For much of the year, the market has climbed the wall of worry, on several fronts:
Worry #1) the virus and, more importantly, the prospects of draconian government responses,
Worry #2) Russia and China taking advantage of our position of weakness and flexing on their enlargement aspirations,
Worry #3) the lack of acknowledgement from the Fed on inflation, and therefore a catastrophic policy mistake, and…
Worry #4) related to #3 – the firing of the final, but toxic and inflationary fiscal bazooka, in the form of a tear down and rebuild of America spending plan.
In less than a week, it looks like three of these worries have beenresolved.
No lockdowns. The Fed is moving on inflation. And Build Back Better is dead (for now).
With that, we talked about the set up for a bounce back in stocks yesterday, particularly small caps (the Russell). Indeed the Russell finished the day up over 3%.
Remember earlier this month we compared the current period to 2014, where the domestic and geopolitical noise was high, and the Fed was ending its QE response to the financial crisis – and setting the table for the rate liftoff.
Through the Fed's taper, stocks went up — about 10%.
From this graphic from Putnam, we can see which sectors performed the best in that period …
Over the past month, we've talked about the reappointment of Jay Powell, and how his subsequent flip-flop on inflation may have made it much more difficult for the Democrat controlled Congress to justify the final fiscal spending bazooka (i.e. the transformative "green" and social spending plan).
If anything, the new positioning by the Fed, from inflation denier to inflation fighter, has given the swing voter in Congress (Manchin) the cover to reject the administration's big wish-list spend.
And here we are, Manchin has now given it a hard no.
As we've discussed in past notes, at this stage, "a smaller deal, or (even better) a nodeal, would be among the best outcomes for markets and the economy. It would be a relief valve on inflation pressure. And it would remove the obstruction of uncertainty on a recovering economy that already has $5 trillion of excess money floating around."
So, at the moment, we have a no deal. This should be good for markets, good for the outlook.
With that, let's take a look at some key charts, after this morning's knee jerk selloff …
As you can see in the chart above, the S&P 500 traded into this big trendline today. This line represents the rise from election day, which was on the anticipation of a big fiscal spending agenda.
We have indeed had another $1.9 trillion, plus another $1.2 trillion. And as we trade into the support of this big trendline (a little more than a year later), we have very accommodative monetary policy (still), strong corporate and consumer balance sheets, a hot labor market and the expiration of debt and real estate moratoriums (which should fuel employment and economic activity).
With this mix, now excluding a toxic and disruptive inflation fire (with a no deal on "Build Back Better"), we get a bounce from this trendline today.
And we have similar technical support holding today in the Nasdaq …
The Nasdaq trades today into this big line, which originates from the March lows — the day the Fed fired the bazooka of monetary policy (intervening in the corporate bond market).
With the above in mind: With these big market proxies bouncing this afternoon from technical support, and with the prospect of an optimal outcome coming from the recent fiscal spending negotiations, this next market (chart) becomes the most attractive buy into the final trading days of the year…
As we discussed yesterday, it looks like the Fed guidance this week served as confirmation of the end of globally coordinated easy money policies.
The question is how aggressive will the tightening cycle be?
Thus far, the Fed wants us to believe that the cycle won't be aggressive. And to justify that, they keep our eyes on the supply chain disruption as the only factor driving inflation. They say it will ultimately normalize. That's reasonable to assume.
In their outlook, they ignore that $5 trillion of new money supply created over the past 20 months. And they ignore the wage growth, which is hot, and sticky (going higher, and will stick).
With that, let's take a look at this chart of wage growth vs. productivity…
As you can see, over the past forty-years, each hour of work generated far more income for all stakeholders, than it did for the average worker. Translation: The lion's share went to the few.
But this productivity/pay gap is about to narrow, thanks to hazard pay through the pandemic, overly generous and lengthy federal unemployment subsidies, and (subsequently and consequently) an imbalanced job market (more jobs than job seekers). Wages are going up, fast.
With that in mind, the gap in the above chart gave us nearly four decades of falling inflation and falling interest rates. Logic would tell us that rising wages and a narrowing of the wage/productivity gap will fuel the opposite.
It looks like the Fed started the end of globally coordinated easy money yesterday.
This morning the Bank of England raised rates this morning, with a surprise 25 basis points. That's the first major central bank to raise rates. The European Central Bank telegraphed an end to its pandemic/emergency asset buying program by March. The Bank of Japan decides on policy tonight.
That said, emerging market central banks have already been moving on rates for much of the year. These are central banks that don't have the luxury of representing 90% of the world's foreign currency reserves (like the U.S., UK, Japan and Europe). They couldn't afford to sit around, waiting and watching inflation. They had to act.
Mexico, South Korea, South Africa, Chile, Brazil, Czech Republic, Hungary, New Zealand, Norway, Poland, Russia, Turkey — all have been raising rates to fight inflation and to defend against capital flight.
So with major central banks joining over the past 24 hours, the change in direction of global monetary policy is probably official now.
With that, as we've discussed, a higher rate outlook makes the high multiple stocks most vulnerable, which includes the no-earnings/ innovation story stocks.
For perspective on today's losses in the big indexes, let's take a look at the sector performance on the day.
As you can see, money moved out of technology (high multiple stocks) and consumer discretionary (a beneficiary of stimulus). And into financials and commodity related stocks (materials). This is the "growth to value" rotation we've been talking about. It's early days.
This afternoon markets rallied following the Fed decision, where Jay Powell guided to a faster end of QE, and three rate hikes next year.
We expected that the Fed might double the cuts to its bond purchases. They did. We expected that the move would open the door to a rate liftoff as soon as March. It did.
While June remains the most probable month for liftoff, the Fed Chair indicated that they could liftoff when bond purchases are ended, which would be March.
On the face of it, this all sounds like a more hawkish Fed communication today than even expected.
But markets liked it. Why?
Because the Fed is forecasting a very shallow rate hiking cycle. That's because they remain arrogant enough to forecast an inflation rate that will reverse (from 7%) and land close to their 2% target, by next year.
With that, maybe the biggest message that markets came away with today: The Fed will not become inflation fighters.
Of course, that may or may not happen. But that was the takeaway today.
If you believe Jay Powell, you expect a hot economy to continue to strengthen, with a Fed that will perfectly thread the monetary policy needle, to produce just 2.6% inflation from a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) — all while keeping the Fed Funds rate under 1% — and over the coming years, never needing to exceed the Fed's long-term target Fed funds rate of 2.5%.
That would be magic.
But remember, the Fed cares more about shaping expectations than they do about forecasting. They have a good record on the former, and a bad record on the latter. What matters most for markets, in the near term is the former. With that, markets go up today. And if we look back at the analogue of 2014, when the Fed was tapering its last round of QE, stocks went up. Only after the Fed actually made its first interest rate hike, in late 2015, did the path become tougher for risk assets.
With the Fed meeting tomorrow, bets were increased today that we could see a first rate hike as soon as March (about a 35% chance).
And the market is now pricing in an 80% chance of a hike by June. It was a 50% chance yesterday.
Over the past six weeks, the consensus view in a Reuters economist poll has gone from the view of: no rate hikes until 2023, to a rate hike in Q4 of next year, to a rate hike in Q3 of next year.
That view will likely get pulled forward again tomorrow.
Let's take a look at real estate, for some insight into what this might mean for record high prices.
The above chart is the Case-Shiller Home Price Index (index of 20 major cities).
It's 47% higher than the pre-financial crisis peak.
Does that mean its a bubble? No. Even though money is easy, and the Fed is pumping liquidity into the mortgage bond market, it doesn't mean that risk in the housing market has elevated.
You can see in the graphic below, the risk profile is very different, which aligns with the current environment of high creditworthiness (low debt service, high savings) and stringent lending standards (post-financial crisis).
The real estate bubble that popped in 2006 was primarily driven by credit agencies AAA stamping high risk/high yielding mortgage portfolios. With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments. And with that insatiable demand, mortgage brokers and bankers were incentivized to keep sourcing them and packaging them. So, whether it was fraud or incompetence (or both) somehow the ratings agencies survived.
Bottom line, this housing environment looks much less vulnerable to rate hikes.
What looks likely, in the face of a rate tightening cycle, is that real estate prices just stay persistently high, and even continue higher — driven by multi-decade high economic growth, massive new money supply floating around, and a very tight labor market. And at higher rates, it will just cost more to live.
Consider this above chart of Australian housing prices. Pre-Global Financial Crisis, the fundamentals of the Australian housing market were every bit as dislocated as U.S. housing (housing price to rent ratio, home price to income ratio), but they didn't have a bust – it just kept going.
We have the big Fed meeting this week, which will conclude on Wednesday.
Given the posturing by Jay Powell a couple of weeks ago at his congressional testimonies, we should expect the Fed to speed up the timeline on ending QE.
Remember, at the Fed's November meeting they projected an end of QE by June.
The path to June came from their plan to taper bond purchases by $15 billion a month.
If they decide on Wednesday to double those monthly cuts,we would then have a timeline to end QE by March.
This matters because it's very, very unlikely that they would raise rates before ending the bond buying program. With that being the case, the recent telegraphing from the Fed would suggest that March would be the earliest the Fed would begin the liftoff of interest rates.
What does the interest rate market think? The market is pricing in about a 30% chance of the March scenario, and about a 50% chance for a May liftoff.
Now, with this in mind, remember on Friday we looked at the inflation spikes in 1973-1974, and the hot inflation of the early 80s. In both periods, the Fed had to ratchet rates above the rate of inflation to finally get it under control.
In the current case, they are nearly seven percentage points behind. And if they aren't positioned to start raising interest rates (from the zero line) until March, at the earliest, the inflation situation is going to be left to only intensify.
Still, even if they begin an aggressive hiking campaign in March, with a 50 basis point hike, they will still be in a stimulative position for quite some time — which will continue to stoke inflation.
If we look back at the past five tightening cycles by the Fed ('87, '94, '99, '04 and '15), the Fed has averaged about 50 bps a quarter.
Keep in mind, the Fed will be tasked with bringing inflation under control, without killing the economic expansion. Given the current position, it will be a tough task. The trajectory looks like 2023 could be a tough year.
The optimistic scenario, within the market, is driven by the idea that supply chain bottlenecks will be worked out, and naturally relieve inflation pressures.
The less optimistic scenario, while acknowledging the chance for a normalization on the supply side, we can't ignore the boom on the demand side, driven by $5 trillion of new money supply added over the past twenty months, a "reopening" economy, and hot job market.
The inflation data came in hot this morning, as we suspected.
Here’s what it looks like with some historical perspective …
This is early 80s-level inflation. The last time we had this degree of inflation, the effective Fed Funds rate (the rate the Fed sets) was 14.45%. Today it’s 0.08%.
What was the Fed Funds rate when inflation peaked in 1980 at nearly 15%? 17.6%.
What about the spike in 1974-1975? Inflation started to come under control, only after the Fed ratcheted rates up above the level of inflation. In late summer of ’74, inflation was running 11.5%. The Fed took rates up to 13%.
So, with the Fed currently at zero and inflation running at (least) 6.8%, this is going to be painful battle. The Fed is way, way behind. Double-digit inflation continues to look like the most probable scenario.
With this in mind, I want to copy in an excerpt from my note back in March, where we looked at this chart from Bank of America, which gives us a visual on the record extreme divergence in the performance of deflationary assets, relative to inflationary assets over the past 30+ years.
Excerpt from Pro Perspectives, March 26: “Are we seeing the turning point, driven by the unimaginable catalyst of profligate monetary and fiscal action, combined with a global supply crunch and pent-up demand from a global pandemic?
If it is, it would have good company, historically, in terms of major events. If we look back at the periods where inflation assets outperformed deflation assets by 15 percentage points or more, we find three:
1941 – End of the Depression and big government spending through The New Deal. Inflation ramped up to double digits in 1942.
1973 – Oil crisis. Inflation ramped to double digits in 1974.
2000 – Bursting of the dot com bubble. The Fed prevented a spike in inflation, through rate hikes, but crushed the stock market and created recession.
Again, these are historic periods where inflation assets outperformed. It looks like we are in the early stages of another one: buy inflation assets.”
For October, the headline number was a 0.9% monthly change in prices. If we extrapolate that out over twelve months, we have double-digit annual inflation.
The November number is expected to be hot as well, at +0.7%. And that leads us into next week's big Fed meeting, with expectations that they will announce a faster taper and project a timeline toward a rate hike as soon as March.
The question becomes, assuming conditions hold, how aggressively will the Fed go after inflation? Economic expansions tend to end when the Fed kills the patient.
With that said, if we look at the Atlanta Fed model, it continues to hold up well.
For Q4, the model is projecting almost 9% growth.
If this number were to hold up, we could see 6% economic growth for the full year 2021. That would be the fastest growth since 1984.
Yesterday we compared the current period to 2014, where the domestic and geopolitical noise was high, and the Fed was ending its QE response to the financial crisis – and setting the table for the rate liftoff.
I failed to mention another very important event in 2014: the Thanksgiving evening oil market surprise. This is when OPEC pulled the rug on oil prices, with a well-timed announcement that they would not defend the price of oil with a production cut.
This event turned out to play a very key role in the Fed’s ability to follow through, in the coming years, with its rate “normalization” plan.
What started as a slide in oil prices back in 2014, turned into a crash with OPEC’s influence. And over the next year, as you can see in the chart below, oil traded down from over $100 to below $40 — ultimately bottoming out at $26 in 2016.
What does this have to do with today?
Oil prices are important.
Though the Fed always likes us to believe that their assessment of inflation, excludes oil prices (which they argue are too “volatile” to consider), they have a very clear history of acting when oil prices make a dramatic move (higher or lower).
In this 2014 analogue, the Fed went from tapering and ending QE in 2014, to telegraphing and executing its first rate hike in nine years (in December of 2015). And from there, they were telegraphing four additional rate hikes in 2016.
But oil kept collapsing. A month into 2016, oil had fallen another 35% to the high $20s. That sounds great for consumers (cheap gas). But it also came with mass bankruptcies in the U.S. shale industry, and therefore threats to the creditors of the industry. And it came with heavy deflationary pressures in the economy. Stocks melted down, having the worst start to a New Year on record.
With that, just one month after the Fed pulled the trigger on its first rate hike, they had to take the four rate hikes that they were projecting for 2016, off of the table. And quickly, they were back in the defensive.
I revisit this scenario: 1) for the similarities between the current period and 2014 (excluding oil prices), and 2) to acknowledge a (low probability) scenario where oil prices could crash (undermanipulation) and completely reverse the outlook on inflation, Fed policy and the economy. It’s far from the high probability scenario, at this stage, but it’s possible.
