March Investment Comments
The evidence continues to grow that the Federal Reserve was caught wrong-footed by how rapidly the economy has recovered. Unemployment has fallen more quickly than expected and wages have moved higher. The healing of the labor market and emergence of higher inflation has resulted in a shift in the Fed’s focus towards tackling inflation, a dramatic change from recent years when it was more worried about inflation persistently running below its targeted 2% level. In less than a year, the Fed has transitioned from forecasting no rate increases before 2024 to now expecting as much as a half-point rate hike in the next month. To be fair this wasn’t easy terrain to navigate, as the Fed was reacting to a multitude of highly variable factors such as how quickly the virus receded and how quickly supply chains healed. Still, for an entity that claims to be “data dependent” the Fed seemingly disregarded earlier signs we were headed in this direction.
The January CPI showed inflation of 7.5%, a 40-year high that was ahead of already elevated expectations. Core prices, which strip out volatile food and energy, advanced 6.0%. Supply and demand imbalances related to the pandemic continue to contribute to higher levels of inflation; however, price pressures have broadened, and inflation tends to be sticky. A stronger economy is pushing up rents and wages, which appears likely to keep inflation elevated even after supply-chain disruptions ease. Despite downward pressure on inflation as supply chains normalize and base effects take hold, it seems rather presumptuous to believe inflation will cooperate by gently trending lower to the targeted 2%.
The market seems to believe a combination of Fed action and improvements in the supply chain will result in inflation approaching pre-pandemic trends. Consensus inflation expectations by year end are hovering around 3% while the 10-year implied inflation rate is closer to 2.5%. Whether these prove to be correct is up for debate, but implied longer-term inflation expectations reflect confidence the Fed will be able to effectively manage inflation.
While inflation is the primary current focus, the employment market paints a sunnier picture. The January jobs data vastly exceeded modest expectations. Employers added 467,000 jobs, while the unemployment rate increased to 4.0% from 3.9% as more people joined the workforce. Employers also added 709,000 more jobs in November and December than initially expected. The U.S. still has about 2.5 million fewer people employed than in January 2020, even as the economy has exceeded its pre-pandemic size. It is hard to argue we are not currently near full employment and the tight job market is feeding into wage inflation. The Federal Reserve Bank of Atlanta’s Wage Growth Tracker, which adjusts for the composition of workers, reported a 5.1% year on year increase in January, the fastest pace since 2001.
In its efforts to combat inflation by slowing the economy, the Fed risks causing a recession. Historically, attempts to bring down inflation have done just that. Despite a clear shift in its stance, the Fed is exercising some restraint in not moving too quickly so as not to disrupt markets. As a result, it is currently in the awkward position of continuing its bond purchases while inflation is running multiples of its targeted level. After initiating a plan to reduce its monthly bond buying last November, the final round of bond purchases will conclude in March, adding to a balance sheet already holding more than $9 trillion, more than double two years ago.
The ongoing bond purchases reflect a particularly odd dynamic given inflation concerns have risen to a level where there is at least some consideration of not only letting bonds mature without reinvesting proceeds, as the Fed did between 2017 and 2019, but also of outright sales. The Fed prefers to implement policy via interest rate hikes, as there is greater uncertainty as to how the economy and investors will respond to changes in the balance sheet. Ideally, it would prefer to mirror the mechanics of the balance sheet runoff in 2017-2019, allowing bonds to mature without reinvesting the proceeds, while simultaneously raising rates. A decision to sell down holdings on the balance sheet would signal increasing concern over inflation and would not likely be well received by markets.
Prior to any balance sheet reduction, there will be rate increases. Following the January CPI report, the question shifted from whether the Fed will raise short-term rates at its March meeting, to by how much? It is a near certainty there will be at least a quarter-point increase and the CME FedWatch tool indicates about a 50% probability of a half-point increase at that meeting. To put that into context, the Fed hasn’t raised rates by a half percentage point since 2000. For the year, the consensus expectation is for the Fed to raise rates seven times assuming quarter point increases, bringing the target rate to 1.75%-2.00%. This is consistent with recent communications by Fed officials focused on returning rates to a more neutral stance that doesn’t slow or spur further growth. This is referred to a “neutral” rate, of which estimates vary but generally fall in a range of 2%-3% assuming inflation returns to more normalized levels.
Yields have moved higher in response to anticipated monetary tightening. The yield on the 2-year Treasury, which is more sensitive to Fed policy expectations, increased to 1.56% in the wake of the CPI report, registering its sharpest one-day move since 2009 and up from 0.73% at year end. The yield on the 10-year Treasury also breached 2% for the first time since mid-2019 after ending 2020 at 1.52%.
The sharp rise in yields has contributed to market volatility, particularly for stocks whose value comes from anticipated earnings far in the future, as those earnings get discounted to a lower present value. This has resulted in value stocks outperforming growth stocks. Through mid-February, the Russell 1000 Value Index has outperformed the Russell 1000 Growth index by 9%. Multiples have come down given the selloff to start the year, which is to be expected with higher interest rates. The forward P/E for the S&P 500 is now just under 20x, down from the 21.5x entering the year.
From an earnings perspective, things look reasonably good even if growth is expected to slow. EPS growth for the S&P 500 in 2021 is expected to register approximately 47%, with 26% growth in Q4. Given more challenging comparisons, EPS growth in the first quarter is anticipated to slow to 5% with full-year consensus estimates reflecting a greater than 8% increase. As a result of the pandemic, there are many companies either overearning or underearning relative to what they would generate in a normalized environment. This presents both opportunities and potential traps. Overlay a Fed that is determined to tighten conditions, and a focus on fundamentals becomes even more important. In contrast to the speculative frenzy that took hold of markets in early 2021, the current backdrop is one that should favor companies with solid and improving fundamentals, which is an environment we prefer.
James Skubik, CFA