Shifting from 'Transitory' to 'Trade-Off,' the Fed Signals a Transition Ahead
While strong demand continues to support the overall economic outlook, price pressures from a combination of excess liquidity and product scarcity are causing imbalances throughout the global marketplace. Most equity markets ended the third quarter with sideways to modestly negative performance, as the Fed began to acknowledge that inflation may be more persistent than originally thought.
The inflationary headwinds that we’re experiencing today stem from the extraordinary monetary and fiscal stimulus absorbed by financial markets over the last 18 months. On the monetary side, Fed Chairman Powell has emphasized maximizing employment over price stability. For much of this year, the Fed has expressed a belief that the trends in inflation are likely to be ‘transitory’ (classic Fedspeak for temporary), and it would tolerate higher inflation in pursuit of substantial further progress on the employment front. However, during the month of September, the Fed began to acknowledge that more persistent inflation might require a ‘difficult trade-off,’ as it would be forced to raise interest rates prior to achieving its employment goals.
The Outlook for the Fed and Inflation
The actual start of the next rate hike cycle will not be clear for many months, but the Fed has indicated that it’s ready to start reversing some of the pandemic stimulus before the end of the year. It’s widely expected that the Fed will formally announce a gradual reduction (frequently referred to as tapering) of its monthly purchases of $120 billion in Treasury and mortgage debt at its next meeting in early November. These purchases have ballooned the size of the Fed balance sheet to nearly $8.5 trillion (roughly 40% of GDP), as Chart 1 shows. Further, it’s driven interest rates in the bond market to all-time lows and been responsible for much of the asset inflation that we’ve experienced in equity and real estate prices.
Current market expectations suggest that the Fed should complete its tapering initiative by mid-2022 and is unlikely to expand its balance sheet again for some time after the reduction in purchases. The rate of change of the Fed balance sheet is a critical element in understanding the outlook for risk assets. When the Fed stopped balance sheet expansion during the middle of last decade, the equity market experienced a modest double-digit correction. Moreover, when the Fed actually reduced the size of its balance sheet coupled with interest rate hikes in 2018, the market experienced a rather severe 20% downdraft. One important difference between then and now is that asset price inflation was not at the extreme levels that it is today in some sectors. Therefore, if a reduction in liquidity causes prices to correct, this time the magnitude of that correction could be more severe.
The immense monetary stimulus is now showing up in consumer prices and appears to be more than a temporary phenomenon limited just to short-term supply-chain issues. The Core Personal Consumption Expenditure (PCE) measure of inflation, which is the Fed’s preferred measure, recently pushed up to 3.6% on a year-on-year basis – well in excess of the Fed’s 2% target range. Consumers don’t need to look much further than the meteoric rise in house prices (see Chart 2) as a gauge for what effect supply constraints and excess liquidity can have on prices.
The Federal Housing Finance Agency (FHFA) measure of house prices has appreciated by 19.2% over the past year through the most recent data release (for the month of July). Multiple factors have contributed to the scorching increase in house prices: low interest rates, historically low existing home supply, the cost of materials and labor, and shortages of materials and labor leading to longer lead times (and those are just the primary sources).
It should be noted that the recent increases in price materially exceed the house price increases that eventually led to the Great Financial Crisis (GFC) of the early-to-mid-2000s. We do not see the same lack of affordability that housing exhibited then and we do not envision the same deterioration in credit quality. As a result, we don’t believe housing represents a systemic risk to the financial system. However, the distortions are likely to have a meaningful impact on inflation data over the coming 12-18 months, and that could signify apprehension for interest rates and asset prices.
It should be noted that Owner’s Equivalent Rent (OER), an important component of some measures of inflation, has not been reflecting the true cost of housing throughout the COVID crisis. That’s been due to extreme changes in interest rates reducing financing costs and a moratorium on evictions. However, as conditions evolve, the trajectory of OER augurs for a more resilient and persistent trend in inflation. This factor illustrates one challenge to the Fed’s view.
While we’ve used housing as an example to illustrate the challenges of operating in a supply-constrained world, evidence of this same phenomenon has percolated throughout industrial supply chains all over the globe. The shortages of semiconductors are affecting the production of autos, and ports all over the world are encountering logistics nightmares. In addition, the general lack of labor availability has extended lead times throughout the industrial and service-oriented sectors, and consumers are enduring higher costs for food and durable goods.
The Fed has acknowledged these conditions and has raised its forecast for PCE inflation for 2021 materially, but the Fed’s PCE forecast for 2022 may still be honoring its underlying ‘transitory’ wishes as it’s barely nudged longer-term expectations. The risk of PCE exceeding its forecast (perhaps significantly) remains high. We are vigilant of these risks because higher and more persistent inflation undermines purchasing power and can force monetary authorities to react aggressively to keep it under control. Should the Fed face the ‘difficult trade-off’ of raising rates before realizing its employment objectives, the economy and equity markets could be exposed to downside risks.
The Aftermath of Excess Liquidity and the Impact on Expected Returns
The COVID-driven recession of 2020 was peculiar and different from previous recessions for a variety of reasons. Throughout the post-World War II era, recessions have been caused by excessive credit extension, misallocation of capital, rising interest rates offsetting an overly strong trend in inflation, or the economy in general – and sometimes the combination of all three. When COVID struck, these conditions were not present. The recession was the result of an unprecedented government-ordered shutdown due to a human health crisis, not a regular phase in the economic cycle. The response from the monetary and fiscal authorities was immense and the excessive liquidity has driven inflationary pressures throughout the financial system.
While monumental liquidity has given rise to an earnings recovery in 2021, it’s also contributed to significant asset price inflation and nurtured a speculative trading environment. As we delve into the outlook for 2022, it’s abundantly clear that the fiscal support we’ve enjoyed since COVID’s onset is giving way to an unavoidable fiscal cliff next year. Even if the current infrastructure and reconciliation bills are passed at their highest levels, the net incremental spending in 2022 would only amount to $100-$150 billion. That compares to nearly $3 trillion in fiscal support that’s flooded the market in 2021.
The massive deceleration in fiscal support coupled with the aforementioned tapering set to take hold at the Fed should predicate a consequential unwinding of stimulus over the coming year. The positive economic attributes of rebuilding inventories, gradually filling record job openings, expected wage increases, and the promise of a boost to capital expenditures offer some offset to the withdrawal of support. Nevertheless, these factors are not substantial enough to offset a multi-trillion-dollar fiscal drop-off from 2021 to 2022. Earnings growth expectations for 2022 are far more modest than what we’ve experienced over the last several quarters, and recent revisions reflect some concerns developing in the earnings outlook, which could challenge equity prices. Further, margin pressures from rising input costs and increased labor costs exemplify a key risk to the outlook. Slowing demand growth can only exacerbate that challenge.
Aside from the earnings trajectory, the current state of valuations should give any conscientious long-term market observer some pause. The excess liquidity and low-interest-rate environment have cultivated speculative behavior and an overhyped stock market.
Importantly, not all segments of the market have benefited from the euphoria. Chart 3 from Pzena Asset Management, showing “Record Valuation Dispersion,” illuminates this development distinctly.
The orange line shows that the market has driven valuations in the most expensive quintile of the market to levels that have never been observed, while the cheapest quintile of the market continues to trade within the same long-term valuation band. This graphic indicates that high multiple growth stocks could be extremely exposed to negative downside should interest rates normalize over the intermediate term.
If your hunting ground is in the cheapest quintile, you can sidestep the risk of overvaluation and identify classic value opportunities with pricing power. That happens to be the area of the market that we continue to find reasonably attractive, and it includes the energy sector along with many value-oriented equities that our portfolios currently emphasize.
Executing a Dynamic Process
The broad equity markets have cultivated a dependence on the success of a narrowing group of highly valued stocks. Current conditions suggest that the forward-return environment is not only low for both equities and fixed income, but it may also offer more downside volatility than many anticipate due to the coming withdrawal of monetary and fiscal support and a normalization of interest rates.
We believe executing a dynamic process that identifies and captures quality investment opportunities (depressed valuations with promising fundamentals) and bypasses unwanted levels of risk (overpriced equities with unachievable expectations) will be a requirement for success. Selected traditional market assets and timely non-traditional alternatives are among the opportunity sets for our portfolios, and our investment team has extensive experience dynamically managing assets in both universes.