November 4, 2021 | Cameron Parkhurst
It is amazing to think that we are already about to close out another year. Halloween came and went. Thanksgiving is right around the corner and the Christmas shopping season is swiftly approaching.
With the upcoming holiday season, many people are beginning to ask questions:
Labor shortages – “Will I be able to get to my destination if I fly?”
Supply chain shortages – “Will my family gifts be stuck out in the Pacific on a Cargo ship?”
Inflation – “How expensive will shopping be for me this season?”
Covid-19 – “Do I need to remain concerned and vigilant?”
In this short piece we will attempt to address many of these questions and highlight how these themes may affect the markets that we access daily.
For starters let us highlight a dilemma that we are having in our IC meetings.
Per the chart above, we see inflation rising all the while GDP forecasts are beginning to turn down a touch. Even with this, we are staring at the S&P 500 bouncing off record highs while the bond market, albeit up in yield a bit recently, is holding steady at calmer levels than one might expect.
This begs the question of “Who is right?”.
Some analysts, such as Morgan Stanley’s Michael Wilson, believe that stocks could be the ones under pressure as tapering begins. He noted “The fundamental picture for stocks is deteriorating as the Fed starts to tighten monetary policy and earnings growth slows” in a recent missive.
The Fed just released its minutes and, in comparing last month’s verbiage to this month’s, a few important items stick out. Surprisingly to us, they continue to use “transitory”. We don’t agree with this. CPI is up 5.4% on the year, with core up 4.0%.However, real wage growth was -0.8% YoY. Rents rose 0.4%, taking it to almost 3% for the year. We don’t see many signs that inflation is turning around across the board. We wonder how long real wage growth can last as workers begin to demand higher pay.
They also spoke to the correlation between COV-19 vaccinations and potential economic shifts. We are gaining a higher percentage of the U.S. population with vaccinations every day. We also saw some very positive news a few days ago highlighting the CDC approval for children 5-11 to begin to get the shot. This should be a sigh of relief to many parents and more importantly short help to add to a downtrend, ultimately, in the virus. Interestingly though, many states who have high vaccination percentages continue to see upticks in the new variants and so the jury is still out as to whether COV-19 will be a significant ongoing factor in 2022 and beyond. The trends of the virus will have significant impacts on future need for sustained stimulus and will have a bearing on supporting economic activity. Our big “what if” is what happens when the stimulus is gone?
One repercussion of COVID-19 however is the slow reopening of the economy and bottlenecks created therein. FOMC Chair Jerome Powell mentioned that the Fed consensus was that supply chain shortages were not helping, but rather adding to the inflationary picture due to these bottlenecks. Another big question is in asking how long we will be looking at empty shelves in many stores and looking at hundreds of ships anchored out at sea? It makes one wonder how this holiday season will play out. Some analysts are not optimistic and believe that it could be tough for supply, and thus demand could drive prices further up in the short term.
At the end of the day, The Fed is keen on keeping the average inflation numbers above 2%. This means that their mandate could allow it to heat up for quarters to meet this average. Fed Funds is still anchored at zero. It will be until we reach full employment and have an average of 2%+ inflation. So that may keep steepness in the curve for some time with short term rates being held artificially low.
The biggest news out of the meeting was the beginning of the taper. The Fed plans to begin reducing asset purchases by $15 billion a month ($10 billion in Treasuries and $5 billion in MBS).Assuming a linear monthly pace, this gives us an 8-month tapering window if you assume the current $120 billion asset purchasing rate. This means that come June or July 2022, the Fed will be done with their first accommodative leg.
The big question comes after the summer of 2022. The Fed has said that they will not raise rates until they are zeroed out on new asset purchases. If one believes this mid-summer timeline hypothesis, do we begin seeing immediate rises in Fed Funds? A lot of it goes back to a feedback loop as to whether we are at full employment and above 2% average sustained inflation. The inflation side may not be the problem. It might be in answering the question as to when we are at full employment. Below is a very interesting intermediate term chart highlighting Fed Funds, implied future path and Treasury/MBS asset purchases. Based on this, we should expect the anchor to be lifted sometime in Q3-4 2022 and expect rate rises all through 2023 at least.
Source: Bloomberg, Federal Reserve
When looking specifically at the bond market, we are seeing essentially a return to pre-covid levels:
10-Year Treasury Yield Source: Bloomberg
However, there was a very different feel between what we experienced during the first throws of COV-19 and a very harsh, rapid spike (and then retracement/downdraft) and the quick but orderly rise we saw in late September through parts of October. During the 2020 spike, there was sheer panic over the short term until the government intervened.
Many desks were simply throwing away paper at any level they could get. This time around, even though rates were consistently moving up, there was almost zero panic, and very little was trading. If it was it was at very tight spreads. The market was extremely orderly. Perhaps this is because of all the stimulus that is been thrown around and investors just assume bail outs going forward? Perhaps it is because of the vaccine and knowledge of the virus? That question remains unanswered to some extent, but we were surprised that we didn’t see a bit more volatility than we did last month.
Focusing on a couple of core sub-asset classes, tax-free munis have become a little bit cheaper as a percentage of Treasuries but are still trading in the 55-75% of Treasury range, and so we would only be using them for higher tax bracket clients. We think that taxable munis continue to have value over corporates here from a variety of perspectives, mainly historically higher credit quality and today they are trading at wider yield spreads relative to their corporate counterparts See chart below:
We are also beginning to see some odd-lot MBS come to the table at times, and this could be in anticipation of the tapering program. We don’t mind owning a low duration MBS in conjunction with your typical bond ladders here. They are high quality and can add yield on the short end if buying the right structures. We believe all of these types of bonds, typically laddered over the short-intermediate term, can add value and be protective if we do get into any sort of rate updraft.
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Thanks,
Your PeachCap Fixed Income Team
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