I’d like to introduce relates to the definition of inflation. For official purposes, we only include certain items, those that affect our cost of living but not those that support it like financial assets. This is the divide between Wall Street and Main Street. All the financial stimulation that we have seen since 2008 has had a major inflationary impact on financial assets and real estate, and has contributed to the financial social divide that we face today. Although the politicians would like to blame it on the capitalists, they are fully complicit in providing the wherewithal for the gap to be created through their own misunderstanding and lack of proper inflationary accounting.
Deutsche Bank published a very good piece on some of the softer aspects that will influence inflation that I would like to paraphrase.
The philosophical shift in government thinking from the fear of inflation and the rising levels of government debt, which shaped generations of policymakers, is now being replaced by the belief that economic policy should now concentrate on broad social goals.
Concerns over high and rising levels of sovereign debt are being relaxed as inflation has remained contained despite low interest rates. Concerns over debt sustainability and inflation have diminished as politicians believe structural forces will continue to suppress prices.
Policy has moved beyond just stabilizing output across the business cycle.
Fiscal stimulus is off the charts while Central Banks have shifted to having a tolerance for high inflation. Price growth could regain significant momentum as the economy overheats in 2022. The sum of the stimulus so far is in excess of $5tn or more than 25% of GDP not including the proposed legislation and deficits that are likely to come in at around $3tn.
Today’s stimulus dwarfs that seen in 2008 and the early 1930’s. Around WWII, deficits remained between 15%-30% for four years and inflation was 8.4%/14.6%/7.7% in ‘46/‘47/’48, respectively.
The Fed’s balance sheet has almost doubled during the Pandemic to nearly $8tn. Compared to the 2008 Crisis when it increased a little over $1tn and then another $2tn over the next six years.
The Fiscal Deficit and Fed balance sheet expansion combined equal approximately 30% of GDP in 2020 and will remain around 20% in 2021. This kind of explosive spike in monetary policy has, for the last 200 years, coincided with a similar spike in nominal GDP. This coordinated monetary and fiscal response has practically no parallel in US history.
Another difference between today and 2008 is that real disposable income has hit an all-time high in the US despite a recession. Consequently, excess savings has reached $2tn or more than 10% of GDP. Assuming 25% of these savings are spent over the next 18 months plus the stimulus from Biden’s Jobs and Families Plan will be enough to push GDP to more than 5% above potential by the later part of 2022. Overheated economies are typically quickly followed by a sharp run up in inflation.
Furthermore, there is political pressure on the Fed to err in the direction of delaying policy tightening, especially while the Fed leadership is up for renewal next year. Today, inflation is much less important than in the Reagan/Volcker era. Today, the focus is on not only employment but also on greater equality in income and wealth.
Monetary policy operates with long and variable lags. So, if inflation overshoots excessively and persistently, what will the Fed do? It will be forced to act, which will likely be highly disruptive to the markets and economy.
The perception that is being engrained is that high levels of debt and high inflation are a small price to pay for achieving progressive political, economic and social goals. This will make it difficult to accept higher unemployment in the interest of fighting inflation.
Now let’s talk about the Fed. We know that at some point, they are going to do two things. First, they will ‘taper’ which means, buy fewer bonds and mortgage-backed securities each month until they don’t buy any. Then they will start to raise interest rates to ‘normalize’ policy. This has a number of consequences for the stock market. Initially, Fed tightening can cause a correction but doesn’t historically end a Bull market. Second, it can change the complexion of which industries perform better, and influences the growth/value strategy. And finally, too much tightening can end the market’s and economy’s advance? So, every Fed meeting and economic release is dissected for some nuance on the Fed’s next move. Chairman Powell has repeatedly said that they will not raise rates ‘until substantial further progress has been made toward the committee’s maximum employment and price stability goals’. So what does that mean? They’ve said they’re willing to let inflation overshoot for a while to get to a socially-adjusted, fuller employment. If we use that as a benchmark and we take the average increase in employment, 468k new jobs per month which was the average in Q2, then it will take until mid-2022 to reach their goal of pre-pandemic employment.
And how long is Transient? Are we talking about fiscal stimulation? If so, and it’s been a one shot, demand-boosting policy, then shouldn’t the US budget deficit recede back to normal? According to Rosenberg Research, when examining prior spikes in inflation and the Fed’s reaction, this suggests that it could take 14 to 22 months before they react.
And what is tolerable ‘inflation overshoot’? Here the Fed talks about symmetry. Well, inflation averaged 1.6% since 2011 and only 1.2% in 2020. So, you need 2.4% average inflation through the end of the decade until 2030, with occasional peaks of 3% or more.
The Fed has also said that it will wait for actual evidence of inflation or other imbalances. This is also quite a departure from past protocol where the Fed has anticipated economic conditions using its many forecasts. After all, monetary policy is a leading indicator and now, it will be used in reaction to a coincident indicator. Consequently, there is a risk that if inflation is more than transient, the Fed will be well behind the curve, which will require a greater than otherwise required reaction to get inflation in check. Can this even be contemplated in an over-leveraged world? If not, what is the antidote for inflation?
Regardless, the mid-June Federal Reserve meeting was a bit of a reality check. Their message wasn’t much different, but they did open the discussion on when they would start to taper. The first sign of monetary tightening. Otherwise, the focus was on what is referred to as the ‘dot plot’. This is a record of when each Fed governor feels interest rates should be adjusted. Until June, the belief was that rates would hold until 2023. But this meeting saw 7 FOMC participants anticipate at least one rate hike next year up from 4 in the previous meeting and of those seeing an increase, two thought there would be two rate hikes. So, what happened to waiting for maximum employment, actual evidence and patience with inflation overshoot? Sounds like someone is looking at economic theory, which is why I elaborated on it earlier, as their inflation expectations rose from 2.4% to 3.4%. The reaction in the bond market was immediate as the curve flattened. Two year yields rose and ten year yields dropped. The reason: tapering means fewer Fed purchases of shorter-duration bonds, which is what they hold. That puts upward yield pressure on the two year Treasury note. However, willingness to raise rates sooner shows an inclination to fight inflation and puts downward pressure on the ten year yield.
The stock market took its lead from the bond market where the ten year yields had already dropped from 1.79% in March to 1.25% by July 9th. As longer rates dropped, signaling lower GDP growth, the growth stocks outperformed value. Some extrapolated this as a sign of weakening economic growth. However, the yield spreads between government and corporate yields would have widened if that had been the case and they did not. Yet, the Fed has not implemented any changes, which suggests that the decline in the ten year yields could be due to technical factors. In the past twelve months, the Fed has purchased $1,395bn of securities and has flooded the banking system with deposits while loans have been weak. This has resulted in the banks also being big buyers of treasuries, $867bn, to invest the surplus funds which drives rates lower. Combined, they have purchased $2.26tn in securities. Basically, government deficits are showing up in savings accounts and paid down loans.
The real question is why the Fed is still buying $120bn of securities each month when the economy is at a new record high and inflation is above their 2% target? On balance, the Fed’s mid-June statement suggested that there was a greater propensity to fight inflation than what there had been earlier.
Regardless, there seems to be an intractable course towards higher interest rates. If the economy continues to grow and inflation remains hot, the Fed may be pushed to react sooner than they have indicated. This would be especially true if the termination of unemployment benefits and the return to school in September drive the unemployed back into the workplace. But even if things cool off, the Fed has indicated a desire to normalize monetary policy. Only an unexpected slowing in economic growth could trigger a reappraisal and with so much consumption firepower sitting in bank savings accounts, that’s a hard case to make.
So, what does this mean for the stock market? Obviously, the focus is on the Federal Reserve and how and when they will start to tighten monetary policy. However, an increase in interest rates is only the beginning of the end and in the current conditions, maybe the beginning will be signaled when the Fed starts to taper its bond buying. This usually gives the market a shake but doesn’t terminate the advance. However, below the surface of the general market’s trend there is a lot happening that will determine performance.
Active management has had several themes to play over the last fifteen months starting with the Covid pandemic benefactors such as Amazon and Zoom. Then there were the ‘stay at home’ stocks like Netflix and Home Depot. This was followed by the recovery names such as the autos, industrials and home builders. The next phase was performance by the ‘coming out’ companies which included restaurants and airlines followed by a recent sell off in value and rotation to growth as the 2-10 year treasury yield spread narrowing surprised the market and concerns over the Delta Covid variant increased.
This growth/value backdrop has been a pervasive theme for the market through this whole period as falling rates in reaction to the pandemic supported growth. But, starting in November of last year the investment landscape changed as the anticipated Democratic victory brought forecasts of larger government deficits and a stronger economy which drove interest rates higher. Value, being more economically sensitive took the market leadership and has maintained that advantage until this June when treasury yields continued to drop from their March peak of 1.74% to a low of 1.25%. Since that peak in rates, the market has essentially flat-lined while growth has recently regained its leadership. During this period, growth is up 4.4% while value has slipped -0.8%. However, year to date through May, value still prevailed at +16.6% vs +7.8%.
In the second half, I would expect the themes to continue to rotate, but I would also expect the general market environment to be a little less friendly. In the second quarter, things were as good as they are going to get. Earnings and economic growth peaked along with government stimulation. The market will focus on what we refer to as the second derivative, which is the growth rate from one quarter to the next. So, earnings may be up 60% in Q2 but are projected to be up only 23% in Q3 and 17% in Q4. A declining rate of change, but still quite strong by historical standards. Nonetheless, the growth rate is slowing. Furthermore, a strong economy will require funding at potentially the same time as the Fed starts to contract liquidity. Financial instruments are generally the source of those funds which withdraws support for the market. Finally, the threat of tax rate increases next year could threaten significant fiscal drag as government spending proposals get watered down which would again be quite a contrast to the first half of this year. Historically, we’re following a fairly traditional pattern where monetary and fiscal policy are quite stimulative in the first year of a Presidency and then fall going into the second year, which is consistent with a market correction.
This combination of stretched valuations, peak economic growth, declining commodity prices and a Fed on the verge of becoming more restrictive provides an interesting but negative contrast to what we saw in the first half of this year.
As the title of my commentary states, I agree with the consensus view, but only up to a point. The economy, inflation and earnings growth are as good as they are going to get and will diminish or transcend in Fed speak. But, I don’t think we’re going to regress back to pre-Covid levels and that the residual economic strength will result in an inflation level above the Fed’s expectations. Will the Central Bankers react to this or will they be compromised by political influence? I don’t know. Furthermore, given the enormous amount of corporate and sovereign debt outstanding, can the Fed even use traditional interest rate increases as an antidote for inflation? If not, it will fuel a secular shift in investments to an inflation hedge type of strategy. For sure, any attempt to stem inflation with monetary policy will be met with a negative reaction by the financial markets, which has normally caused the policymakers to back off and certainly today’s collection of politicians and bankers stands in contrast to the Reagan/Volcker era which was prepared to do what was necessary to preserve some fiscal and monetary responsibility. The current Fed is not a guardian against inflation, but instead a proponent of it. ‘Group think’, low interest rates, debt monetization and massive borrowings not resulting in inflation has resulted in a re-appraisal of traditional economics. Structural forces are seen to replace traditional paradigms, and this has allowed monetary policy to go beyond stabilizing the business cycle to underwriting political social agendas under the excuse of a pandemic.
Although I do expect the market to work its way higher, I think investors are going to have to be a little more astute as to what they invest in. I don’t think the general market averages will provide a rising tide to make index investing attractive. But, I do believe equities, even with a market correction, which is overdue, will be the best asset class to protect your wealth.
Gerald R. Connor
Grant’s Interest rate Observer
Deutsche Bank Research
Ned davis Research
This time last year we were in a pretty dark place. The economy was being shut down, COVID-19 was out of control and the stock market was crashing. The worst was feared and the only glimmer of hope was a government recovery bill for an astronomical $1.9 trillion that had just been passed by Congress. We’d seen recessions before, but nothing like this one.
Yet, here we are today. The markets are at all time new highs. The economy has almost fully recovered in GDP. There is still unemployment, but it is improving, and COVID is still around but on the decline, unless you live in Canada.
I can’t help but believe we are witnessing financial history in the making. Winston Churchill is credited with saying, “Never let a good crisis go to waste”, and all the politicians on both sides of the border are fully embracing this.
Monetary policy, social reform, the environment and more are all being swept along on this ride to respond to a virus.
The immediate consequences of all this feels pretty good right now. The stock market is up, the economy is recovering, spring is here and the vaccine, at least in the US, will have us back to normal by summer. This cocktail of one part vaccine and two parts stimulative monetary policy and fiscal spending could lead to a party that gets out of control.
So, let’s delve into some of this and I’ll try to make the boring stuff, like the economy, either interesting or short. I’ll start with the Federal Reserve’s monetary policy and free money before getting into the stock market.
The Federal Reserve is in the lead on rewriting conventional policy. Historically, the Fed worked through the commercial banks to affect monetary policy. When they decided to stimulate the economy they would traditionally buy government bonds from the banks, which would create free reserves. Free reserves could be leveraged by the banks. They were allowed to lend $10 for every $1 of reserves. So, bank lending would rise. Consumers could buy a car, a house or run up the balance on their credit cards. Corporations could borrow to build a new plant or buy a piece of new equipment. It worked.
But, after the 2009 recession, the Fed initiated Quantitative Easing. They bought trillions of dollars of bonds from the banks, but lending didn’t pick up. The banks kept the money to replace bad loans and investments. So the economic recovery, after the Financial Crisis, was weak. During the Covid crisis, the government has apparently decided not to leave something as important as the economy to the banks. They decided they would get the money directly into the economy by either increasing their spending or by sending checks directly to their citizens. Ben Bernanke, a former Fed Chairman, referred to this as helicopter money. The government does this by borrowing the money and the Federal Reserve gives them the money but by buying those bonds. We’ve never seen this before and academics refer to it as Modern Monetary Theory. So far, this experiment is into the trillions of dollars without any true understanding as to how the deficits ever get resolved. But for sure, it accomplishes a couple of things. It gets the government directly involved in the economy deciding who should get the money and how much instead of the commercial system. It also means the government doesn’t want to see interest rates go up when it owes so much money. As Lloyd Blankfein, former head of Goldman Sachs, says, “A commodity, including cash, won’t be allocated efficiently if it is free. You need some kind of scarcity.”
So, the two players in this event are the Federal Government and the Federal Reserve. It’s worth reviewing what they have done before getting into the results.
The first major COVID response was last March with the CARES Act. It totalled $1.9 trillion and sent $1,200 to each citizen, which amounted to $275 bn and raised unemployment benefits to $551 bn. For perspective, the Labor Department estimates that unemployment benefits and personal income amounted to $550.2 bn last year compared to $27.7 bn in 2019. In January of this year, an additional $600 per person in stimulus cheques were mailed. These first two rounds totalled $438bn.
Recently, President Biden got the American Rescue Plan Act, ARPA, approved for another $1.9 trillion. It provides for an additional payment to 287 million Americans (80% of the population) of $1400 totaling $402bn.
These three payments amount to $11,400 for a married couple with two kids. Furthermore, the Wall Street Journal estimates that under this new bill that same unemployed couple would be eligible for $135,000 in unemployment benefits if they lived in Kansas and $170,000 should they live in Massachusetts.
The Biden plan also extended unemployment benefits from March 14th to August 26th. We’ll come back to why this is important later.
So far, it is estimated that the total cost of the COVID relief bills is $5.3 trillion.
But the stimulus doesn’t end here. The stimulus packages that have been approved get spent almost immediately, however there are other programs on the docket which are large but spread the stimulus out over several years. The most recent proposal is the America’s Jobs Plan. It is represented as an infrastructure bill. It asks for $2.3 trillion, would be spent over eight years and paid for by tax increases over fifteen years. This is under debate in Congress. But, it doesn’t stop here. There is a second round of spending expected that will also be in the trillions under the guise of Build Back America Better and focus on “social infrastructure “ which would expand health care, paid-leave and extended child care.
In the context of never letting a good crisis go to waste, I’ll quote Treasury Secretary Yellen’s statement in her Senate appointment hearing, “Indeed, the reason I went from academia to government is because I believe economic policy can be a potent tool to improve society. We can, and should, use it to address inequality, racism and climate change.”
So, these enormous spending bills that are being ushered through Congress aren’t just about transitioning the economy through the Covid Crisis, this is also about social change. There is nothing wrong with that, so long as a government has a mandate. But to push it through under the cover of a pandemic response without knowing how the financial issues will be resolved is worrying.
The other half of this duo is Fed Chairman Powell. Where does he stand? On unemployment he stated “This means that we will not tighten monetary policy solely in response to a strong labor market. In particular, we expect that it will be appropriate to maintain the current accommodative target range of the Federal funds rate until labor market conditions have reached levels consistent with maximum employment and inflation has risen to 2% and is tracking to moderately exceed 2% for some time. In other words, “Don’t worry, be happy.”
And, don’t worry about missing out in Canada. Last year’s budget deficit is expected to be as high as $354 bn. For comparison to the US multiply everything by ten. Finance Minister Freeland, like Ms. Yellen, stated that the pandemic has created a window of opportunity for a national childcare plan and a shift towards a more sustainable economy. A green and innovative recovery plan. The government’s new budget is expected to project a deficit of around $155bn in order to get the economy back on its feet. However, of the three million people that lost their jobs to the pandemic it is now estimated that only 296 thousand remain unemployed and the economy has expanded for nine straight months.
So, what has all this stimulus resulted in? Well, the economy is ripping. The Fed has recently raised this year’s economic guidance and now expects the GDP to rise by 6.5%. That’s up from an earlier estimate of 4.2%. And, they see further growth of 3.3% in 2022. Yet, private forecasters such as Morgan Stanley think the economy show even greater strength and could improve by 8.1%.
Furthermore, the Fed sees unemployment dropping to 4.5% by year end and improving further to 3.9% next year. Inflation is seen rising to 2.4%. Yet, the Federal Reserve Open Market Committee which sets interest rates doesn’t see an increase until 2024.
So, why is the economy so strong when you still have so many unemployed? A lot of it has to do with government policy. When they shut the economy down last spring they also sent people a lot of money. Some of it went into savings, but some of it got spent on stay at home type goods, not services like restaurants because they were shut down. This was a classic manufacturing recovery. Stores like auto show rooms ran out of merchandise so manufacturing was ramped up to not only meet the consumer demand, but to also rebuild inventory levels. This is generally what happens coming out of a recession and why the Purchasing Manufactures Index (PMI) expands rapidly until the inventories get rebuilt and then slows to the sell-through level. When these numbers are released, there are a number of other facts that are released as part of the survey, which gives us better colour on what is going on.
The release of the March PMI showed the index had risen to 64.7, the highest reading since Dec. 1983. Non mfg PMI (ie services) rose to 63.7, its highest reading since July 1997. The prices index rose to 74, the highest since July, 2008. The Fed Philly Region’s survey provides a little more colour. It suggests that business conditions are at their highest level since April, 1973. New orders have also surged at the fastest pace since 1973 while the work week lengthened at a record pace. Manufacturers also reported a backup in UN-filled orders, slower inventory builds by their customers and more delays in supplier deliveries. The future employment index posted its highest level since October 1976, while 64% of firms reported labor shortages and 59% reported jobs/skills mismatches. They further reported input price pressers surged at the fastest pace since March, 1980, partially due to higher wages and they anticipate being able to pass higher costs on to their customers. However, seemingly inconsistent with these reports has been an increase in initial jobless claims. In total, there were still more than 18 million claiming State or Federal unemployment benefits. Yet, total job openings rose to 7.37 million, the highest since January, 2019 and the ratio of unemployment to openings declined to 1.35, the lowest level since last March when unemployment was 4.4% vs 6% today. Overall, 42% of independent businesses had openings while 19% of small business owners plan to raise worker compensation over the next three months. Furthermore, the number of commodities that rose in price or were in short supply hit record levels last month. These conditions are usually associated with an impending inflation.
For perspective, let’s look at where we have come from. Last spring payroll employment dropped by 22.4 million people. Eight million dropped out of the labor force leaving 17.4 unemployed. GDP dropped 19.2% in the first half of last year then soared at an 18% rate in the second half. Employment is still 8.4 million below its record 152.5 million in February last year.
So, the point I’m trying to make is that there is some reason for the disconnect between the demand for employees and their reluctance to return to work. For sure, some of it could be due to a member of the family having to stay at home to take care of children. It’s estimated this could be five million people. But substantial unemployment benefits could also be causing people to stay home to collect these payments. $140,000 in Kansas for a couple probably goes along way and now that summer is almost here and benefits last until September, there is probably no hurry to get a job.
The picture this paints is a strong economy that has yet to see the services side engage, but which will as vaccines roll out. Stresses in manufacturing from supply shortages, rising commodity prices and labor shortages are likely to result in higher prices and inflation, which could be the most critical variable affecting interest rates and the market. From the Fed’s perspective, they feel that inflation in the near term will be higher due to the “base effect”. This is the year over year difference between last year’s depressed prices and where they are today. Furthermore, they have already conceded to inflation reaching 2.4% this year and have said they wouldn’t mind seeing a period of overshoot before getting concerned. Others believe that secular forces such as technology, globalization, demographics and excessive levels of debt will contain inflation in the long term. Maybe so, but I have my doubts. Outsourcing manufacturing jobs to China may be last decade’s theme. Going forward, a lot of jobs will be created in healthcare, especially caring for the elderly at home. It’s hard to outsource that. Also, the Financial Crisis of 2009 threw thousands of homes on the market at depressed prices. Housing prices are, dare I say, going through the roof and will eventually back into home owner’s equivalent rent, which is one third of the consumer price index. Furthermore, the Producer Price Index, which reflects a lot of commodity prices, showed the highest annual gain in nine and a half years in March. It takes a long time to build a new copper mine or steel mill. And although people may start coming back into the workforce this fall, the hourly compensation for all workers is already rising at 5.3%.
But supply and demand will also play a role in determining interest rates. Debt, which the government is relying on to stimulate the economy and accomplish its social goals is beyond anything that I have ever witnessed. The sum of all government and corporate debt is now about 2X GDP. Bonds issued by non-financial corporations rose from $355 bn in 1980 to $6.38 trillion in 2020. Year to date, the US Treasury has issued $4.1 trillion in debt, up 50% from a year ago, while globally the supply of new government debt has risen 78%. One has to ask, how does the government ever get off this treadmill without the economy falling off a fiscal cliff? Modern Monetary Theorists say don’t worry, the Fed will keep buying. But the caveats is that there would be a reaction if inflation heats up. Taxes would have to be raised. Unfortunately, I don’t see how raising taxes helps an economy.
On the supply side, personal savings rates are the highest since the mid 1940’s. Last April savings soared to $6.4 trillion on the CARES Act distributions before falling back to $2.3 trillion in December as people were able to get out and spend. This January saw savings climb $1.6 trillion to $3.9 trillion on the distribution of the social benefits from the second stimulus bill. That leaves us with about $2.4 trillion in excess savings over base line which amounts to about 11% of GDP. Furthermore, revolving credit dropped $118bn adding even more firepower to the consumer’s war chest. Maybe an even better way to look at it is through M2 which is the aggregate of all savings, currency, money market funds, etc., which rose 27.1% year-over-year to $4.2 trillion an unprecedented level.
Deposits at commercial banks that include corporations rose $2.9 trillion last year causing banks to buy $758 bn in Treasuries bringing their total to $4.8 trillion. Along with the Federal Reserve, this has helped finance the government’s deficit. The trouble with this is that consumer savings short circuit the government’s stimulus objectives just as the banks did after the Financial Crisis by not sending and getting the funding into the economy. With the vaccine being rolled out, services like travel and entertainment coming back and summer weather arriving, it is likely consumers will start to spend more aggressively and add to what is an already robust economy.
So, where does this leave our investment strategy? Well, the first quarter treated us very well and was a nice follow up to a strong year-end finish. In Canadian dollars, the S&P 500 finished +4.9%, while the TSX improved 8.1% and the Canadian bond market declined -5.04%. However, below the surface there was a lot going on. Value outperformed growth which can be measured in a number of ways. Using the S&P indices value outperformed growth 10.664% to 0.746%. The NASDAQ, home to a number of technology companies saw over a 10% decline from its mid-February peak. And, as I said, the first quarter was a follow-through to a trend that started September 1st, last year, which has seen the value companies appreciate 18.5% while growth marked time up only 1.9%. There are a number of explanations for this divergence, but the one that probably has the best correlation and fundamental rationale is interest rates.
As measured by the 10 year US Treasury, rates bottomed at 0.54% last August and increased to 0.93% by the year end. They then moved significantly higher to 1.74% by March 31st. This increase in rates reflects both the strength of the economy and the perception that inflation could heat up. Fundamentally, it will help the bank stocks as higher rates will help their earnings and financials are the poster child for value. If higher rates correlate to higher inflation and a stronger economy, that means good things for commodity producers and economically sensitive companies which again are generally value stocks. To the contrary, higher interest rates tend to hurt growth stocks and any long dated assets such as bonds. It doesn’t effect growth company earnings, but it does hurt their valuations as most carry high price earnings valuations. These valuations are determined through discounted cash flow models and the higher the discount rate, the lower the valuation. Goldman Sachs did a study that equates a 100bps rise in rates to a 14% impact on DCF models. In fact, the 70bps rise in rates we witnessed this year seems to correlate well with the 11% drop in the NASDAQ Composite that we saw from February 12th to March 8th. This also explains why the bond market experienced its worst quarterly performance since 1976 as the 30 year Treasury fell 15.66%.
The question we now face is whether this value versus growth competition is about to flip back in favour of growth. It could, but from our view on the economy and inflation it seems like interest rates will continue to support value. As we stated above, the economy is quite strong, about to get another jolt of fiscal stimulus and will see vaccine relief open up the service sector. Inflation should heat up even if only transitionally as workers wait for benefits to run out creating a labor shortage until at least this fall. Finally, the government is going to continue to float more bond issues, but will need even greater reliance on the Fed if banks start to sell their treasuries to make loans.
Furthermore, growth hasn’t had any kind of a setback, so it is still expensive. The elite eight which includes the FANG stocks still trade at 40X earnings. For context, the S&P 500 trades at an elevated 22X forward earnings. That is expensive and one has to hope this is resolved through continued earnings growth which is what is now expected. But that growth is likely to come from the more economically sensitive companies. Value on the other hand has outperformed for only seven months after underperforming for thirteen and a half years, the longest stretch on record. Previous underperformance was during the tech bubble from 1998 to 2000 and before that, the second longest underperformance was the biotech bubble in the early 1990’s that lasted 3.8 years. And finally, there was the devastating period for value in the early ‘70’s when the “Nifty Fifty” took charge. So, I’d give value the benefit of the doubt right now.
As for the market generally, we might start looking out for a correction. Working against this caution is the enormous amount of liquidity that could come into the market. Some of the money from President Biden’s latest bill will find its way into the equities. But as we proceed through the summer and the economy picks up further, liquidity will have to come from somewhere if there are no more cheques from the government. Historically, it comes from financial assets. Furthermore, as you get closer to 2022, the prospects aren’t as compelling as they are now. You’re likely going to be looking at tax increases. They are already built into corporate earnings forecasts of roughly $20.00 per share but I’m not sure there are not more on the way. The economy could overheat and inflation could move higher than the Fed antipicates, and I would expect Powell to do an about-face as he did in January, 2019 when his rising interest rate policy caused a dramatic stock market sell off. His last two policy changes have been market driven and a bad reaction in the bond market to higher inflation would force him to act.
You will also have the prospects of the current government losing some seats in Congress which traditionally happens in off-year elections. You could then return to a more divided agenda and less likely stimulation.
So, we’ll stay with a value bias and remain somewhat cautious as we move through the summer.
Grant’s Interest Rate Observer
Wall Street Journal
November’s stock market gains will go down as some of the best on record. These were driven by earnings growth as well as three pieces of news that were a relief from worst case fears. First was the Biden win without giving control of the Senate to the Democrats, second was the Pfizer vaccine announcement and last was Biden’s telegraphed appointment of Janet Yellen as the next Secretary of the Treasury.
Here are some thoughts on the market, the election, the economy and the Federal Reserve.
The S&P 500 gained 10.8% (7.74% Cdn) in November, while the Dow Jones did 1% better. That’s the strongest monthly gain since January 1987.
Interestingly, value stocks outperformed growth stocks by roughly 45% with energy, financials, industrials and materials doing better than the technology, internet companies and stay-at-home stocks that had been leading the market.
Smaller companies significantly outperformed bigger ones, and businesses like airlines, hotels, resorts and cruise lines surged on the prospect of a vaccine.
A critical issue is whether value-oriented stocks will maintain their leadership or whether leadership will revert back to a small group of technology companies. The test is likely to come after a small correction, when we see which group leads the next rally.
With 86% of companies trading above their 200-day moving average and bullish sentiment at 60%, short-term caution is warranted. Nevertheless, there is a lot of money still available to enter the market, as cash and other liquid assets have shot up $2.6 trillion to $16.3 trillion.
The Biden win without a blue wave allowing the Democrats to take over the Senate is probably more about what won’t happen than what the new administration will propose. Off the table are higher taxes, massive federal spending, universal basic income, nationalized healthcare, a packed Supreme Court and a Green New Deal.
However, there is a runoff election this January for two Senate seats for Georgia. The Republicans lead in the polls, but it is worth anticipating what happens should the Democrats win those seats and the Senate becomes tied at 50 members each.
Kamala Harris as Vice President presides over the Senate and would then have a tie-breaking vote. In this scenario, Republicans would lose their committee chairmanships and their ability to serve as a check and balance to Biden’s plans.
If the Democrats get organized, what has come off the table would suddenly be back on again. However, the Democrats aren’t unified. For example, Joe Manchin, a Senator from West Virginia, is an avowed conservative who recently said, ”I want to rest those fears for you right now… whether it be packing the courts or ending the filibuster, I will not vote to do that.” He further stated that the “Green New Deal and all this socialism was not who we are as a Democratic Party.”
Nonetheless, as Yogi Berra once said, it ain’t over until it’s over.
Third quarter GDP came in at +33.1% and the fourth quarter is expected to be around +11%. Nonetheless, the market is caught in a conflict. For the next six months, the Corona virus count could continue to climb, threatening the near-term expansion until a vaccine finally rids us of the pandemic and we can get back to normal.
Back in March, the passing of the CARES Act provided Americans with a one-time payment of $1,200 and an additional $600/mo through August. In all, the government provided $842 billion in new benefits while the earnings shortfall amounted to $444 billion, resulting in $398 billion in extra stimulus. It’s the first recession where personal income actually increased.
Not all of this income was spent right away. April savings hit $400 billion, well above the $103 billion baseline as stores were closed. This pushed the amount of cash on household balance sheets over $2.0 trillion. More recent spending on goods has benefited from pent-up demand, while spending on services remained restricted. For manufacturing, this spending arrived as inventories were depleted.
Today, savings are being drawn down and CARES ACT benefits will run out for about five million people at year end. With COVID cases spiking, we’ll have to wait and see if the economy can skate through this soft patch.
Nonetheless, a vaccine and better weather in the spring provide a lot of hope.
One of the recent announcements that encouraged the market was Biden’s telegraphed nomination of past Fed Chair, Janet Yellen, as Secretary of the Treasury.
First, it eliminated a more threatening option such as Elizabeth Warren, and was a more moderate choice than what many progressives in the party had hoped for. The selection immediately sent bank stocks 1.9% higher on the day and 4.6% higher for the week.
However, Yellen has a lot in common with the Biden agenda. She favours more government fiscal spending, shares concern over labour market inequality, and was considered one of the most dovish FOMC members. As chair of the Fed, she even suggested that congress should give the central bank the authority to buy equities.
Loose monetary policy is good for stocks and will give Biden a workaround for his policies if Congress won’t cooperate, as he can apply executive orders with financial support from the Fed.
Down the road, this is embarking on untested Modern Monetary Theory, where the government takes over from the banks in deciding what gets spent and who gets to spend it. It is further confirmation that the government will practice Financial Repression, a time-tested method of inflating away the excesses of too much debt by holding interest rates below the level of inflation and GDP growth.
The market has had a pretty significant rally but nothing that isn’t consistent with what we have seen coming out of other recessions. Yet, in the short term, it’s overvalued and could react to negative news coming from a Covid lockdown. The election is behind us, which has resolved a major uncertainty with an acceptable resolution, especially since it appears to assure further monetary policy support.
What is still uncertain is the potential for a surprise coming in January from the Georgia Senate runoff and the stock market leadership in this next phase of the market. But a rotation to value or economically-sensitive companies would be consistent with what we have seen before.
In the meantime, November’s performance has been a reassuring shift in market sentiment.
Last fall, the market sold off sharply as Federal Reserve Chairman Powell suggested that the Central Bank was intent on raising interest rates further. Bad views for the economy and the stock market.
At the end of July, President Trump tweeted that he was going to introduce tariffs on another $300 billion of Chinese goods. The 10-year Treasury yield promptly dropped to 1.70%. Lower rates, good news, right? Nope. The market dropped over 6% in a week.
So, what gives, and who is setting interest rates?
What’s the old axiom? If it’s too good to be true, it probably is. That might be fitting for how the market performed last year.
By the end of 2017, most forecasts were pretty optimistic. First, you had a tax cut approval, earnings for the year now look like they will come in about 24% higher, GDP saw two quarters of growth over 3% which is pretty rare at this stage of the business cycle. To top it off, unemployment remains very low at 3.7%. How could the market not be higher?
Each quarter, we write a commentary about the stock market which generally has a pretty near-term focus. In our most recent piece earlier this month, we reiterated a positive outlook for equities as long as a recession or tight monetary policy can be avoided.
However, if you step back from the day to day barrage of facts, there are some longer term factors and issues which we’ve identified and explored regarding the direction of interest rates and are monitoring in the context of the direction of the Fed’s policies and the economy.
We’ve said repeatedly that we believe the current bull market will continue until there is either a recession or a restrictive monetary policy.
So far, that position has been accurate as the S&P 500 recently hit a new all-time high and the length of this bull market, according to some, has become the longest on record, beating the previous bull market that took place between October 11, 1990 and March 24, 2000. However, there are those who say the market decline in the 3rd quarter of 1990 was actually a correction. If they are right, then the bull market of the 1990’s actually started on December 4, 1987. That extended bull market lasted 4494 days compared to about 3500 for our current run. That might lend some comfort to those trying to handicap how far we are into this cycle. Furthermore, the current economic expansion supports the market as it will become the longest expansion on record in July, 2019.
Since the January high and subsequent 10% correction, the market has been in a relatively narrow trading range for roughly five months. However, earnings estimates continue to improve and the economy is reasonably strong. So, why the hesitation? In my opinion, it has to do with having a clear view of the future and what is fogging our lenses is the Federal Reserve policy and foreign trade negotiations. Markets don’t like uncertainty and until we get some resolution to these issues, especially the trade impasse, the market isn’t likely to make much headway.
Believe in the Easter Bunny? Then maybe you’re an April fool. Believe in foxes, as in “Crazy like One”? Then maybe Trump’s tariff strategy isn’t that bad. OK, my apologies to the foxes.
Nonetheless, tariffs and trade seem to be the latest issue to afflict this market which came shortly after an inflation scare in the form of a higher than expected January wage increase which sent the market to its first correction of over 5% in more than a year.
Although they may seem like uncorrelated issues, they are not. Both factors have an impact on profit margins. But I’ll come back to this shortly because it is the essence of the bear case for this market.
In the meantime, I wonder if this market is like the proverbial bug in search of a windshield; it is looking for a reason to correct and these are the most convenient excuses. Earlier, many thought the market was overvalued and should correct. But, with tax cuts and synchronized global growth, valuations have come back into the reasonable zone.
There’s an old adage on Wall Street that says, “Buy the rumor, sell the news.” It’s a simple synthesis of how the market operates in that it reacts to expectation or forecasts, it doesn’t wait for them to be announced. And when there is an announcement, it’s often too late for an investor to take advantage of it because it’s already priced into the market. And for a trader, it’s time to sell.
We saw a good example of “buying the rumor” late last year as it became more apparent that tax reform legislation would be passed in the United States. When it was signed into law on December 22nd, that was the news. Time to sell? Well, we think not. In this case, tax reform is broadly considered positive, but the real impact will be company and industry specific. So, we think the “news” will be revealed in the fourth quarter earnings reports which will start in mid-January.