The market is digesting two pretty important events over the past few days, both of which could have dramatic implications for investors going forward. First and foremost, the Federal Reserve announced a historic change to their long-term mandates on inflation and employment. The Government’s recent helicopter money actions have also led to a new concern for me that stems from Wednesday’s market action. A Salesforce# earnings report caused a massive jump in software related technology players eerily similar to the Nasdaq bubble action from the late 90’s. First, the Fed news.
Chairman Powell’s comments were eye opening. The Fed has a dual mandate of full employment AND stable inflation. Back in 2012, Chairman Bernanke took the significant step of setting an actual inflation target of 2%. This put the U.S. in line with many of the globe’s other major central banks. They left the goal for full employment without a fixed number. Historically, when employment got below 4%, inflation followed. Therefore, every period that saw full employment resulted in the Fed raising rates, crimping growth, halting inflation and creating a slowdown in economic activity. Subsequently, unemployment rose. A vicious cycle to say the least.
Fast forward to today. Powell’s admission that the Fed does not know everything and has made mistakes leads him to believe there is no reason to let full employment drive their “fear” of inflation. This is a different world for sure. Now they will look for an “average” inflation target of 2% annual increases in the Consumer Price Index (CPI). For example, if we have three years of 1.5% inflation, we can accept three years of 2.5% inflation without the Fed raising rates. Inflation hasn’t been above 2% since 2012, so there is plenty of work to be done.
Chairman Powell also provided another very important quote: “One of the clear messages we heard was that the strong labor market that prevailed before the pandemic was generating employment opportunities for many Americans who in the past had not found jobs readily available.” Letting the jobs market run hot is great for those looking for work. It could also drive overall wages higher, which has been a sore spot since the last recession. Either way, the Fed will provide ample liquidity for longer than normal. Immediate market reaction was a reversal of previous trends. Investors sold technology stocks and bought banks, industrials and cyclicals. It looks like the Dow Jones will finally join the party and set new all-time highs at the open today.
The negative consequences here are real for the low-income cohort. Housing and implied rents are 42% of the CPI weighting. Food & beverage are only 15%. Medical care is only 9%. For a large portion of America, their spending habits on food and medicine is much higher than 24% of their income. Inflation here has been well above 2% for many years. In effect, low interest rates are making housing more affordable, lowering implied rent computations. Its outsized weighting in the CPI formula can artificially keep inflation well below the long-term target. The average American is spending more money on life’s necessities without a commensurate increase in wages. Time will tell if this can change.
For equity investors, this can only be described as bullish. Fed Funds will stay at zero for an extended period. Don’t fight the fed is the most powerful market phrase around. When money is free, it will flow to riskier assets, i.e. stocks. The new targets also mean employment can run hotter than previously thought. The 3.3% unemployment rate in late 2019 was the lowest since 1969. Getting back there will take time post-Covid, but the Fed has our backs. Full employment is a beautiful thing. The U.S. Dollar should continue to weaken, resulting in faster growth for those with international exposure. TINA (There Is No Alternative) for risk assets leads to higher multiples.
On the other hand, bubbles are created in easy money markets. The aforementioned Salesforce earnings bounce is testament to this. We’ve seen this story before. In the late 90’s, Fed funds were cut in anticipation of a global slowdown and any perceived Y2K issues. The market was fine before this and capital flowed to the fast growing dotcom market. That bubble lead to massive losses in the following years.
When a $200B market capitalization company, namely Salesforce, lowers revenue projections by $1B in one quarter, then follows up with an increase in revenues by $800 million the next quarter, they didn’t do anything special. In this case, it caused a stir among all the high flyers. Salesforce tacked on 25% on the day, resulting in a $50B increase in value. That’s equivalent to Schwab’s# entire market cap. Facebook added the same in terms of value, on no real news. Netflix was up 10% on nothing. Other software companies also bounced substantially. Salesforce is a great company, but jumps like this leads me to believe we’re entering the euphoric phase of this cycle.
This follows Tesla’s rampant rise over the past few months. Tesla’s stock is now valued at nearly $100,000 per car sold. Apple’s# revenue has increased 3.3% a year for the past 5 years. Yet the stock is up 5-fold! The big 5 technology stocks are now 24% of the S&P 500. Over the past 6 days, the S&P is up 100 points but 5 of those days saw more stocks go down than up. That is not healthy and rhymes with the Tech Bubble. How long can this go on? If 1998 – early 2000 is the example, this mini-bubble can advance another 50% or more. That is not our base case but is certainly possible in a world with zero interest rates as far as the eye can see.
There are a multitude of factors that could cause the long overdue correction in big cap tech. Most likely would be a rise in interest rates. Market valuations are based upon discounted future cash flows. When interest rates are low, those cash flows become more valuable today. PE’s then rise.
The Fed can only control short-term interest rates. They can buy long-term bonds but these yields are set by the market, not the Fed. 10-year Treasury yield movements are driven by inflation expectations. After Powell’s speech, the 10-year Treasury yield popped 9%. That’s only 6 bps in today’s world, bringing the overall yield to just 0.74%, but a sizable move nonetheless. Bond traders are starting to think inflation will pick up over the coming years. Investors do not want 0.74% annual returns if that is the case.
What happens when we get past Covid? There is over $1.5T sitting in money market funds earning a negative real rate of return. Current consumer savings rates of 20% will come down. This money will get spent. It will create pockets of inflation. When Fed funds were at 0% a decade ago, long-term yields were over 2%. A tripling of current yields would do a lot of damage to today’s high fliers. Their earnings trajectory would be fine, but this rally today is primarily a P/E expansionary one driven by low rates. When that changes, investors must change. We’re not there yet but the easy money has certainly been made. More caution is warranted, but on the other hand the punch bowl is here to stay for a while.
Actor Jack Black is 51 today. Country singers Shania Twain and LeAnn Rimes turn 55 and 38, respectively.
James Vogt, 610-260-2214