November Investment Comments
Covid-19 statistics have improved recently for our country as a whole, although trends differ by region. About 65% of U.S. adults have been vaccinated according to the Mayo Clinic. For those over 50 years old the vaccination rate is higher than 80%. Covid-related fatalities are very rare for vaccinated people. Further good news comes in the form of a new antiviral pill from Merck which improved outcomes dramatically in a placebo-controlled trial, stoking hopes that future waves may be easier to treat. Life is gradually getting back to normal. International travel restrictions are loosening, and most schools have reopened for in-person instruction.
Life is also getting back to normal in Washington DC, where division typically rules. A spat over the debt ceiling looks like a small skirmish in the larger battle over ambitious spending and tax increases. Centrist Democrats hold a lot of power in the Senate and appear to be taking full advantage of their political leverage.
The debate in Washington is affected by the fact that the economic recovery looks a little fragile. The economy continues to show steady growth, but at a rate modestly below prior expectations. September’s jobs report was disappointing, continuing a theme from August. Approximately 200,000 jobs were added, well short of estimates for 500,000. Upward revisions from prior months could be viewed as closing about half the gap versus expectations, but the number remains a little disconcerting and raises the question whether the economy can be expected to reclaim its pre-pandemic growth trajectory? More patience seems to be warranted, as the pandemic’s shadow is likely to be very long and affect different industries over different timeframes. The Labor Department highlighted seasonal school staffing as one area of particular weakness in the latest report.
Despite the tepid jobs number, many businesses are complaining about a shortage of workers. People simply aren’t showing up to take the jobs available, which may say more about the jobs themselves than the people eschewing them. Arguably worker shortages are simply wage shortages by another name. Any job can be staffed for a high enough wage. Businesses with serious staffing shortages will have to raise prices and pay employees more. Businesses who cannot raise prices in an inflationary environment are uncompetitive. Average hourly earnings increased 4.6% in the latest jobs report, similar to the rate of measured consumer price inflation.
The Federal Reserve is changing its tune subtly but significantly on inflation. Critics challenged, even mocked, the Fed’s previous position that inflation would prove “transitory.” With the CPI up over 5% in the trailing twelve months, financial markets roaring, and the economy still far from the growth frontier where inflation typically accelerates, it is very hard to imagine that inflation will politely return to its pre-pandemic average of approximately 2% on any kind of transitory timeframe. The Fed is now backing down from that position. Chairman Jerome Powell recently admitted that inflation is running above the Fed’s estimates with no sign of abating until 2022. St. Louis Fed President James Bullard warns of possible reacceleration from the current level and speculates that when inflation does eventually cool down it “may not dissipate back to the Fed’s 2% goal. Small changes in expectations for long-term, steady-state inflation, say from 2% to 3%, can have very big implications for the valuations of long-duration assets. Bond yields have increased recently but generally remain below the levels reached earlier in the year when inflation first started to accelerate. The market seems to hold out some hope that the inflation genie will slump back into the bottle. If not, then this trend of rising rates will have some legs.
Fed balance sheet tapering would have seemed like the rational response to rising inflation earlier this year, but the Fed chose the transitory stance. This stance provided cover for the Fed to continue exchanging new dollars for existing bonds. At this point, the sheer quantity of dollars sloshing around in the financial system has reached a ridiculous level. On a nightly basis the combined banking system is sending back to the Federal Reserve about $1.4 trillion of digital dead presidents in exchange for a tiny interest payment via the Fed’s reverse repurchase window. Banks are supposed to be in the business of lending dollars, not pushing them back and forth to the Fed overnight. When lending opportunities are scarce, plan B is normally to purchase low-risk securities—such things as corporate or government bonds. This reverse repurchase volume implies that banks have nowhere they want to lend and no debt they want to buy, at least not at current rates. Enough is enough. The Fed should have tapered its bond buying long ago.
In fairness to the Fed, assuming inflation does not run absolutely rampant in the coming years—which we do not expect—the Fed’s response to the pandemic will probably go down in history as quite successful, if maybe somewhat excessive. Writing today in late 2021, and currently living through the “excessive” part of that story, however, we report that balance sheet expansion no longer feels supportive of the financial system. If anything, the Fed may be destabilizing the system by suppressing interest rates, hollowing out the banking sector, and stoking inflationary concerns.
Speaking of unstable situations, we said last month that China’s Evergrande Group was on the cusp of bankruptcy. Early indications are that China’s ruling party is reluctant to offer support, preferring to let market forces determine the losers and the extent of contagion. As of this writing Evergrande has not yet triggered the conditions that define bankruptcy. It is starting to miss interest payments on its debt, however.
The U.S. stock market has faltered since the start of September. This seems logical in the presence of rising interest rates, political arguments, and financial stresses overseas. We can only expect more volatility heading into the third quarter’s “earnings season.” We observe that about 25% of U.S.-listed stocks are currently down at least 20% from their 52-week high. About 10% of stocks are down that much from their highs in the last fifty days. Volatility is generally a good thing for stock pickers. That is where opportunities come from. Investors who focus on growing, profitable companies should make progress over time, whatever happens to prices and interest rates.
Miles Putnam, CFA