Transitory, Temporary, Tapering, Tightening, Treasury Notes, and other “T” Words
I’ve been doing investments for over forty years now, and it has always amazed me how market observers will focus on and repeat words or phrases until we all get tired of hearing them. Today’s hot words are transitory, temporary, tapering, tightening, and the phrase “talking about talking about”. Listen how these words are used over the next few months because these may affect the bond and stock markets. With the U.S. emerging from the largest economic shut-down in history, there is increasing talk about how this re-starting will effect economic growth, interest rates, inflation and asset values. I believe everyone (and their mothers) have heard how inflation measures have spiked up recently and the question that just about everyone is asking is whether inflation will continue to rise or if inflation will be transitory or temporary. Federal Reserve Chairman Jerome Powell has said often that he and the Fed believe the recent inflation spike will be transitory or short lived. Mr. Powell has said “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future. Clogged supply chains won’t affect Fed policy, Powell said, because “they’re temporary and expected to resolve themselves.”
In April, Mr. Powell made clear that the Federal Reserve isn’t even close to beginning a pullback in its ultra-low interest rate policies. In a statement after the April policy meeting, the Fed said it would keep its benchmark short-term rate near zero, where it’s been pinned since the pandemic erupted over a year ago. The goal is to help keep loan rates down, for individuals and businesses, to encourage borrowing and spending. The Fed also said it would keep buying $120 billion in bonds each month to try to keep longer-term borrowing rates low, too. At a news conference, Powell stressed that the Fed would need to see more evidence of sustained and substantial improvements in the job market and the overall economy before it would consider reducing its bond purchases.
A quote of Mr. Powell that has been often repeated is, “we are not even “talking about talking about” tightening monetary policy.” However, we all knew that the time until the talking begins is drawing closer. In the past, Powell has said that the Fed’s eventual pullback in its economic support would start with a reduction in its bond buying and only after that a potential rate hike. Two words that have in the past sent the stock market into shock have been tightening or tapering, meaning a slowing of its massive bond purchases. In June, the chairman responded to concerns about spiking inflation by reiterating his view that current price increases will likely prove temporary. However, he also said that officials had begun a discussion about scaling back bond purchases after releasing forecasts that show they anticipate two interest rate increases by the end of 2023.
Over the next several months, we may see inflation rates much higher than normal and the Fed’s patience may be tested in terms of keeping monetary policy steady in light of surging inflation measures. Consumer prices jumped 5% in May compared to a year earlier and in June registered a 5.4% increase. Even core CPI (ex-food and energy) rose at a 4.5% yearly increase. This was the largest year-on-year in core inflation since 1991. Much of the recent increase can be tied to transportation (car and airline prices have been surging) and shelter (with housing prices and hotel lodging prices both spiking higher). Oil prices recently hit a 33-month high and lumber prices earlier quadrupled within a year. Even though lumber prices have fallen from their highs, many prices remain far above pre pandemic levels. The $100 question is how long some of these pandemic related adjustments will take to subside? Supply shortages will ease gradually, but possibly not as quickly as some hope and may continue to put some pressure on inflation. In addition, the post lock-down booms in business and residential investment will fade, but investment growth may remain strong for some time.
Economists say that a large part of inflation is affected by consumer perception on what inflation will be. The longer that inflation remains elevated, the more the inflationary expectations may begin to be built into consumer behaviors. Perhaps most importantly, widespread labor shortages have pushed up wage growth as many businesses struggle to staff positions with qualified workers. We believe that labor cost inflation may be stickier and may be less transitory than some of the other inflation pressures. Widespread labor shortages, in part due to longer-lasting factors such as a skill mismatch and an increase in people nearing retirement mean that wage inflation may accelerate and remain at permanently higher levels. A record share of small firms report it is difficult to find workers. The surge in job openings has been most extreme in those areas hardest hit by the shutdown such as the leisure and hospitality sector, but all sectors have seen increases. While factors such as childcare problems, health concerns and overly generous unemployment benefits are partly to blame for worker shortages, the previously mentioned, but significant skill, and location mismatches as well as an aging America are factors that won’t go away. Therefore, we think wage inflation will continue for some time and hit 4% or more.
How will all these factors affect the investment markets? As you might expect there are differences of opinion. Many agree that consumer companies may benefit as people spend money on everything from wardrobe refreshes, to travel, to dining and so on. Medical device companies and healthcare supply companies may benefit as people go ahead with delayed elective procedures. Financial companies should benefit from a broad rise in economic activity. Stretched supply chains may mean more industrial spending. However, many observers worry that stretched stock valuations may not hold up if interest rates rise. On the other, expanding corporate profits may offset moderate interest rate increases. Despite the worries about inflation, we continue to think that interest rate increases will remain very moderate. In fact, several clients have asked why the ten year Treasury Note yield has fallen from 1.75% to as low as 1.20% this year. Four major reasons are: a) the huge amount of liquidity out there b) the bond market really isn’t that worried about inflation, c) the rest of the developed world has even lower rates and d) short-term technical factors that I won’t try to explain here. While US growth may peak in 2Q, we still forecast GDP growth of more than 6% this year and at least 5% in 2022. With a Fed taper announcement likely in the coming months and the labor market recovery set to continue as frictions ease, we expect the 10-year yield to reach 2% within the next year. What are some other reasons that the forecast for stocks might not be quite as rosy? First, market pricing leaves little room for disappointments. Second, economic growth both in the U.S. and overseas might fall short of very optimistic expectations. Third, we think that China’s economy may continue to lose momentum. Fourth, inflation and/or interest rates may surprise both the Fed and markets. Fifth, the battle with COVID and its variants may linger longer than some expect, especially in the developing world. This all means that returns from risk assets may be both volatile and limited over the next couple of years.
Our advice remains to continue to diversify your investments, keeping enough in risk control assets to fund necessary expenditures for at least three years and to not chase recent performance of some assets. Finally, keep a close eye on the “T” words that I mentioned earlier. Things seldom happen just the way that the forecasters predict. Last of all, be sure to check in with your advisors at First Merchants.
Director, Investment & Portfolio Mgmt