We trust this “Note” finds everyone safe and well as we wind down the summer fun and get ready for a new school year. In our last edition we promised a deeper dive into the current drivers for the stock and bond markets, and fortunately for us, we have no shortage of topics to discuss. All-time market highs; record earnings; rising inflation; lower bond yields; talks of “taper”; supply chain disruptions; labor shortages; a Senate-passed bipartisan infrastructure bill; a not-so-bipartisan, but much larger spending proposal from the House, being referred to as the “reconciliation” package; as well as the military withdrawal from Afghanistan are all high-profile themes making headlines and impacting markets. This is quite a mouthful, but over the next few paragraphs we hope to give a little insight into what we believe are some of the key market drivers over the final four months.
At the time of this writing, US equity markets are near all-time highs and yields on 10-year treasury notes remain low, at around 1.30%. Rich Weiss, CIO for money manager American Century, has an interesting take on this that we believe describes current market conditions well. Stock investors are taking their cues from the record earnings reported by many S&P 500 companies. Bond investors are looking at global businesses flush with cash that are expected to experience continued growth as the pandemic eventually subsides. Both outlooks assume the recent spikes in inflation are temporary, resulting primarily from temporary supply chain issues and the economic rebound from last year’s slump. As global supply comes back online, we should see prices normalize.
In the US the 2nd quarter GDP annualized growth rate came in at 6.5%. While this is a strong number, it was below the consensus forecast. Inflation, on the other hand, came in much higher than expected at a rate of 4.2% annualized. Both have been impacted by the improving economy, supply chains dislocations, and labor shortages. Let’s look at the impact of strong demand for light trucks in the quarter as an example. As manufacturers responded with increased production, they were unable to get supplies fast enough from their existing supply chains. As a result, they turned to non-traditional suppliers at increased cost and directed the supplies they did have to their most profitable products, which are the pick-ups, SUVs, and crossovers. To the extent they were unable to keep up production, they had to draw on inventories to meet demand, and where they could, they passed on higher prices. The strong demand bled over to used vehicles, driving price increases there as well. While the strong sales added to GDP, the decline in inventories subtracted from GDP, and the combination of the above contributed to inflation. The logic for expecting the inflationary pressures to subside is that the influences of strong demand, regional shutdowns, and supply chain problems will eventually be resolved.
Another factor effecting both growth and inflation has been labor shortages. Employers have found it harder to get people back to work than they expected. We believe we could see a pick-up in jobs growth in the very near future as several potential hindrances are removed: more individuals are getting vaccinated, infection rates may have peaked, and unemployment benefits are set to run out in early September. These developments should help get people back to work and ease its inflationary impact as well.
Another recent topic that has received a lot of attention is the Federal Reserve’s discussion of reducing (or “tapering”) the amount of bonds it has been buying. Since the pandemic, the Fed has been buying $120 billion of Treasury and mortgage bonds per month to support the economy with additional liquidity. This has been a key feature of the Fed’s Quantitative Easing, or QE for short. Given the improvement in the economy since 2020, various regional Presidents of the Federal Reserve have recently begun calling for the immediate reduction (or “tapering”) of bond purchases with a goal of ending them completely by early 2022. This has caused some to fear that the removal of excess liquidity would remove a support to stock and bond prices.
We believe the Fed will continue to base its decisions on data as it comes in, which as of now suggests it may begin to reduce its bond purchases around November and end them by mid 2022. The next question is when the Fed would begin to raise interest rates. We believe the most likely scenario as of now would be for the Fed to wait until early 2023 to do so. Based on our expectation that the “taper” and the subsequent increase in interest rates will be orderly and measured, we don’t expect it to be disruptive to the broader bond markets as the “taper tantrum” of 2013 was. We will most likely know more on the “taper” when the Fed meets mid-September.
September will be a busy month for Congress. Currently, there is much debate over the Senate-approved $1 trillion infrastructure bill, as well as the House’s efforts to push through a spending bill with an additional $3.5 trillion using the budget reconciliation process. While the Senate’s bill includes specific spending line items, the House’s proposal is less transparent on how its $3.5 trillion in spending would be allocated. Currently there is no draft legislation but only talking points to act as a guide. As a result, it is more like Forrest Gump’s box of chocolates—you don’t know what you are going to get.
The “reconciliation” package has been described by some as a “governmental SPAC”. SPACs or Special Purpose Acquisition Companies are shell companies listed on a stock exchange whose purpose is to buy another company. The catch is that investors typically don’t know what the target company is when they invest in the SPAC. (Click here for our May “Notes” on our Blog where we discuss SPACs). Taking a cue from Wall Street, the House of Representatives is attempting a similar approach, seeking approval for a multi trillion-dollar spending plan through the Budget Reconciliation process while leaving the actual details to be determined later. Congress would then rely on committees to fill in the details as to how the $3.5 trillion would be used.
Since Republican members of Congress broadly oppose the reconciliation package, voting on the bi-partisan infrastructure bill is being held up in an effort to increase the chance of the reconciliation package’s passage. The reconciliation package’s future is therefore dependent on moderate Democrats, who have their own reasons to oppose it. Calls for tax increases are one reason for their resistance. The outcome may now be even more uncertain, given the blowback from the disastrous pullout and related unfortunate events in Afghanistan.
Yes, September looks set to be extremely busy and make plenty of headlines. And yes, we are still positive on markets. As usual, we will continue to monitor the headlines and look for opportunities as they present themselves. Please reach out to us if you have any questions.
As for the geo-political events taking place in Afghanistan, we are saddened that our military’s withdrawal from the country unfolded as it did. We honor the sacrifices made by our country’s military personnel and their families during the war in Afghanistan and pray for peace for those who have suffered as a result and peace for the Afghan people.