February Investment Comments

While Covid and politics still dominate the general news cycle, the financial news is focused on inflation concerns.  Economic growth appears solid, but that is exactly when the Federal Reserve needs to act.  In the words of former Chairman William McChesney Martin, the Fed’s job is “to take away the punch bowl just as the party gets going."  The challenge is that the Fed failed to notice the party was in full swing for six months.  Perhaps the reason it has fallen way behind is that it not only served as bartender but began imbibing its own concoction.

Inflation soared to 7% in 2021, a rate last reached 40 years ago.  Even excluding the volatile food and energy sectors, so-called “core inflation” rose 5.5%, the highest in 31 years.  Left unchecked, inflation can become imbedded in our cost structure through cost-of-living allowances in wages and Social Security.  On top of that, flaws in the way housing is figured into the Consumer Price Index mean that recent increases in home prices and rents have yet to be fully reflected in inflation statistics.

One minor cause of higher inflation is that prices were subdued by weak demand in the early part of the pandemic, leading to below-average inflation of 1.2% in 2020.  However, the real culprits are overstimulated consumer demand at a time when global production and transportation have been affected by responses to Covid.

The Fed dropped interest rates to zero in March, 2020 and took other actions such as purchasing Treasury and mortgage bonds.  At the same time, Washington unleashed three waves of stimulus spending.  While these responses made sense at the outset of the pandemic, the economy stabilized fairly quickly and each additional round of stimulus has become less effective and less necessary.

Despite generally strong job gains and an unemployment rate approaching the record low of 3.5%, the U.S. still has 2.7 million fewer people employed than in January, 2020, even as GDP roared past pre-pandemic levels.  A lack of workers has constrained our ability to meet demand for goods.  When demand is greater than the capacity to produce, manufacturers, distributors, and retailers have the opportunity to raise prices.  That is how supply and demand interact.  Higher prices should draw out more supply, but few firms will build more factories to meet a temporary supply-demand imbalance.  Higher wages are drawing out more workers, but whether through fear of contracting the virus, child care requirements, or a decision to retire, the workforce hasn’t rebounded fast enough.  Typically, consumers would say no to higher prices, but U.S. consumers are flush with cash following three rounds of stimulus and reduced opportunities to spend in early 2020.  They have largely cooperated with rising prices.  Imports haven’t provided much relief, as China’s “Covid Zero” policy has led to reduced factory output.

All signs point to strong U.S. growth, and that is part of the problem.  GDP is expected to rise at an annualized rate of 7% in the fourth quarter, up from a disappointing 2% in Q3.  About 90% of the global increase in consumption of durable goods (autos, appliances, furniture, etc.) since 2018 has occurred in the U.S.  Strong demand from the American consumer is stoking global inflation.  U.S. factories are trying to keep up, with U.S. spending on factory equipment rising 13% last year vs. 3.6% growth in the eurozone and flat spending in Japan.  Still, it hasn’t been enough to keep pace with demand.

At its November meeting, the Fed tacitly acknowledged its tardiness.  It decided to gradually reduce its purchases of Treasury and mortgage securities over a period of six months, a prelude to hiking interest rates.  It pays for these securities by debiting the Fed account of the bank or brokerage firm processing the sale.  That is to say, it prints the money.  In promising to print less new money this month than last month, the Fed is still pursuing monetary expansion, but at least it admitted that a new direction is called for.  The Fed is also haunted by the 2013 “taper tantrum” when it induced market convulsions while trying to reduce, or taper, similar purchases.

At its December meeting the very next month, the Fed decided tapering over six months was being too patient.  Instead, it would wind down purchases by March according to the announcement following the meeting.  After ceasing new purchases, the Fed will likely vote to increase short-term interest rates, the first of three rate hikes anticipated in 2022.  When minutes of that meeting were released in early January, investors discovered that the Fed is also considering shrinking its bloated balance sheet by not reinvesting proceeds from maturing securities.  That’s when investors began to realize the Fed is serious about slowing the economy in order to reduce inflation.

Equity investors don’t like to hear about “slowing the economy.”  Economic growth is good for corporate sales and profits, even if some inflation is involved.  But when inflation runs too hot for too long, the Fed ends up slamming on the brakes rather than gently tapping them.  In fact, the Fed has a history of hitting the brakes harder than equity investors would like.  Hitting the brakes can induce a recession, investors’ greatest concern.  Tapping early is better than slamming late.

The impact of the Fed’s pullback in bond purchases is evident in the market.  Treasury yields have gradually risen to their highest levels since before the pandemic.  Even still, the 1.85% yield for a ten-year Treasury doesn’t seem like adequate compensation when inflation has been running 7%.  That equates to a “real” yield of -5%.  We are surprised rates aren’t higher still.

Equity investors need to be cautious given the Fed’s growing realization it has fallen behind and its determination to make up for lost time.  But where else can we turn?  Bond yields will likely go up, causing prices of existing bonds to decline.  Yields are already lower than inflation.  Build up cash?  Bank, CD, and money market yields are virtually zero, or -7% in real terms.  Commodities?  Not a good answer since they will likely bear the brunt of any economic slowdown.

Our approach is to remain fully invested most of the time, even when it is uncomfortable.  We look for opportunities to make shrewd investments when the market turns choppy, setting ourselves up for success when the market stabilizes and goes on to new highs.  The lack of appealing alternatives suggests staying the course.  But the captain has turned on the seatbelt sign as we have some turbulence ahead so please remain in your seats.

Scott D. Horsburgh, CFA