I can almost copy and paste what I wrote the last time the Federal Reserve met. They have been consistent in their messaging and are proving to not be a negative surprise for markets. There exists a delicate balance between being too hawkish (raising rates too much and pulling liquidity) or too dovish (keeping stimulus in for too long), which has been a concern for decades of intervention. Powell and the team threaded the needle yet again and major stock averages bounced back towards all-time highs before succumbing to some selling pressure in high-beta growth stocks yesterday afternoon.
As we’ve noted, bull markets don’t usually die of old age. They turn into bear markets when a recession occurs after an aggressive Fed forces a yield curve inversion and/or when valuations get way out of hand. Today, there are pockets of valuation concerns, but Fed officials clearly put inflation at the forefront of their minds, finally. Containing inflation today helps alleviate fears that the Fed makes a policy mistake which forces their hand to become too aggressive later, creating havoc.
To summarize Fed action, tapering will be increased to double its original plan, which leads to a March ending instead of June. Purchasing mortgage-backed securities and Treasuries at this point in an economic boom is excessive to say the least. Fixed-income markets have been accustomed to Fed involvement for a while now, so if they pulled it all at once, dislocations and chaos would be possible. It is prudent to proceed with some caution, but this will end soon enough.
Next up are the infamous dot plots. Every Fed official predicts where they think Fed Funds should be over the coming years. They pointed to 4 rate increases next year, while the markets were pricing in 3, possibly starting in March. The accuracy of forward projections by the Fed and market this far out is suspect at best, but what this does say is that the Fed knows inflation is an issue and will do what is needed to get us back to a 2%+ level from the current 6%+. This should calm down some inflation bears for now.
Lastly, and most important from a market perspective, Powell noted the differences between economic conditions today relative to our last tapering and tightening phase. Today, we have 5%+ GDP, ~1.5% long-term Treasury rates, and 6% inflation. Even 2022 is expected to bring forth above-trend 4% GDP and 3% inflation. Compare that to our prior tightening phase where GDP was only 2% and interest rates were a lot higher. Simply put, the Fed has a lot more room to raise rates today without really impacting these extremely favorable conditions. Even at 1.5% Fed Funds, monetary conditions would be advantageous.
Higher near-term rates won’t greatly impact what we have going for us. Wage increases are impressive and sticking. Jobs are plentiful. Consumer balance sheets have never been better. Low long-term rates still allow for ample borrowing by consumers and corporations. Even after the most inflationary environment in 40 years and a massive slowing of Government bond buying, 10-year Treasury yields are only 1.4%. Government spending never slows down, and a lot of money has been approved to be spent domestically in 2022 and beyond. 401k’s are at record levels along with the value of our homes. Corporations have never bought more stock back than in 2021, hopefully indicating foresight for continued expansion as well. Earnings will grow well above trend next year again. If Fed actions, along with supply chains improving, can help slow inflationary spikes, we are left with valuations becoming one of the last major issues.
Following the Fed announcement, almost every sector showed positive momentum on Wednesday. Valuation concerns came back to the fore yesterday as money continues to shift out of expensive stocks and rotate into more fairly- valued pockets of the market. While some earnings updates helped drag the tech-laden Nasdaq down 2.5%, Financials, Energy and Basic Materials sectors gained about 1%. At the end of the day, earnings and valuations still matter. While day traders and Reddit investors enjoyed buying cultish stocks that always went up during the pandemic rebound, they are getting an expensive lesson on what happens when extremely accommodative conditions decline to a more normal policy. Old favorites like Bitcoin, Ethereum, Snowflake, and Doordash, among many others, took another 5% drawdown yesterday. Even FANG favorites are slowly coming back to earth with some profit taking.
Glance at stocks making new highs and you can clearly see a leadership change to world class, high free-cash flow, positive earnings companies, and out of yesteryear’s hot names. Yesterday we saw new highs for Pfizer#, Coca Cola#, Abbvie, Proctor & Gamble#, Mondelez#, Nextera#, CVS#, and PepsiCo#. Common theme? They all possess clean balance sheets, have real products that produce gobs of cash and are not excessively priced. On the other hand, DraftKings, Penn National Gaming, Carvana, Teladoc, Wayfair and Trip.com are making new annual lows. Common theme? Minimal to negative earnings, negative cash flow and excessively priced. This will continue.
As we have noted, this is all very healthy. Straight spikes higher in stock prices ultimately create bubbles similar to the Nasdaq in 2000 and housing in 2006. Slow and steady is preferred and a lot less stressful. Our current bubble that is deflating is confined to the boom/bust growth sector and no-earnings companies that many of us don’t want to own. Although next year will have more volatility with 5% – 10% moves in both directions, long-term, prudent investors should not worry. We do not have an inverted yield curve. Most of the market is fairly priced, considering how low interest rates are. Earnings will continue to trek higher. 2022 will be a bumpy ride, but new highs are likely ahead. Stay the course but remain within asset allocation guidelines.
Actress, Sarah Paulson is 47 today. Pope Francis turns 85. Eugene Levy is now 75.
James Vogt, 610-260-2214