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Gerald Connor / July 19, 2021

We All Agree, Up To A Point

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.

Economy

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.

Inflation

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.

Economic Theory

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.

Federal Reserve

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.

Stock Market

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.

Conclusion

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
Chairman

Credits
Grant’s Interest rate Observer
Deutsche Bank Research
Apline Macro

Rosenberg Research
Yardeni Research
Ned davis Research
John Aitkens

J.P Morgan
Barrons

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