It was certainly our hope that we could spend a few months without talking about inflation and the Federal Reserve, but the events of the past month demand otherwise. Both inflation readings and Fed policy changes had a heavy impact on all aspects of capital markets in January. US equities are in a stealth bear market. From their peak, the average stock in the S&P 500 is down 19%. US small-cap firms and the NASDAQ are down 40% and 50%, respectively, from their highs last year. The impetus for these steep declines is changing Fed policy in the face of inflationary concerns. Understanding how and why the Federal Reserve changed course and the impact of these changes on the market are the topics of this month’s commentary.
A Bit of Fed History
Arthur Burns was chairman of the Fed from 1970-1978, a period with some parallels to today in terms of building inflationary pressures. During his tenure, Burns placed a heavy emphasis on achieving full employment, a condition which is necessarily uncertain and subject to revision. Full, or maximum employment is part of the dual mandate of the Fed, but it is only known in hindsight and with some degree of subjectivity. When Burns was faced with ever increasing rates of inflation in the late 1970s, he instructed his analysts to devise new ways of measuring inflation to push the official figures lower. He simply didn’t believe inflation was as bad as the numbers indicated. Rather than using data to build conclusions, Burns was accused of massaging the data to suit his beliefs. Ironically, high rates of prolonged inflation, by any measure, can lead to increased unemployment (stagflation). By ignoring inflation, Burns made his primary goal of full employment unachievable.
The lessons of the 1970s were very clear to policy makers in the ensuing decades. For the past forty years, if inflation looked like it could stay above target for a sustained period, the Fed would raise interest rates and choke-off inflation well before it could become a problem. Proving their inflation-fighting skills became a way of measuring success at the Federal Reserve. That changed with the Global Financial Crisis (GFC) of 2007-early 2009.
The period after the GFC is known as the slowest economic recovery on record. It took nine years for the labor market to return to its pre-crisis unemployment rate. Clearly, this was not the outcome the Fed wanted. Research into the period suggests that the Fed’s eagerness to increase interest rates and end stimulus programs came far too early in the recovery, though six years of accommodation seemed sufficient at the time. This policy error prolonged high rates on unemployment and drastically increased wealth inequality. The Fed was too busy fighting the inflation boogeyman to realize they were hurting workers and the health of the real economy.
Under the current Fed Chairperson, Jerome Powell, the Fed has changed their language around the concept and importance of full employment. The term today refers to more than just the headline number and looks more closely at employment to overall population to consider discouraged workers outside of the active labor pool. Like his predecessor Arthur Burns, Powell has a policy focus on full employment, even if that means letting inflation move above the targeted goal. As recently as last fall, Powell was quoted as saying it was acceptable to have inflation well above the 2% target to allow for a stronger employment picture. The same conclusion was repeated forcefully by Fed governors and reams of research papers. Even as inflation moved higher throughout the course of 2021, Powell made it clear that full employment was a key measure of monetary policy success.
The Powell Pivot
Unlike his predecessor Arthur Burns, Powell will not be accused of ignoring worrying rates of inflation - not after January’s Fed meeting. The Fed now thinks the labor market is near full employment; some committee members suggested that the labor market is past full employment. This is even though 3.5-4 million people who were employed before the pandemic remain out of the labor market entirely. Controlling inflation has returned as the Fed’s key measure of success.
As a result of its January meeting, the Fed is now forecasted to end quantitative easing (QE) in March and bring short-term rates from nearly zero to 1.25% by the end of the year. Further, the Fed could begin quantitative tightening (QT) this year, according to some comments. In early December of 2021, the market was forecasting an end to QE in June along with one rate increase of 0.25%, with no expectation of QT during 2022. QT is a policy tool that removes cash from the financial system, pushing up interest rates (at first) and decreasing investment risk appetite. Pragmatically, QT is the reverse of QE, an unavoidable eventuality following an extended period of easy monetary policy.
This change in policy expectations produced a three-sigma repricing in interest rate and inflation expectations during the second week of January. For those markets to move so significantly and concurrently in one week should occur roughly once every 38,000 years. We did make some statistical assumptions to make the math more straightforward, but the number is in the ballpark. The market was clearly very surprised by the abrupt change in Fed monetary policy.
Roll the Tape
With the Fed’s policy pivot from inflation dove to rigorous inflation hawk, the key question is whether the employment situation is as tight as the Fed believes. Clearly wage growth is moving higher (4.5%, highest since September ’07), and employers are still finding it hard to find new employees, according to all survey data. Yet, after accounting for those who left the job market during the pandemic and are yet to return, the unemployment rate is 6%. This is far above anything resembling full employment. The Fed believes that many of the people will be returning to the labor market, but not for several years:
“Participants cited a number of pandemic and economic factors likely depressing labor force participation, such as increased caregiving needs amid a shortage of workers in the care giving industry, remaining concerns about the virus, and healthy balance sheets for households, including for those who retired early. A couple of participants cited factors that could support higher labor force participation over the next few years, including waning fiscal stimulus; depleted savings, particularly for lower-income households; and the historical tendency for labor force participation to lag improvement in the labor market.” -Minutes of the Federal Open Market Committee December 14–15, 2021
The Fed’s research suggested that those who left the workforce during the pandemic would return when public health concerns abate. Now the Fed believes that the 3-4 million working aged individuals who remain out of the workforce are unlikely to return in the short term. That implies that interest rates are lower than justified given the strength of the economy. The timing of this shift in policy is unfortunate as it coincides with slowing economic momentum. Real consumer expenditures, a proxy for retail sales adjusted for inflation, have been negative for the past five months and consumer sentiment is at the lowest level in a decade. If the economy is booming, someone should tell the US consumer. Even with rising wages, the average American took a 2% pay cut in inflation adjusted terms last year.
Shifting Policy, Shifting Sentiment
Capital markets like their monetary policy bland, predictable, and transparent. That type of policy makes it easier for investors and businesses to make long-term capital decisions and promotes economic and market stability. Fed policy has been anything but bland and predictable this year, which is a key risk we highlighted in last month’s commentary.
When the market is forced to adjust to rapid changes in key economic variables, such as interest rate expectations, traditional quantitative models lose their predictive power. In periods like now the market trades not on fundamentals, but on technicals and sentiment. A proxy for investor sentiment is the VIX index for equities and the MOVE index for the bond market, both of which attempt to measure investor expectations of volatility. Technical analysis is an attempt to find patterns in trade data from equity and bond markets, such as price levels and volumes. These measures have been studied for a century but have more recently found their intellectual footing in the evolving school of behavioral finance.
From a technical standpoint it appears the major US markets found a bottom the week of January 24th. The sharp correction moved markets to the most oversold levels since the severity of the pandemic became apparent. Trading volumes also moved to multi-year lows, exacerbating price movements. Investor demand for “insurance”, in the form of equity put options, moved to record high levels as well. These are contrarian indicators that suggest weak hands in the market exhausted investors’ desire to sell. This conclusion is confirmed by investor sentiment. Although sentiment remains low, it has moved past levels traditionally associated with capitulation of selling pressure. We should expect volatility to remain high over the coming weeks as the market builds support near current levels.
The market is ignoring market fundamentals for the moment, but these measures are encouraging. US small cap firms (Russell 2000 index) have their lowest valuations of the past twenty-five years. The Russell 2000, on a forward price to earnings basis, is cheaper today than during the dark depths of the financial crisis. Valuations are a terrible timing tool, but they are an excellent measure of expected returns over the next few years. For US large cap firms, the S&P 500 is trading at the same price to earnings ratio today as it was prior to the pandemic. All of the stimulus-fueled excess valuation has come out of the broad market in recent months.
There is a fear that the Fed will err on the side of fighting inflation aggressively and make financial conditions too tight to support a healthy economy. The Fed’s tools to fight inflation work on the demand side of the economy, but it is the supply side that appears to be driving the issue. The Federal Reserve’s own researchers recently released a paper showing that nearly all of the current inflation rate can be pinned on the pandemic’s impact on supply chains. For example, new cars have been a key source of inflation over the past year, increasing by 11% in 2021. However, fewer new cars were sold in January ’22 than in January of the year prior to the pandemic. The current inflation issue is based on the availability of new cars, not excess demand that outstrips the economy’s ability to produce cars under normal conditions.
This line of thinking suggests that inflation today is not reflective of a structural change in the economy and will ebb with the pandemic. The challenging part is answering the question of when the pandemic will come under control. No truthful person has an answer. Chairman Powell was clear in his latest press conference that the Fed was going to be flexible and sensitive to incoming data, which is probably the right answer, but one that fails to provide clear guidance to the market. The Fed doesn’t want transitory supply chain issues to bleed into something more permanent, such as wages, so they are likely to err on the side of higher rates in the face of uncertainty.
Excluding the last trading day of January, this year was off to the worst start for the S&P 500 since 2009. In 2009, after a -8.6% start, the S&P 500 finished the year up 23.5%. This is not to suggest that 2022 will post similar returns, but to remind you that capital markets are prone to overreactions. The Fed’s willingness to tackle inflation aggressively is a big shift that caught the market completely off guard.
It won’t make headlines, but leading inflation measures from goods producers have been falling quickly, as have industrial commodity prices and shipping rates. Wage growth is also diminishing faster than expectations, although readings remain elevated. If inflation continues to moderate on its own the Fed will not be as aggressive as feared.
PIM’s investment committee has determined our asset allocation priorities for the current environment. We affirmed our view that quality, defensive growth firms combined with exposure to the energy and materials sectors is appropriate during a period of slowing economic expansion and increasing interest rates. We will limit exposure to certain international asset classes that face particularly challenging environments. We are adjusting our fixed income portfolios to reflect assumed interest rate increases throughout the year, while also limiting credit risk.
The preceding economic conditions and policy initiatives are present, and real. We hope you enjoyed our presentation of the details. More broadly however, there’s another way of looking at this.
Investments are, at any time and by historical standards, either expensive, fairly valued, or inexpensive. When stocks become expensive (often referred to as “multiple expansion”), they may remain so for some time. Eventually however, a reversion to the mean is triggered by some event. Usually an event is required, but one could argue that the event doesn’t matter. Mean reversion is inevitable.
When stocks fall (because they’ve become too expensive over time), we call that a “correction”, or if lower prices last long enough, a “bear market”. At some point however, stocks become so inexpensive by historical standards that buyers return to the market.
Regardless of why it happened, the carnage in the markets last month could be considered normal. Where we go from here will be determined by policy and economics.