Teacher Says, 'Every Time The Fed Speaks, An Angel Gets Volatility'
I borrowed this week's title from a Christmas movie classic to relay how much the Fed can move markets. The famous quote from the movie "It's A Wonderful Life" has become iconic as more than four generations of movie watchers can likely quote the moment George Bailey learns that his friend and mentor, Clarence the angel, finally gets his wings. The movie, released in January of 1947, was not originally thought of as a Christmas classic - as you can tell from the timing of its release.
However, the movie has become so well-loved and associated with Christmas, that it's typically part of the holiday season. There is so much trivia about the movie, for example, it was James Stewart's first film since returning from World War II. Yet, one of my favorite pieces of trivia surrounding the movie involves one of the supporting cast members, Thomas Mitchell, who plays Uncle Billy. The actor was filming a scene where he had too much to drink and must pretend to stumble home and out of the picture frame. At that moment, a crew member drops a large tray of props, making a loud noise off camera. Mitchell quickly improvised and yelled offset, "I'm alright, I'm alright." The director, Frank Capra, left the moment in the film to give the allusion Uncle Billy had stumbled into some garbage cans down the street.
This week has been all about the Fed. Investors feared the Fed would go too far and take a considerable hawkish tone. Other investors were skeptical if the Fed could navigate the rise in inflation without making a major policy mistake. The jury seems to still be out on that one. Yet, the market praised comments from Chairman Powell yesterday. Here's what we're seeing so far this week...
Hark, The Herald Powell Speaks. Wednesday, Fed Chairman Powell released the highly-anticipated cat out of the bag by announcing a faster pace to Tapering of bond purchases. Originally, Tapering was set to involve $15 billion in bond purchase reductions over a six-month period ending in June of 2022.
Instead, due to higher inflation numbers, the Fed announced that Tapering would be at a pace of $30 billion per month and end likely in March of 2022. In addition, the Fed increased the number of interest rate hikes in 2022 from 1 to 3 (back in July the expectation was no rate hikes in 2022). Inflation expectations for the Fed were revised up to 2.6% PCE (headline) from 2.2% by the end of 2022. And lastly the Fed sees the labor market end 2022 with an unemployment rate of 3.5% versus the previous target of 3.8%. Overall, the announcement was in-line with market expectations and equities trended higher in the last hour and a half of trading on Wednesday.
Thursday, it was a different story as technology shares have been under pressure with the anticipated rise in interest rates. Forward earnings estimates for the Nasdaq 100 in 2022 show a base case of 14%. Per past Fed rate hikes, the yield on short-term bonds has climbed 71 basis points on average per 25 basis point rate hike. Unless earnings for tech companies grow well above the long-term average next year, tech shares could hit a wall with much lower returns in 2022 compared to 2021. Conversely, while the Technology sector was down roughly 3% today, Financials (+0.8%), Basic Materials (+0.9%), Energy (+0.5%), and Utilities (+0.4%) were all higher on the day. The larger issue going forward now becomes how does the market and the economy fare with easy monetary conditions coming to an end?
Baby It's Cold Outside. As we get ready to enter 2022 and the "dead of winter", I thought it the best time to flush out the concerns we have entering the new year. This is likely the final Market Musings for the year due to holiday travel and lower market activity. There are 5 primary themes that we think are likely to affect markets next year. How each of those pan out will likely determine where the markets end in 2022. The 2022 headwinds are as follows (in no particular order):
Fed Policy Error - this headwind will probably not become evident until middle of next year as the Fed plots out when the 1st rate hike will take place. By then, if Inflation (another headwind) has continued to run, raising rates might be too late. That has been the primary fear of some market prognosticators as inflation has proven not to be "transitory" as the Fed promised for much of 2021. The Fed has been battling inflation behind the scenes by utilizing Reverse Repo Agreements.
This is something of which the average investor is likely unaware. The Fed can offer higher interest/credits to financial intermediaries in the overnight market to discourage the lending of assets, especially to institutional customers. Commercial loan demand is down 19.5% since peaking in May of 2020. About 2 months prior, at the end of March 2020 is when Reverse Repos began out-pacing Repos in the overnight market. This has allowed the Fed to keep inflation lower by preventing growth in the commercial loan sector, thereby, reducing substantial investment and money flow. Just yesterday, the Reverse Repo market hit a record $1.65 trillion.
Inflation Cometh, And Inflation Taketh Away - this headwind rose by more than 500 basis points this year. In certain areas, groceries & gasoline, the average consumer has been forced to pay price increases in the double-digits. The primary reasons this has not phased consumers to this point is that the Savings Rate exploded in 2020 and producers were willing to eat some of the initial cost increases. The Savings Rate has come down substantially since the beginning of the year. In March of this year, the Savings Rate peaked at 26.6%, well above the long-term historical average of 6.5%. But, since March, the rate has dropped and is how at 7.3%.
At the same time, producers are signaling higher prices going forward. The Producer Price Index ran hot for the first 6 months of this year, but the Consumer Price Index is steadily catching up. There is still a year-over-year lag between the two of a little over 2%, which means Inflation for the consumer is likely to increase form 6.9% to at least 8.9% in 2022. The only things that could offset inflation for the consumer at this point is for the U.S. to increase oil/gas production to lower costs at the pump and for the shipping crisis (another headwind) to slowly improve. If shipping were to improve quickly causing goods to flow in from anchored ships more quickly, that could actually worsen inflation by increasing consumers' appetites. Connected to Fed policy error, inflation could be the one thing that upends the current cyclical bull market.
Interest Rates and Gravity - Warren Buffet once famously said, "Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices." I other words, as interest rates rise, cheaper assets look a lot more attractive than expensive assets. We can see this from the market action today. Technology stocks, with average Price-to-Earnings ratios in the upper 20s, look much more expensive than say, Financials, with average Price-to-Earnings multiples in the mid-teens. At such low interest rate levels today (10-year Treasury Bond at a handle of 1.42%) versus much higher historical yields, it may take some time for yields to eat into equity returns.
However, higher yields will affect other consumer behavior, such as personal loans and mortgages, causing some sectors to take it on the chin as the Fed prepares to raise rates 3 times. If the Fed's projections are accurate, I'm not sure how you get to 4% GDP with rising interest rates and rising inflation. There was a delay effect on the 10-year Treasury Bond yield the last time the Fed began to increase the Fed Funds Rate in late 2015. However, by mid-2016, interest rates had bottomed and finished that year up 119 basis points.
These Are A Few Of My Favorite...Oops, Shipping Crisis - There are still too many ships loitering or anchored off the coast waiting to get into U.S. ports to get offloaded. At current count there are more than 100 total ships anchored or loitering off the LA/Long Beach port. As we have previously stated, this situation has led to greater inflation (too many consumers chasing too few goods). Air Freight Rates have skyrocketed this year (some by as much as +180%).
How this crisis shakes out depends upon bad government policies being removed and labor shortages in transportation & warehousing to be solved. However, if this crisis is corrected too quickly, consumers may continue chasing sought after goods that were not previously available, which could drive inflation higher. If the crisis lingers well into 2022, it would lead to consumers giving up on discretionary purchases and that could lead to a recessionary environment.
Without Workers, Nothing Gets Done - The shipping crisis is partly dependent on a labor shortage - fewer truck drivers, fewer carrier operators, fewer freight conductors. Martin Luther King, Jr. once famously said, "No work is insignificant."
Unfortunately, in America today, a certain segment of the population would rather receive government benefits than strike out and work in a satisfying job. And, there are plenty of jobs to be had - more than at any time in the last two decades. How do we know that American workers are choosing other things to do with their time than work?
The number of "quits" among U.S. workers has also reached a two-decade high. This phenomenon could easily be corrected by policymakers by removing all unnecessary government benefits for the unemployed and incentivize them to look for a job. There are more than 11 million job openings and roughly 7.5 million unemployed persons. That's more than enough jobs for each able-bodied person to find meaningful employment. A relatively quick filling of open jobs could help alleviate the burdens of a shipping crisis and rising inflation.