Stocks inched higher on Friday, but futures have reversed course this morning and are now solidly in the red. The issue of most importance to equity investors is word from the Fed that FOMC members are coalescing around the September meeting as the time at which it will finally announce the details of its program to taper bond purchases. That is likely to begin this Fall. It will set up a roadmap that could allow the Fed to start raising interest rates late in 2022 if GDP and inflation data demonstrate a persistence in inflation beyond current Fed predictions.
In addition to the timing of the FOMC decision, markets must deal with the economic impact of the Covid-19 Delta variant and the fall of Afghanistan. Add in signs that growth rates in China are slowing, and a 7.2 magnitude earthquake in Haiti, and the news over the weekend was all bad. On the positive side, looking ahead retailers will start to report Q2 earnings this week and they should be quite good across the board.
But let’s start at the top. Last week’s inflation data reinforced the thought that inflation is likely to be more persistent at the core than Fed officials expected just a couple of months ago. While there was some moderation of reported CPI inflation data for July, the main cause was a sharp de-escalation in the rise of used car prices. That is hardly what I would call a core event. Rather, the overall rate continued hot at 5.4%. And this was without any reported acceleration of significance for either rents or wages. Anecdotally, there is wide evidence that both are rising at an accelerated pace. So far, productivity gains, always high early in a recovery until hiring matches up with the pace of recovery, are offsetting the rise in wages. But as productivity stabilizes at a much lower number closer to 2-3%, the impact of wage increases bears watching. As for rents, they are accelerating, pushed higher by the surge in housing prices. That surge has sent potential home buyers back into the rental market. Overall, shelter costs, the most important factor in the CPI calculation by far, rose more than 4% even with a subdued rise in rents. It is unlikely that rising shelter costs are transient by anyone’s definition.
Yet while the inflation clouds are gathering, the yield on 10-year Treasuries have started to fall again. A few weeks ago, they reached an interim low of about 1.12%. They then rallied to over 1.35% before falling back below 1.3% at the end of last week. If investors need a reminder, the Fed is still buying $120 billion of bonds each month and there remains about $9 trillion of sovereign debt overseas still sporting negative yields. Thus, to foreign investors, 1.3% looks tantalizing. Even when the Fed decides to slowly recede from a program of steady bond purchases, there will be lots of demand for Treasury debt among investors. That will limit the speed at which interest rates might rise, if they rise at all. Slowing economic growth (10%+ is clearly unsustainable) in the U.S. and signs of slowing in China, the world’s second largest economy, support the notion that rates will stay low for a long time.
With all that said, economic predictions are just that. When it comes to interest rates and future growth, predictions are notoriously fuzzy. That is why when the Fed announces its tapering program, there will be a lot of flexibility factored in. The speed of tapering can be adjusted to economic conditions. While the outline would likely allow an actual increase in the Fed Funds rate before the end of 2022, it would be much too premature to write an increase in ink in one’s interest rate calendar. Clearly, the rate of growth and inflation next Fall will govern any such decision. But asset prices are a set of future expectations discounted back to the present. The news that tapering might be slightly accelerated will impact today’s collective assumptions and be a modest negative to asset prices.
While not an obvious economic event of importance, the speed at which Afghanistan has fallen has dominated news headlines over the weekend. The Biden Administration is getting a lot of blame from all corners. But the U.S. campaign in Afghanistan has been a 20-year failure. There is blame to be shared with past administrations all the way back to George W. Bush. That isn’t meant as a statement absolving Biden of his share of the blame. What the fall of Afghanistan does do is reinforce the need to reexamine our role in future world conflicts as well as our defense strategy. Here is where the economics come into play. When Congress returns, it will have to deal with roughly $5 trillion in spending requests related to new programs President Biden and the Democrats are imposing. It will be tempting to fund part of that increase with cuts in defense spending. The sorry ending in Afghanistan could impact what cuts, if any, are made, and what increases might be necessary to insure world and domestic safety.
When Congress returns and takes up the humongous budget requests, it will also have to tackle a need to raise the debt ceiling. During the Trump administration, the ceiling was raised to a level that expired in July 2021. That level has been reached. An increase will be necessary. Democrats don’t want to raise on purely partisan terms for obvious reasons. They will try to attach the request to legislation that cannot be done through reconciliation, thus requiring 60 votes in the Senate and some bipartisan support. For instance, they could attach a request to raise the debt ceiling to a continuing resolution needed to keep the government fully funded and operating.
Republicans are unlikely to take that bait. They will accept another government shutdown to focus attention on the Democrats huge spending plans with inadequate funding sources. Given that Democrats control the White House and both chambers of Congress, and that a standalone request to raise the debt ceiling can be done via 50 votes in the Senate, the Democrats would have to own any failure to raise the debt ceiling. Simply said, it is the medicine they will have to swallow to move their economic agenda forward.
As for the agenda itself, 9 moderate Democrats in the House have sent a letter to Speaker Pelosi demanding that the infrastructure bill get voted on separately. There are others who agree but didn’t step forward to sign the letter. The action itself is less important than the obvious fact that Democrats are not yet unified on the size and scope of their economic package. Passage requires support from all 50 Democrats in the Senate and all but 3 House members. There will be no Republican support beyond a bipartisan infrastructure bill. So far, progressives have written the outline. But that outline hasn’t provided any details on how the spending will be paid for. That is always the hard part. If there is to be any package, it will likely be no more than half the $5 trillion requested. Getting even that done won’t be easy. If spending is to be halved to gain a total majority, the proposed tax increases will be reduced as well. The bottom line is that it is much too soon to presume anything. We will get more details of the outline in September. Then the real horse trading begins. Only then can one realistically make educated guesses.
Today, Steve Carell is 59. Madonna turns 63. A special Happy Birthday to my daughter, Sarah.
James M. Meyer, CFA 610-260-2220