Stocks resumed their march higher yesterday with the S&P 500 setting yet another all-time high. However, the record didn’t exactly create broad based excitement. In an earnings season where the average company is reporting year-over-year earnings gains of close to 90%, managements are expressing all kinds of caution that the future won’t repeat the past.
OK, we aren’t likely to exceed 90% growth again. I can live with that. For one, last year the economy started to reopen in the second half of the year, so we all know comparisons will get tougher. That is already built into stock prices. But even as we understood that 90% growth couldn’t be sustained, did we fully expect another surge like the one the Delta variant is delivering now? Did we expect supply disruptions this Fall to still be cascading throughout the economy? Did we expect the persistence in inflation even as commodity prices recede from record levels?
The problem is that as growth reverts towards normal, no one really knows what the future normal might be. We don’t know the impact of the tapering of central bank bond purchases. We don’t know what, if anything, Congress might pass in the way of new spending and taxes. There is a rather wide moat between absolutely nothing and something north of $5 trillion with added taxes layered on top. Right now, I would give better odds to nothing happening as I would to the full package being passed into law.
Then there are the crazy unintended consequences. It’s August, peak travel season. As part of previous packages, the government gave billions in lifeline support to airlines to maintain staffing levels through the pandemic even when no planes were flying. Now planes are flying and both Spirit and American can’t find the staff to man its scheduled flights. What am I missing besides ineptitude? Beach resorts are packed but many restaurants are takeout only because they can’t find workers. The Fed says full employment is many months away even though there is more than one job posting for every unemployed American. A couple of months ago, there were lines at open houses for people trying to buy new homes. Prices skyrocketed. Potential buyers became renters again. High prices convinced others to sell. They became renters as well. Now renters can’t find places to rent. When they do, they find the same bidding wars for apartment leases that home buyers saw a few months ago.
Meanwhile, the Fed keeps buying $120 billion of bonds per month and the ECB does the same, adding $4 trillion to its balance sheet. If you do the math, that’s over $7.5 billion dropping from the sky to support economies here and abroad that are hardly in crisis mode. All asset prices rise as a result. Rising bond prices mean lower yields, even with inflation upon us. The Fed labels that transient. History shows that when the Fed labels inflation transient, watch out. The last time they used that word was a few years before the Great Recession. When it got caught behind the curve, the Fed had to aggressively raise rates at a time when too many people had too little equity in homes they couldn’t afford.
Legislation since the Great Recession almost certainly will prevent another mortgage crisis, but what legislation and regulation have done is moved riskier loans off bank balance sheets. The biggest mortgage lender today isn’t a bank, it’s Rocket Mortgage. Newbies like Square and PayPal are telling you to buy now and pay later. That’s fine when everyone is flush with cash, has a job, and interest rates are near zero, but it won’t always be that way.
Can the Fed thread the needle this time around? It’s possible, but it’s risky. The Fed and the ECB alone are buying $7.5 trillion of bonds on an annual basis. To give perspective, the total size of the U.S. stock market is about $46 trillion. U.S. GDP is a bit over $21 trillion. When central banks stop buying, then what? If rates rise too quickly or the economy slows too fast, can the Fed afford to continue tapering? Or are they stuck in no man’s land?
Don’t get me wrong. There are a lot of very smart people who think inflation will stay below 3%, and that the Fed can taper slowly and defer actual interest rate increases to 2023 or beyond without disturbing the economic recovery. They believe supply chain disruptions will get solved soon, that technological deflationary pressures will prevail, and that productivity can offset any impact of wage inflation. The reality is that where we are heading is unchartered waters. We have never had this much stimulus worldwide, and we have never had such stimulus at a time when economies all over the world are booming. Maybe taking it away will simply allow the world to normalize and there will be a pot of gold at the end of the rainbow.
Economic policy is meant to create or maintain balance. Too much of anything has bad consequences. Inflation derives from too much demand or an imbalance in the supply/demand equation. In the short run, we are experiencing more demand than the system can meet. That is why prices are rising, supplies are short, and airlines are canceling flights. Hopefully, natural forces will restore balance.
One thing is for sure. Both the stock and bond markets act as if inflation is fleeting. Bond rates are near record lows and inflation expectations are less today than a couple of months ago. Meanwhile, our economy is adding hundreds of thousands of jobs every month and profits are at record levels. Starting workers from entry level to investment banker newbies are being paid record salaries. Let’s hope for the best, markets are. If they are right, the bull market keeps going. If there are speed bumps, don’t be surprised by a correction or two. There isn’t a recession in sight. The threat is inflation and higher bond rates. No sense in predicting now, we will have to watch and adjust. What we can say, however, is that inflationary pressures so far look more persistent than the Fed wants us to believe. I hope the Fed is right. Hope, however, isn’t a prediction, it’s a wish.
Today, Meghan Markle is 40. Barack Obama is 60. My invitation to Nantucket must have gotten lost in the mail. My wife would be interested to know that today is the 200th anniversary of the birth of Louis Vuitton.
James M. Meyer, CFA 610-260-2220