May Investment Comments
After taking extraordinary measures to counter the impact of the pandemic, the Fed can reasonably claim “mission accomplished” as it relates to the full employment component of its dual mandate. The March report showed employers added 431,000 jobs while the unemployment rate dipped to 3.6% from 3.8% the prior month. This was only slightly higher than 3.5% registered in February 2020, representing a 50-year low. Job gains were also revised higher for the first two months of this year. Employment has rebounded sharply, with the economy now possessing just 1.2 million fewer jobs than in February 2020, a far cry from 21.6 million fewer jobs at the trough two years ago.
Labor force participation continues to run below pre-pandemic levels but is recovering. In March it inched up to 62.4% versus a recent low of 60.2% in April 2020. There are multiple drivers leading individuals to rejoin the workforce including declining household savings, as well as lower Covid cases, allowing workers who were home with children during school or caring for sick family members to return to the workforce. It would be helpful if this trend continues given there are currently more job openings than unemployed workers. Also reflective of the tight labor market, workers are quitting their jobs at near record rates, often for better opportunities. Fed Chair Powell has even expressed concern that the job market may be overheating, feeding higher inflation. Average hourly earnings grew 5.6% in March from the prior year, though this remains below most measures of inflation.
The progress made on the jobs front leads to the second directive under the Fed’s dual mandate, price stability. The Fed pivoted from its “transitory” stance regarding elevated inflation late last year, and as 2022 has progressed its concerns regarding inflation, have seemingly only increased. In March, consumer prices grew at their fastest pace since 1981, up 8.5% compared with the prior year. A portion of the increase can be attributed to energy prices that surged following Russia’s invasion of Ukraine. Energy prices in March were up 32% versus a year ago while groceries increased 10%. Excluding volatile food and energy prices, “core” inflation grew 6.5%, slightly below expectations but still the highest core measure in nearly 40-years.
The pandemic-related supply chain disruptions that were once expected to self-correct in a relatively timely manner have persisted, leading to higher prices that have proven sticky. There are other factors exerting upward pressure on prices as well. Russia’s invasion of Ukraine added a commodity supply shock, reflected by the surge in energy prices, along with further constraints on the supply chain that don’t appear likely to ease in the near term. Furthermore, the pandemic exposed supply chain vulnerabilities and set off a trend toward onshoring as companies attempt to secure more dependable supply. This shift represents the reversal of a multi-decade trend of moving production offshore in an attempt to lower costs. Consumers in turn benefitted from lower prices, reflected by inflation that ran just 2.4% annually from 1990-2019 according to the consumer-price index. The shift toward onshoring will unwind some of this benefit and put upward pressure on prices in coming years, implying inflation going forward may be something other than cyclical. A survey recently released by the Fed’s New York branch showed consumers anticipated inflation hitting 6.6% over the next year with expectations over three years at 3.7%. Both are well ahead of the Fed’s 2% inflation target.
To quell inflation, in March the Fed increased interest rates for the first time since 2018, bumping the targeted range for the federal funds rate by a quarter point to 0.25%-0.50%. Officials’ projections also reflected expectations the rate will increase to nearly 2% by year end, modestly higher than pre-pandemic levels. The median forecast from Fed officials also reflects rates increasing to approximately 2.75% by the end of 2023. Investors are looking at this forecast with a skeptical eye, as market expectations for 2023 reflect rates higher than that.
Many have argued the Fed is behind the curve in fighting inflation given high recent inflation readings and the fact the Fed kept rates near zero and continued to buy securities until March. The March decision seems late in coming given the Fed’s pivot late last year to abandon the word “transitory” in describing inflation along with comments from certain Fed officials acknowledging serious concerns regarding elevated prices. These officials have expressed an opinion that a faster return to a “neutral rate,” which neither spurs nor suppresses growth, is warranted under the current circumstances.
The minutes for the March meeting indicated the Fed resisted a half-point increase due to the uncertain impact of Russia’s invasion of Ukraine. However, a half point move at its next meeting in early May is viewed as a near certainty. If this occurs, it will be the first time the Fed has raised rates at consecutive meetings since 2006 and the first time it has raised rates by a half point since 2000. The Fed is also poised to begin reducing its $9 trillion balance sheet as soon as May. The minutes offered some detail as to how that runoff might proceed, and it is faster than the last time the Fed shrunk its balance sheet between 2017-2019, when the monthly securities runoff peaked at $50 billion. Indications are after a three-month ramp, the Fed would allow up to $95 billion in securities to mature each month without reinvesting the proceeds. Given the limited history of asset runoff for the Fed, it is hard to quantify the potential impact. Chair Powell recently estimated the impact might be the equivalent of another quarter point rate increase this year, though an argument could easily be made it will be greater. Avoiding a recession while raising rates and shrinking the balance sheet will be far from an easy task.
The Fed’s anticipated actions have led to a rapid rise in Treasury rates. Since the start of the year, 10-year Treasury yields have increased from around 1.50% to approximately 2.75%. The impact can be seen in rising consumer borrowing costs. For example, 30-year mortgage rates are now approaching 5.00%, significantly higher than the sub-3.00% rates available over much of 2021. There are concerns about what this means for affordability. Higher rates also put pressure on P/E multiples, meaning heavier reliance on earnings growth to move the market forward. Earnings are expected to be solid in the coming year, with consensus expectations of just under 10% earnings growth in 2022. Also, real yields — the rate investors receive on government bonds after subtracting inflation — remain negative, providing investors incentive to seek out assets farther out on the risk spectrum.
While there remains a great deal of macroeconomic uncertainty, the economy today looks to be in reasonable shape and private balance sheets remain relatively strong. The uncertain environment reinforces the importance of investing in growing companies with strong fundamentals and reasonable valuations.
James Skubik, CFA