Stocks got routed yesterday amid multiple concerns I will detail in a moment. Despite the drop, the yield on 10-year Treasuries rose again, topping 1.5% (Spoiler alert: this is one of the concerns). But don’t forget two things: First, my two-day rule says a trend isn’t reversed based on one bad day. Just harken back to last week for proof of that point. Monday’s decline a week ago was quickly reversed. Second, although the Fed talks of tapering bond purchases, it is still buying $120 billion of bonds every month. Worldwide, central bank purchases top $300 billion. That is a lot of firepower supporting the rise in asset prices.
Now to the concerns. As noted, the rise in interest rates punctuates the rising concerns of higher and persistent inflation. Yesterday, Fed Chairman Jerome Powell said in prepared remarks before testifying to Congress, that inflation will stop when supply chains are healed, or the Fed will make it stop, a hint that the Fed will be willing to raise interest rates if needed to halt the rise in inflation. That isn’t what equity investors want to hear. Also yesterday, Treasury Secretary Janet Yellen said that the debt ceiling will be reached within three weeks. While most investors still assume Congress will step up and raise it before the specter of default rears its ugly head, Congress has proven many times how dysfunctional it can be at times of controversy. Finally, we still don’t know the status of the infrastructure bill or the larger reconciliation bill. Progressives in the House want moderates to give a top line number for them to support the infrastructure bill. So far, moderates have said show us the details, then we will decide. Nancy Pelosi promised moderates in the House a vote on infrastructure Monday. That deadline passed without a vote. The new deadline is tomorrow. Don’t be surprised if that passes as well.
The infrastructure bill should be the easy one to get done. It has some level of bipartisan support. The public certainly is in favor of it. The $3.5 trillion reconciliation bill, filled with new liberal entitlements plus large tax increases aimed at business and wealthy individuals, will be tougher to get done. It is much more expensive. Perhaps more important, it simply has so many moving parts that many both in Congress and outside simply can’t support the entire package. Businesses now are lined up and pushing hard to remove controversial measures. Tying drug prices to some index is right at the top of the list of items that could fall by the wayside. Expansion of Medicare to include hearing aids and eyeglasses is another at risk.
There is also political gamesmanship at play. Democratic leadership has levers to pull that will lower the nominal price of the bill without sacrificing any programs. To get approval to pass with 50 votes in the Senate under reconciliation, the program must be considered revenue neutral after 10 years. To pass, it also must fit into a sized package that members of Congress can accept. That is where sunset provisions come in. The provisions put an apparent end date to constituent entitlements created within the bill. For instance, perhaps 2-year college could be funded until 2025 or 2026 under the plan, but if the deadline were shorted by a year, the cost would come down. Those supporting the bill are willing to bet (rightfully so, in my opinion) that once a new entitlement is created, no one will take it away. At the sunset date, Congress will simply vote to extend the program.
Thus, when progressives push moderates to give them a number, all progressives intend to do is pull some of the sunset provisions forward. Moderate opponents aren’t going to get caught in that trap. They want to see the bill’s details, decide what is too expensive, and then modify the bill toward a compromise all can accept. That is exactly what happened with the infrastructure bill that passed the Senate with bipartisan support. Liberals rightfully believe that if the infrastructure bill passes first, they will lose leverage regarding the larger reconciliation package.
They are right, but they must ask themselves whether half a loaf is better than none. That answer isn’t likely today or tomorrow, despite the new deadline for a vote. Even if the infrastructure bill can pass next week (and that is still an IF), it is likely to be several more weeks before the fate of the larger tax and spending bill is clear.
Politics is clearly a market concern, but it is hardly the largest one. Right now, there are four questions weighing on investor’s minds.
1. What is the future path of inflation?
2. When will supply-chain bottlenecks be resolved?
3. What is the true growth rate of our economy?
4. How will market behavior change after the Fed stops buying bonds?
Inflation: Powell says it is transitory, elevated for the moment by supply-chain issues and concerns. When Covid-19 fades and life gets back to normal, whether that be 3 months or more than a year from now, inflation will fade back toward 2%. Despite the rise in the 10-year yield over the past two weeks, the yield curve still supports this belief. On the other hand, the two largest components of the CPI are wages and shelter cost, and both are rising and accelerating. Mr. Powell says there remains a labor gap. We are not likely to be at full employment until the middle of 2022 or later. Tell that to CEO’s who can’t hire what they need today. Who’s right? The answer is likely in the middle. Wage growth is likely to remain elevated as full employment arrives, whether that is now or six months from now. Productivity growth will fall as the economy gets back toward normal. Capital spending is strong, but adjusted for inflation it isn’t above normal.
Supply chain: Have you ever been stuck in rush hour traffic barely moving? Go on the same road two hours later and it will be clear sailing. Too many cars trying to enter at the same time creates a bottleneck. It ends when more cars leave the road than enter. Take a picture of U.S. ports in LA and Long Beach. Dozens of ships are lined up offshore. Thousands of offloaded containers sit on the docks waiting to be driven away. Too many goods coming at the same time with not enough dock workers or truck drivers. And Christmas is still almost three months away! What’s in those containers? Anything and everything, that’s why so many shelves are bare. The problem is worldwide. Look at the semiconductor industry. Semis are in short supply, but even if the manufacturers wanted to ramp up production, they lack the equipment to do it. They can’t even get enough wafers. Six months ago, it was thought that auto dealer lots would be restocked by now. They aren’t. It may take another year for supply chains to fully heal. That sounds like a long time, but when calculating economic value, it isn’t that long.
Economic growth rate. It certainly isn’t 10%+ as it was last Spring when we were all emerging from our cocoons. Nor is it 2%, the rate achieved most of the decade before the pandemic. There are enough parts of our world still reopening, mostly in the travel and leisure sectors, for rates to fall that low any time soon. The spread of the Delta variant has ticked a percentage point or two off Q3 growth, but the variant peak has passed. Q4 growth could get some of that back, depending on the severity of supply-chain issues. Long-term growth will fall toward 2%, dictated by demographics and future productivity growth, but for 2022 growth will remain above average. American wallets are full, jobs are plentiful, and everyone is eager to get out, move around, shop, and travel.
Market behavior when the tapering ends. If you accept that at least part of the cause of rising asset values for the past two years is linked to the Fed’s massive monetary easing, you should expect that tailwind to subside. That doesn’t mean markets have to fall, but it does mean the rate at which asset values rise will moderate. And yes, depending on the other factors discussed above, a down year in the stock market isn’t out of the question. If inflation is higher than expected, and supply-chain issues are still unresolved, the end of bond purchases could coincide with a market correction, and possibly higher interest rates. The word stagflation would reappear. But that is still an IF. If supply-chain problems moderate, inflationary pressure would moderate as well, economic growth will continue. If growth overcomes any rise in inflation expectations, stocks could hold their ground. If inflation expectations decrease, 2022 could be another good year for equities.
There are lots of moving parts. Little has been resolved. Over the next several months the picture will become clearer, and markets will set their future course. As I have noted often, markets hate transition. That is why volatility has increased and a modest negative trend has set in. Q4 is normally a good quarter for stocks, particularly in years when equities have been going up. Logic says we are in for a few more bumpy weeks, perhaps through earnings season as the bar gets reset. But the strong economic outlet through 2022 should carry the day thereafter.
Today, Kevin Durant is 33. Jerry Lee Lewis turns 86. There will be a “whole lot of shakin’ going on”!
James M. Meyer, CFA 610-260-2220