You couldn’t help but be amused with some of the analysis this week after the Fed made a very expected announcement that it would keep rates at zero. Yet the reaction from markets was fixated on indications of what the Fed would be doing a year and a half from now, indicating they may raise rates twice in 2023. Stocks sold off and pundits noted that the indication that rates would rise sooner than anticipated hurt stocks, but was this really the case?
Not a Normal Recession
As fallible humans, we tend to focus on the recent past as opposed to looking for new risks approaching in the future. There seems to be an expectation by some that much like the post crisis economy in the US, rates will flatline for an extended period of time, yet even though the pandemic produced an economic contraction, it cannot be characterized as a normal recession for a couple of reasons.
1. The first being that, almost across the board, white collar and many high income jobs were less affected by the change to working from home. After the initial shock, many workers and their managers realized they could actually continue much of their business with the majority or all of their staff working from home. This didn’t produce the typical dip and long recovery that we see in highly skilled jobs during a recession. The segments that bore the brunt of the downturn were physical labor jobs outside of the healthcare and critical transportation sectors. Tourism and hospitality were particularly hit hard. After spiking during the pandemic at 6.7%, the college grad unemployment rate is already back down to 2.5%. This took 5 years to get back to the 2.5% unemployment figure after the Great Recession.
We can think of the pandemic as more of a forced government contraction which punished industries with high human interaction, not an across the board slowdown. I’m still amazed at the fact that the US produced the GDP of China from our kitchens and bedrooms in the 3rd quarter of last year.
2. The second is the massive stimulus that was thrown at the pandemic. The amounts that the fiscal government as well as the Fed put in play to fight off the worst of the economic effects would have been unimaginable during the last downturn. Trillions were pushed out without much thought to the long term consequences or outright fraud for that matter, and the Fed moved into assets that it previously shied away from such as junk bonds, plunging rates on these securities in a bid to maintain liquidity. This made previously attractive asset classes, which had started to price at deep discounts in March of last year, less appealing for investors. At the same time, this likely kept companies that should have failed and had access to the bond market afloat. Once the Fed was acting as a backstop, the prices for their bonds increased and they likely have been able to refinance their way out of debt maturing during the pandemic when cash flows were weaker. This has essentially kicked the can down the road for junk borrowers, instead of being able to flush out the weakest companies, they have survived and an anti-cyclical debt resurgence, egged on by the Fed has emerged as junk borrowers actually increased their debt levels during the pandemic. The below data from The Economist shows this anomaly compared to previous spikes.
Outside of corporate debt, the Fed now owns almost a third of US mortgages. With the mortgage market so hot across the country, there is now some speculation that the Fed will start to taper some of its $120 billion monthly bond buying by scaling back their purchases of mortgages first as opposed to When tapering first appeared in 2014 and was uniform across treasuries and mortgage securities. Investors and traders may be attempting to anticipate this by selling down or even shorting some of their mortgage securities. Prices for mortgage securities lost 0.18% last month while my bet on home builders has now seemed ill times at the home builders index has fallen about 14% since it’s peak on May 10.
Sell in May or Fed About Face?
The S&P 500 found itself down 1.9% for the week but I see this as just transitory choppiness. Although the now famed “dot plot” of individual Fed members expectations of rates moved up its projected rate hike from 2024 to 2023, there was a lot to like in their comments.
The first was that they were consistent in their view that inflation remains transitory. We were worried about deflation last year so we’re starting from a low base. What spooked people a bit here was that the Fed raised their headline inflation expectation a full percentage point to 3.4%. This also signaled to some investors, apart from the dot plot, that rate hikes would be coming sooner than previously anticipated.
The second is that the Fed seemed bullish about the state of the economy. The US likely finds itself at the beginning of the end of the economic recovery from the pandemic. As people continue to get vaccinated and states as well as other countries open up, the Fed expects GDP growth of 7% this year. This is a huge bounce back for the world’s largest economy and is likely catching the Fed and other by a bit of a surprise given the pace it has gathered in the last few months.
Yet investors should take heart in this hawkish stance towards inflation because it’s a very positive signal that the Fed still takes inflation seriously and remains intent to stamp it out. There was some room left open with Powell saying that saying that inflation could remain higher and more persistent than they anticipate. Yet the core message was that they still see this inflation as transitory.
Takeaways
The takeaways from this are that in order for rate raises to come by 2023, tapering will definitely have to start by 2022 and maybe even late 2021. This maybe pushed up the timeline some investors had planned on.
If these statements reinforces your view that inflation was indeed transitory, then an inflation normalization trade may be in the works. This is a bullish indicator for dividend paying stocks which may continue to add wind to the sails of financial stocks and industrial stocks which I had been touting last year.
This hopefully will also start to move fixed income rates up in anticipation of tapering and rate hikes. This would be a welcome development for savers who have been hit hard by these low rates. I personally haven’t had any interest in junk bonds below 5% yields, something which may start to change in the coming months.
The question this then leaves for my own view is where is the US dollar headed compared to its peers? I had previously been bullish on emerging market and foreign stocks with a tilt towards value. This has served me well over the past few months by overweighting UK stocks and foreign small caps. Even emerging market stocks have started to show some life as of late, benefitting from the weakening dollar.
Yet with rates of many of the major economies remaining depressed or negative, it starts to beg the question whether we will see another US led global recovery with rates rising sooner in the US compared to other markets. This is a negative development for the outlook for foreign currency returns. I will be carefully monitoring the dollar index and the performance of the dollar against major currencies given this development.
For this reason, I think stocks will continue their run this year when investors return next week. The summer has normally been a choppy time for stocks with volumes lighter as traders tending to go on vacation. This summer is shaping up to not be much different in that sense but the looming questions will be will we see this inflation through back to a more normal level and if the dollar will see a resurgence given the prospects for the US compared to the rest of the globe. Don’t let the market’s Fed jitters get you down.
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