By Justin Pawl, CFA, CAIA, CFP®
Last Week Today. Retail sales fell in Feb (-3%), but January’s estimate was revised higher by 2%. Overall, the retail sales level remains above the pre-pandemic trend line and supports continued economic recovery. | The FOMC meeting did not generate any surprises, and Chair Powell continued to stress there will be no near-term change to the Fed’s accommodative monetary policy stance. | Russian President Vladimir Putin didn’t take kindly to President Biden calling him a “killer” and challenged Biden to a public debate. | The first meeting between Biden’s administration and Chinese officials was tense. U.S. diplomats accused China of threatening world stability. At the same time, China called the U.S. a human rights hypocrite because of its mistreatment of African American citizens. | The first $242 billion in American Rescue Plan stimulus payments went out last week. Meanwhile, equity funds experienced record inflows of $68.3 billion. A coincidence?
Interest rates crept higher again last week, but it did not create the same disparity in performance between technology stocks and the rest of the market. Instead, U.S. stocks gave up 0.7% to 0.9% across the board in major indices. Yet, most domestic indices remain in positive territory for the month, with the S&P 500 +2.8%. Developed market international stocks rose last week and are outperforming this month, with the MXEA Index +3.2%. Commodities were mixed on the week, with precious metals rising by ~1%, while WTI Crude declined 6.4% to $61.42 per barrel. For detailed asset class performance, click on the table below.
Fiscal Stimulus and Inflation. The government has thrown the fiscal “kitchen sink” at the pandemic. It’s easy to lose track of just how much money the government has authorized to spend on Covid-related issues, so below is a summary of key fiscal stimulus packages implemented in the U.S. over the last 15 months (source: International Monetary Fund):
- ~$200 billion Coronavirus Preparedness and Response Supplemental Appropriations Act (1/3/2020) and Families First Coronavirus Response Act (3/18/2020)
- ~$2.3 trillion Coronavirus Aid, Relief and Economy Security Act (“CARES” Act, 3/19/2020).
- $483 billion Paycheck Protection Program and Health Care Enhancement Act (4/24/2020)
- ~$44 billion via President Trump’s executive orders for extra unemployment benefits, student loan payment relief, and deferring collections of employee social security payroll taxes (8/8/2020)
- $868 billion coronavirus relief and government funding bill passed through the Consolidated Appropriations act of 2021 (12/28/2020).
- $1.8 trillion American Rescue Plan (3/11/2021)
In total, the U.S. government has authorized ~$5.7 trillion of stimulus thus far. Before the pandemic, the total output of the U.S. economy equated to $20.9 trillion in 2020, meaning that total expenditures equate to more than one-quarter of the value of goods and services produced by the U.S.
The common thread in these stimulus programs is that most of the stimulus was designed to replace lost income. That’s not a criticism, just an observation. There is no doubt the stimulus was needed as governments worldwide engineered the first self-induced global recession in history. Households, businesses, and communities required support to keep the recession from spiraling into a global depression. But in effect, the trillions upon trillions of dollars simply fill the consumption chasm and do nothing to advance the economy for the future. In Fed Chair Powell’s press conference following last week’s FOMC meeting, Powell remarked, “What it takes to drive productive capacity per capita or per hour worked, to raise living standards over time, is investment – investment in people’s skills and aptitudes, investment in plant and equipment, investment in software. It takes a lot of investment to support a more productive economy and raise living standards. And that hasn’t been the principal focus with these measures.”
Increased consumption in the absence of higher productive capacity leads to inflation (too much money chasing too few goods). Per comments from Chief Economist Chris Low of FHN Financial last week, “Manufacturers and importers are already having trouble keeping up with demand.” Yet, the stimulus is temporary (or at least it is supposed to be temporary), which is why the Federal Reserve believes the coming rise in inflation will be temporary as well. As such, the Fed’s “not even talking about talking about” tapering bond purchases yet.
In the coming weeks and months, we will hear a lot about inflation. This is especially true because soon inflation metrics like the Consumer Price Index (CPI) will be comparing today’s prices to prices during the Great Lockdown that was in full force by April 2020. The Fed will not act in response to the inflation spike, viewing it as transitory. Under their new policy framework, the Fed no longer relies as heavily on their economic forecasts. Instead, they will wait to see evidence that there is “substantial progress” toward the Fed’s twin goals of full employment and sustained inflation above 2%. Moreover, Chair Powell continues to remind the markets that the Fed will not even begin discussing rate hikes until the Fed ends Quantitative Easing, which currently consists of at least $120 billion in bond purchases every month.
The Fed’s lack of urgency and higher interest rates is understandably creating much chatter about the potential for 1970s-style runaway inflation. Investors are prone to mistakenly extrapolating recent moves in markets well into the future. But on that topic, it’s worth noting that even as interest rates moved swiftly higher in the last three months, rates remain low. Indeed, the recent rise in rates that put the 10-year yield at 1.7% and the 30-year bond yield at 2.4% essentially reversed the steep declines brought on by the pandemic. In other words, the market is not pricing in runaway inflation in nominal bonds nor inflation-linked bonds (see chart below), rather more of a return to the pre-pandemic “normal.”
Source: Goldman Sachs
We expect rates to rise further over time, but at a slower pace than what’s transpired thus far. Indeed, we wouldn’t be surprised to see rates pull back some (as bonds are oversold) before nudging higher again. Rising interest rates are consistent with our thesis that the U.S. economy has transitioned from an era of disinflation to one of reflation aided and abetted by the Federal Reserve’s new and untested monetary policy framework. However, we acknowledge the risk of problematic inflation (i.e. 3%+ inflation) has increased, but that’s not our baseline forecast. Even without excessive inflation, the game has changed. The deflation/reflation transition implications are important to recognize in the context of portfolio construction as risk-free yields are lower than inflation rates and will likely remain there for the foreseeable future.
K-Recovery. The official unemployment rate has declined from 14.8% to 6.2% in the last eleven months. Although rapid, the recovery has been highly uneven, a condition that is not lost on the Federal Reserve. Below is a redline version of the FOMC’s recent statement, compared to its statement following the December 2020 meeting.
“The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world.
The Following a moderation in the pace of the recovery in , indicators of economic activity and employment has moderated in recent months, with weakness concentrated in have turned up recently, although the sectors most adversely affected by the pandemic . Weaker demand and earlier declines in oil prices have been holding down consumer price inflation remain weak. Inflation continues to run below 2 percent. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.”
Overall, the Fed’s comments reflect a brighter outlook than in December. Still, the recovery is far from complete and significant pockets of weakness remain, giving rise to the idea of a K-shaped Recovery. That is an economic recovery in which some segments of the economy are doing well while others are struggling. The table below, illustrating near real-time labor market data, highlights this disparity.
The table ranks economic sectors by job listings growth since February 2020 (the last month before the Great Lockdown). The areas of strength are not surprising: pharmacies (Covid testing and vaccine distribution), manufacturing (inventories are low and need to be replenished), loading/stocking (online sales distribution), and construction (the housing market is on fire). The weakest areas of growth are primarily those that require close physical contact to work, including services industries, such as restaurants and leisure/hospitality.
In a sign of things changing for the better, the 4-week trend (right column) indicates the lights are turning back on in the services industries. With accelerating vaccine distribution enabling more of the economy to open, demand for service sector employees should continue to track higher. As some of these workers have been unemployed for a year and relied on government stimulus checks to get by, increased hiring in these sectors will bolster sustainable growth and help even out the recovery.