Stocks continued their upward march on Friday despite a somewhat disappointing GDP report for the third quarter. Analysts were willing to shake off that news, betting that the weak Q3 numbers related to Covid-19 and supply chain problems may be fading. Interest rates remained well contained, although a flattening yield curve caused a bit of consternation.
This week promises to be all about politics and the Fed as earnings season starts to wind down. Two key governor races are on tap tomorrow, perhaps offering a hint of what’s in store going forward as we look to next year’s mid-term elections. President Biden is overseas, first to the G-20 meeting this past weekend (which didn’t seem to accomplish anything of substance) and then to Glasgow for the big climate change summit.
The climate change summit brings back to mind the very beginning of the United States. After declaring independence in 1776, Articles of Confederation were drawn up and signed in 1777, setting out a roadmap for the future and setting obligations for the 13 colonies. Yet, there was no enforcement mechanism, and each colony effectively remained an independent state. It wasn’t until the Constitution was adopted in 1787 that we truly became the United States, where federal government superseded state rule in areas defined by the Constitution. Fast forward to today. While the goals of these climate summits are noble, they rely on the consistency of commitment by 200 separate nations. President Biden’s plans so far are pledges not yet fully backed by Congress. They are clearly far different from those of his predecessor, Donald Trump. What happens three years from now is anyone’s guess. And that just applies to the United States. Everyone agrees climate change and greenhouse emissions are an issue, and there will likely be some broad conclusions drawn at the end of the conference. But true commitment and enforcement are key, and both will likely be lacking at the end of the conference, unfortunately.
Biden, however, is probably happy to be overseas as his job approval rating continues to slip. Perhaps that is why 71% of Americans now feel the nation is headed in the wrong direction. Perhaps most concerning to the President is that 48% of Democrats feel that way. And much of that discontent is coming from the progressive left that feels the President is letting them down as he drops several provisions from his reconciliation package. If you listen to Speaker Pelosi, the “framework” announced last Thursday will be presented as legislation for a vote as early as tomorrow. But that is yet another deadline that is likely to pass. No one has actually seen the text of a bill to be voted on. It is unlikely that text is yet completed.
Last week, I equated the Democratic process to the arcade game of Whack-a-Mole. While the President said that they finally agreed on a framework, 50 Democratic Senators have not explicitly expressed approval. Key House moderates still want a relaxation of SALT provisions to come onboard. The Senate parliamentarian has nixed $100 billion in immigration spending as part of any package that can pass with just 50 votes under reconciliation. In the end, that will probably get dropped as well. Look for Democrats to sign something before the end of the year. It might resemble the framework. But it won’t pass this week, and it won’t be an exact replica of the framework. Whack-a-Mole continues.
With that said, so far the corporate tax rate stays at 21%, there appear to be few changes affecting capital gains, and inheritance tax laws remain intact. For investors, that is probably as good as it can get, but nothing is certain until we get to the end. One of the pay-fors in the package is $400 billion in savings from better IRS enforcement. There isn’t a person on the planet who would buy that argument.
The looming tax package, a slowing economy, and inflation more persistent than first thought all lead up to this week’s FOMC meeting. The facts to come are a virtual certainty. There will be no change to interest rates and the Fed will announce that in November it will begin to taper its rate of bond purchases by approximately $15 billion per month until it stops increasing the size of its balance sheet by mid-2022. It will still buy bonds, but only to replace those rolling off at maturity. If all goes well, interest rates will remain near where they are today, and inflation will begin to recede as supply chain bottlenecks start to unwind. But Fed leadership has been surprised over the past six months by the persistence of inflation. No doubt the President’s weak approval rating can be tied, at least in part, to that same persistence. Food and energy prices may not be part of core inflation, but they are part of the American psyche.
Note that what you will see this week is a plan written in pencil, not ink. If facts change, the plan can be altered. It certainly won’t change for a few months, but the Fed will take its cue both from data going forward and the reaction of the bond market. Should long rates rise too sharply, look for the tapering process to change. Look for hints of interest rate hikes to change as well. Right now, markets are pricing in two hikes in the second half of 2022.
The key, of course, is the future course of inflation. Forget any changes in the dot plots, showing the expectations of Fed officials, that you will see on Wednesday. If possible, Fed officials are worse predictors of rates 12 months ahead or longer than most economists. That isn’t meant to damn them. It’s just like the weather, it’s simply too difficult to predict past a certain horizon. Thus, the Fed will have to be reactionary no matter how convincing they lay out a precise plan Wednesday. For that reason, don’t expect a huge market reaction right away. We all know the first steps by now, it’s future changes that will be important.
Markets have gotten very buoyant lately as we enter Q4 and look ahead to next year. The prime factors are a general belief that the near-term problems caused by the Delta variant and supply chain snarls are beginning to crest. In the case of Delta, they probably have already crested. The investor class isn’t all that happy with the Biden economic program, but it looks much better than it did a few months ago. Beginning next year, look for little in the way of new legislation for the balance of Biden’s term. On Wall Street, that’s good news.
No doubt, the biggest question is the path of interest rates over the next 12 months. Other than interest rates, all else is lining up well. The economy should grow 3-4% next year, with the only constraint being a reduction of Federal spending as the Covid relief spike in spending winds down. Americans remain loaded with cash and are willing to both spend and speculate. There are red herring risks still out there, China comes to mind, but they are always out there. Inflation will come down some as supply chains are rebuilt. Away from autos and housing, inventories in many industries could return to normal within six months. Production throughout Asia is starting to accelerate as post-Covid lockdowns are discontinued. But I expect labor to remain in tight supply, and so will housing. How inflation ends up will be a function of the cross currents of higher wages and higher shelter costs, against the trend of receding price spikes caused by recent short-term factors. Headline numbers will matter less than the detail within. Over the short term, however, the picture has brightened. Stocks should continue to do well into the end of the year.
Today, Jenny McCarthy is 49. Apple CEO Tim Cook turns 61. Somehow, I doubt those two will end up sharing a birthday celebration together.
James M. Meyer, CFA 610-260-2220