Fed Tapering—Monetary Policy Still Accommodative—Potential Changes in Fed Membership More Dovish Policies—Financial System Awash in Cash, Fed Drains Cash Using REPOs---Delta Variant Likely Peaked, Mini Cyclical Fourth Quarter Rebound—Shipping Delays and Locked Down Asian Factories Negatively Affect Fourth Quarter Sales and Earnings—Pricing Power of Goods Suppliers Will Determine Their Ability to Protect Margins From the Covid Spillover--Shelter Cost Inflation Heavy Weighting in CPI and PCE—Lags Real World Change 6-12 Months---Rent Increases Sticky
In its recent meeting, the Federal Open Market Committee (FOMC) stated it looks to moderate its pace of asset purchases “soon”—tapering—likely no later than year-end. Each month the Fed increases its holdings of Treasury and agency mortgage-backed securities by at least $120 billion. The Fed will likely taper its asset purchases by $15-20 billion monthly. This pace would end incremental purchases around the middle of 2022. In a $20 plus trillion economy, eliminating these incremental purchases would likely show little impact on growth and remain accommodative. Admittedly, so-called tapering by the Fed would concern investors by moving monetary policy closer to hiking the Fed funds rate.
Potential changes in Federal Reserve Board leadership next year could importantly influence the speed of rate increases. President Biden will shortly determine whether to reappoint the Fed Chair and two vice-chairs. In the case of Chair Powell, his term as Chair ends in February and most expect renomination. The two vice-chairs will not be reappointed. Therefore, these two plus an already empty seat on the seven member Fed Board of Governors will likely be filled next year by President Biden with Senate review. In appointing new board members, he will emphasis diversity. Therefore, with a more dovish board, a Fed funds rate increase may be at least 18 months off into the future. That also assumes the Fed meets its goals of maximum employment and “inflation on track to moderately exceed 2 percent for some time.” However, if inflation runs hotter than expected, the Fed may face the need to quickly curb the rise with a rate increase.
While financial markets focus on tapering, in reality a form of tapering already occurred this year. Through overnight reverse purchase agreements (RRP,) the Fed sold securities from its balance sheet unlike its ongoing QE buying program. By selling securities instead of purchasing, the Fed in effect drains cash out of the financial system. Using the RRP facility, counterparties send cash to the Fed in return for equivalent securities. Figure 1 shows the total amount of RRP’s reached nearly $1.4 trillion. This year represented an unusual level of activity due to unspent stimulus funds held by the Treasury. That increase equals roughly 10 months of the monthly QE purchases made by the Fed this year. Participants in the Fed’s RRP facility include money market funds—about half the total of RRPs—as well as prime dealers and government sponsor agencies. The important point--draining cash out of the financial system did not affect economic activity. The financial system remains awash in cash.
Since our last Commentary (8/23/2021,) many economists further reduced their 2021 GDP forecasts to reflect the impact of the Delta variant. Much of their reductions reflects their downward revision of third quarter forecasts. GDPNow, issued by the Atlanta Fed, shows the downward trend for third quarter GDP forecasts (see Figure 2.) Looking forward, the Delta variant seems to be peaking (see Figure 3.) With this likelihood, fourth quarter economic activity should show improving momentum. With that, it seems likely the economy will experience a mini cyclical recovery to the benefit of so-called value/cyclical stocks.
With the onslaught of Covid-19 early in 2020, businesses sharply reduced their inventories in expectation of a deep recession. With the same economic concerns, Congress passed a series of massive pandemic income replacement programs totaling over $5 trillion—equal to 25% of annual GDP. The combination of these actions resulted in accelerated demand producing product shortages with the low inventories. Not surprisingly, prices shot up for selective products such as used cars. With the full impact of stimulus programs and the Delta variant fading, consumers will likely shift their spending to services from goods. With this shift, the Fed expects this inflationary spike will likely prove transitory—admittedly an undefined time period.
Speedily refilling inventories will prove key to meeting the Fed’s expectation for “largely transitory inflation.” Once again Covid will play an important role in determining whether inventories can be rapidly rebuilt to relieve shortages. Shipping products represents one friction point as Asian air and ship ports close periodically due to outbreaks of Covid. At the same time, a lack of sufficient workers and equipment in this country, resulted in ships backed up waiting to enter jammed U.S. ports ( see Figure 4.) If consumer spending shifts from goods to services this backup could be relieved in the first half of next year.
Further limiting a rapid rebuilding of U.S. inventories, Asian manufacturers lock down production lines due to Covid. For example, Vietnam, which now accounts for roughly a third of U.S. footwear and a fifth of apparel imports, shut down most factories for at least two weeks at a time. One major footwear manufacturer lost half its production as its factories shut down for ten weeks. Figure 5 shows that, hopefully, the recent covid spread peaked in Southeast Asian countries. The resulting delays and higher shipping costs for the holiday season will still likely negatively impact fourth quarter earnings for retailers and manufacturers. Key to that outlook will be their pricing power to offset these incremental costs. In the end, consumers will pay more.
History shows the deadliest periods for viruses come in the two-three years following the first year. How fast Southeast Asian countries can increase their rate of full vaccination will likely determine whether manufacturing interruptions can be minimized to speed up inventory rebuilding (see Figure 6.). This will provide an important answer as to how transitory will this source of inflation prove to be. If the rate of vaccination in the emerging market countries improves substantially, that group may become more attractive to investors. In the meantime, how much pricing power goods manufacturers can exercise to meet the spillover effect of covid will be key to profit margins.
The other important open inflation question, one that will prove more sticky, will be the outlook for shelter costs---rent and owners’ equivalent rent (OER)—the amount of rent equivalent to the cost of home ownership. Figure 7 shows the shelter weightings in the Consumer Price Index (CPI) and the price index for Personal Consumption Expenditures (PCE.) The weighting of nearly 30% in the CPI represents roughly double that of the PCE price index .
The Apartment List national rent report showed rents increase 2.5% in August vs. July which compares to a 0.4% seasonally unadjusted increase for rent in the CPI. Since January 2021, median rent showed an increase of 13.8% nationally. In rough comparison, through August 2021, the CPI shows a rent increase of 2.1% year over year. Changes in the PCE and CPI shelter cost indices tend to lag by roughly 6-12 months real-world changes as illustrated in Figure 8.
The lag effect of heavily weighted shelter costs in the CPI as well as the PCE could offset potentially ebbing transitory inflation and importantly prove stickier. Figure 9 shows shelter cost forecasts for the next two years. The Dallas Fed’s shelter cost forecasts for 2023, if realized, would prove to be the highest increase in more than 30 years. Their increased shelter costs forecasts would contribute roughly 0.6 and 1.2 percentage points in 2022 and 2023 respectively to 12-month core PCE inflation. For the CPI, that impact would likely be higher. These increases would not likely prove transitory but could be offset by product price declines as the economy returns to more normal demand/inventory balances. In our view, despite the Fed’s mantra, investors need to remain wary that inflation will prove higher and last longer. The key question, if this proves correct, how rapid will the Fed respond and to what degree.
Fixed Income and Alternatives —In our view, inflation will likely prove higher and last longer than the Fed expects. Nonetheless, interest rates will remain historically low for some time—no matter whether moving up or down. With inflation materially higher than interest rates, this combination results in negative real interest rates—inflation less nominal interest rates—for fixed income investors. Therefore with both low nominal and negative real interest rates, fixed-income investments remain unattractive and should only be used to protect capital. For that portion of the portfolio historically committed to fixed income securities, investors should primarily focus on a diversified group of alternative investments.
Increased Market Volatility — Investors face the last part of 2021 with continued question marks. These include the Covid spillover impact on profit margins, the resulting greater uncertainty for the 2022 economic outlook, and higher tax rates that could diminish next year’s corporate earnings outlook. These will likely produce greater market volatility between now and year-end particularly if the covid spillover produces a greater impact on profit margins then currently forecasted.
Mini-Cyclical Rally — The Delta Variant slowed third-quarter economic expansion, but its influence will likely diminish as vaccines, and importantly booster shots seem ready to provide appropriate protection. Such protection will enable consumers to prudently go on about their lives. Sizeable untapped consumer savings and growing employment levels will help drive the economic expansion further. As the variant becomes less of a factor, inventory rebuilding will likely speed up again as supply chain bottlenecks begin to open up. Later in the year, as the economy regains greater momentum—experiencing a mini-cyclical expansion---so-called value/cyclical stocks will prove a prime benefactor.
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