A Matter of Trust

June 11, 2021

Weekly Summary: June 7 – 11, 2021

The long-term mantra of “Don’t fight the Fed” has never been more evident judging by the reactions of most financial markets over the past few weeks. The view that any inflationary spikes will be transitory—and even if not, that the Fed has the necessary tools to deal with more persistent inflation is accepted as fact by many market participants—and perhaps the consensus. It appears that despite strong inflation data, the only data that matters now is nonfarm payrolls. The reason: That’s what matters to the Fed. In case anyone had any doubts, noted Goldman Sachs’ June 7 report, Vice Chair Clarida said on May 17 that a tapering decision will have “more of a focus on the labor market.” The strong wage inflation numbers also don’t seem to matter, as many of those increases are concentrated in the lower-paid services industries. As Bloomberg reported on Jun 9, wage gains at the lower end of the spectrum are strongly desired by both the Fed and the Biden administration.

Key observations:

  1. Many investors appear to have adopted the Fed’s view that inflation spikes are transitory.
  2. At least presently, inflation spikes are largely being ignored. The only economic data that matter – specifically nonfarm payrolls – are those that will affect when the Fed tapers its asset purchases, and when it will raise interest rates.
  3. The Fed will continue to influence real interest rates: The longer it delays tightening its monetary policies, the lower the real rate of interest will be.
  4. Lower real rates benefit the overall equity markets.
  5. Perhaps investors are beginning to question the extent and durability of economic recoveries.

The upshot: Investor sentiment will likely continue to shift. This could translate into financial market volatility. We therefore continue to recommend being selective and thoughtful in positioning.


Only employment matters

Two recent trading days exemplify these views. U.S. nonfarm payrolls for May, announced June 4, was modestly disappointing despite surprisingly strong average hourly earnings and an unemployment rate that dropped to 5.8% from 6.1%. The 10-year Treasury yield traded down 6 bps, to 1.57%. Nasdaq was the best performing major U.S. average that day. The more cyclical averages underperformed. Tech was also best that day, but the S&P 500 sectors were rather mixed with respect to their performances. To the financial markets, this meant the U.S. economy was recovering gradually, and the Fed need not rush to taper asset purchase. It did not matter that the ISM manufacturing and services indexes for May had shown very strong price increases. Supply shortages constrained rising business activity. Labor shortages remained a key issue. And delivery delays impacted both manufacturing and services. (Citi Research Economics June 3 report).

Similarly, on June 9—despite no specifically relevant news—the 10-year Treasury yield traded as low as about 1.47% intraday (its lowest yield since March 1) before closing at 1.49%, down 4 bps for the day. Although slightly negative, Nasdaq was the day’s strongest major U.S. stock index, and the best- performing sectors were decidedly more defensive. This was rather remarkable only one day before a very high U.S. CPI number was expected, especially because the prior month’s surprisingly strong showing caused a short-term spike in Treasury yields.

The adoption of the Fed’s narrative that inflation spikes will only be transitory was again prominently displayed on Thursday of this week when the U.S. CPI for May was announced. Although interest rates rose modestly to start the day, the 10-year Treasury yield was soon back to 1.49% despite higher-than-expected CPI. The yield eventually dropped 5 bps to close at 1.44%, but it seemed that most investors really did expect CPI to beat expectations. Core CPI (minus food and energy) rose 0.7% from April and 3.8% from May 2020—its largest 12-month increase since at least 1992. Meanwhile, headline CPI, which includes all items, rose 5.0% vs. last May. Again, most of the increase stemmed from transitory factors such as used car and truck sales (up 7.3% and about one-third of the headline increase).

But not all increases were seen as transitory. Strong shelter prices, generally considered more persistent, suggested a solid underlying trend. Owners equivalent rent rose 0.31%, and primary rents rose 0.24%. The S&P sector performance had a more pronounced defensive tilt. Nasdaq was the best performing major U.S. equity index on that day. Health care, real estate and technology led the S&P 500 sectors, while financials performed worst, marking the fourth straight day of a decidedly defensive pattern. Last week’s sector performance was mixed: Energy was best, followed by real estate, financials and tech.

Source: Citi – Stronger shelter prices most important part of May CPI (6/10/2021)


Let inflation be bygone

Even so, there were signs that investors had already begun to accept the Fed’s narrative. Goldman Sachs’s June 4 U.S. Weekly Kickstart showed that over the previous few weeks, stocks with low pricing power (up 7%) have outperformed high pricers (3%). At the same time, 10-year inflation breakevens were down 14 bps to 2.4%. Goldman interpreted these trends as an unwinding of investor inflation concerns. In March, however, when inflation fears grew, high-pricing-power stocks began to outperform others, reversing a five-month trend. We will probably see further swings in sentiment on inflation.


Repercussions from the Fed’s stance?

But not everyone is so sanguine about rising prices. The “Price Pressure Model” maintained by the St. Louis Fed, based on over 100 indicators, showed an 84% probability that PCE (the Fed’s preferred inflation gauge) will exceed 2.5% over the next 12 months. This is one of the highest readings since 1990. The Fed forecasts PCE at 2.5% this year, but just over 2.0% for 2022. According to CNBC on June 7, Deutsche Bank has even warned of a global “time bomb” due to the Fed ’s stated policy to not tighten monetary conditions until inflation shows a sustained rise and unemployment is much lower: “The consequences of delay,” its chief economist said, “could create a significant recession and set off a chain reaction of financial distress around the world, particularly in emerging markets.”

Bill Dudley is also worried. In a Bloomberg report on June 7, the former New York Fed president, and Fed vice chair said that the U.S. central bank is risking another recession. Dudley views the Fed’s new policy as allowing inflation to overshoot its 2% target in order to offset previous undershoots. He believes that Fed officials have indicated that they won’t raise short-term interest rates from near zero until three conditions are met: 1) employment has reached its maximum sustainable level, 2) inflation has reached 2%, and 3) inflation is expected to remain above 2% for some time. Essentially, this means a loose monetary policy until “overheating” begins—something Dudley believes will eventually lead to more volatile interest rates and increases the probability of a hard landing.


It takes two to persist

Most economists believe that at least two critical elements are necessary for persistent inflation: inflation expectations and wage growth. In a prior weekly letter, we highlighted a recent University of Michigan consumer sentiment survey that showed increasing inflation expectations for both one year and multiple years. Meanwhile, this week’s Department of Labor “JOLTS” report indicated possible future wage gains. On the last business day of April, that report showed a record 9.3 million job openings in the U.S. QUITS, which gauges worker confidence in finding other jobs, rose by 384,000 to 3.95 million. The resulting QUIT rate as a share of the labor force rose to a record 2.7% from 2.5%. This rate was especially high in retail: 4.3%, up from 3.6%.

Another promising sign for potential wage gains came from the NFIB (National Federation of Independent Business) survey. A record 48% of small business owners reported unfilled job openings in May, up from 44% in April. NFIB’s chief economist said that “inflation on Main Street is rampant and small business owners are uncertain about future business conditions.” More than one-quarter (26%) of respondents called quality of labor the most important problem, and most said that they had few or no qualified applicants. Owners were offering higher wages to attract workers, then passing on the higher operating costs to customers, much like they did in 2008. More than a majority indicated increased CapEx over the prior six months.


Possible investment positioning

Given so many uncertainties, especially around inflationary pressures, what sort of investment approach might be appropriate? As we have noted, a balanced equity approach should be well positioned to take advantage of swings in sentiment about inflation, interest rates, and the rapidity and durability of economic recoveries, both domestic and international. High-quality growth stocks should perform well when real interest rates are relatively stable to lower; value stocks should outperform amid rising inflation and interest rates; and cyclicals should be outperform as economies continue to grow. International exposure should help as the rolling economic recovery unfolds, and, as we have also noted, commodities—especially energy—will likely outperform in an inflationary environment. Residential REITs (real estate investment trusts) might also be attractive.

Source: Goldman Sachs – What next for Growth vs. Value? (6/9/2021)


Stock prices amid rising prices

How do equities generally perform in a rising inflationary environment? Which sectors tend to do best? Which factors seem to be most relevant? Some answers came in the June 4 Goldman Sachs report: Typically, sales growth via rising prices more than compensates for margin compression driven by rising input costs. Energy companies, whose revenues largely depend on commodity prices, and financials, whose revenues typically rise along with interest rates, should benefit disproportionately.

Since 1962, health care, real estate, and consumer staples have also outperformed during periods of high inflation, while materials and tech shares suffered the most. (For their part, value stocks performed about the same whether inflation was high or low.) In general, the median monthly real return was 2% annualized when inflation was high and rising vs. +15% when inflation was high and falling. Inflation dampens stock valuations because it leads to expectations of Fed tightening, which results in higher real interest rates. With the Fed indicating that it won’t tighten short-term interest rates until there’s a prolonged labor market improvement and broad wage gains, perhaps this time equity returns will exceed their historical performance in periods of high and rising inflation. How quickly real rates (which include assumed inflation) increase will play a large part in determining investment returns. According to Citi Research’s June 7 report, high debt and big fiscal funding requirements will make the world’s major central banks reluctant to tighten policy despite rising inflation.

Citibank believes that—the 1970s aside—history suggests that equity returns usually beat inflation. But even in the ’70s, EPS gains generally matched inflation. Real rate increases were simply too great to overcome as price/earnings multiples contracted. Citi estimates that the current real interest rate on 10-year Treasuries is -0.8%. If that rate increased to its pre-COVID-19 level of zero, they wrote, global equities would trade at a 12-month forward P/E of 16.5 (vs. the current 19.5, or down 15%). A real 10-year yield of 1% would imply a global P/E of 13.5, which would lower equity values by 30% on average. In general, negative real rates prop up equity valuations—especially among growth stocks. So far, the world’s major central banks are helping to ensure that real rates don’t follow inflation higher as they usually have. Should real rates increase, it will become increasingly important to consider how much earnings growth can outpace P/E contraction.

Source: Goldman Sachs – What next for Growth vs. Value? (6/9/2021)


Source: J.P. Morgan – EYE ON THE MARKET – Topic: Inflation. Duh! (5/24/2021)

In its May 24 report, J.P. Morgan’s M. Cembalest was unconvinced that rising inflation equals better equity performance. His data showed that since 1960, equity returns over cash were similar whether inflation was rising or falling. In fact, nearly half (44%) of monthly returns during inflationary periods were negative.

Source: J.P. Morgan – EYE ON THE MARKET – Topic: Inflation. Duh! (5/24/2021)

Clearly, many factors will influence equities’ performance in an inflationary environment. For example, how did the stagflation of the 1970s and early 1980s affect analyses of inflation’s impact on equity prices?


Where are we in the “cycle”?

It’s become rather difficult to adopt a decisive investment posture. Most investors seem to accept that we’re in an inflationary environment. Many, if not most, seem to have adopted the Fed’s narrative that inflation spikes are transitory.

Given these attitudes, do we invest assuming extended inflation, or do we look past inflationary concerns? Are exercises on how equities perform when inflation increases irrelevant? Are we in a “pause” before economies and earnings show how durable and expansionary they really are? And while we’re at it, why have so many investors recently accepted the Fed’s narrative? Investors are always looking forward; most are thinking at least six months ahead and into next year. There’s been a lot of focus on when growth rates will peak in different countries and regions. We have been among those touting a “rolling” economic reopening. China’s growth rate is assumed to have peaked already, while the U.S.’s could be topping out now, with Europe and then emerging markets to follow. Perhaps investors are now more concerned about economic, sales, and earnings growth in general—and losing faith in “reopening trades” that would favor value and cyclical stocks. But peaking growth rates don’t mean that economic growth can’t remain robust.


Half-full glasses

We remain optimistic that many economies, including the U.S., could continue to expand for quite some time. Among the many driving factors are the very low inventory levels worldwide—those will take time to replenish. Witness residential real estate, a sector with very low inventories and surging prices. Increased housing activity is well known for generating jobs and strong economic activity. Unlike the “Great Financial Crisis,” CapEx has been robust in the pandemic recovery. On June 8 Morgan Stanley’s economic team was confident that CapEx will propel the next leg of economic growth: They expect capital expenditures to rise to 116% of pre-pandemic levels after just 12 quarters. (CapEx tends to follow increasing profits and should be helped by more relaxed bank loan qualifications.) Expenditures related to climate change should also continue to expand.

Source: J.P. Morgan – EYE ON THE MARKET – Topics: An investor’s look at the China recovery, the Sinopharm vaccine and scientific methods (6/8/2021)

Similarly, in its June 7 View report, JPMorgan recommended staying overweight in cyclical, value and other inflation-linked assets, as inflation surprises are likely to persist. JPMorgan expects earnings growth to continue in the second half of 2021, supported by increasing consumer and capital expenditures. Let’s also not forget about the trillions of excess U.S. dollars consumers saved during the pandemic.

JPMorgan further expects poor 2Q emerging market (excluding China) GDP growth (-3.1%, annualized) to accelerate into +6.5% growth in the second half. Emergency-level stimulus and more successful virus containment have given developed markets a decided advantage in their economic growth prospects to date. JPMorgan also believes that inflation remains an underappreciated risk and that nominal yields will be driven higher by rising real interest rates. The rolling economic worldwide recoveries should extend economic growth.

The massive U.S. fiscal and monetary stimulus should continue to add to economic growth for quite some time, as many of these measures become more effective with a lag. The U.S. has provided much more stimulus than China during this recovery—a stark reversal from the measures taken in the wake of the 2008 Financial Crisis. In fact, the U.S. continues to provide fiscal and monetary stimulus while China is trying to “normalize” its policies. China is now more concerned about ensuring financial stability than pandemic recovery.

Source: J.P. Morgan – EYE ON THE MARKET – Topics: An investor’s look at the China recovery, the Sinopharm vaccine and scientific methods (6/8/2021)


Bottom line

Judging by recent financial market reactions to surprisingly high inflation data, many active investors seem to have adopted the Fed narrative of transitory inflation. The U.S. focus appears to be entirely on nonfarm payrolls. The pandemic has caused a long list of upheavals in many economies: supply chain disruptions, long lead times for supplies and products, difficulty in attracting qualified workers, wage gains, higher input costs, low inventory levels, uneven economic recoveries, uneven efforts to contain the coronavirus, uneven vaccination rates, increasing demand for new products and services, and decreasing demand for other goods and services.

Many of these disruptions have been considered transitory—and they’ve accounted for inflationary pressures that are also considered transitory. But the latter are beginning to translate into more entrenched expectations of rising inflation. Wage gains continue to become more common. And remember: Inflation expectations and wage gains are key drivers of persistent inflation.

We believe that the Fed’s real goal is to attack inequality issues by achieving the lowest sustainable unemployment rate possible. As pre-pandemic unemployment approached 3.5%, wages of lower-paid workers had finally begun to show progress. This remains the Fed’s focus. By assuming that today’s inflationary pressures won’t last, the Fed has essentially constructed a more positive risk/reward scenario to achieve their real goal. The irony, of course, is that through easy monetary policies, their quest for equality has exacerbated inequality.

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