The Real Surprise

The Real Surprise

It was quite surprising to me that the June 16th FOMC (Federal Open Market Committee) meeting was so surprising to many pundits and investors. It appeared to bring about a sudden shift within the market. The reopening stocks that have been rising in recent months sold off sharply and the growth sector rebounded after consolidation for 6 months.

The dot diagram, which is simply an array of guesses on interest rates by the FOMC members, only needed one member to move his/her guess forward for the median estimate to go from 2024 to 2023. Given the fact that the Federal Reserve is outcomes-based in setting policy, the rise in the inflation rate, employment, and economic growth over the last two months as the economy has reopened would easily raise expectations.

The observant investor should recognize the improving business environment and the effects of the disrupted supply chain on inflation. The sudden rebalancing of portfolios based upon something that should have been easily anticipated raises other questions. Are we dealing with a recognition of yesterday’s developments and policy guesses based upon those developments, while some of the underpinnings of the inflation story are changing? Some key commodity prices are receding. As of June 21st, 2021, lumber prices have fallen over 40% from their May 10th peak, while copper has declined nearly 15% over the same time period. Even corn and soybeans have turned down. Are the markets responding to changes that are underway, but not built into current forecasts?

Expecting inflation to recede in 2022 and 2023 seems reasonable, but employment growth may not follow the projected path. Initial claims and continuing claims for unemployment insurance have paused, while the housing sector has experienced a stall in starts and permits. Maximum employment may become elusive as the sub-categories proceed at a different pace.

The quadruple event last Friday, June 18th (expiration of stock index futures, stock index options, stock options, and singles stock futures) and the speed of the pullback, particularly in the economically sensitive sectors, may have punctured some of the market excess. Also, St. Louis Federal Reserve President Bullard’s comments indicating his opinion regarding the economy, inflation and interest rates increases also produced a dose of reality to those who chose to ignore the events that have been unfolding in recent months. However, it is important to recognize that his is one man’s opinion: an opinion (guess) at a time of many disconnected trends.

It is unlikely that the scenario will unfold as indicated by the Fed and I am confident they are aware of that. As we move forward, additional data will emerge, and the scenarios will change, as will expectations.

What do we know at this juncture?

1. The federal funds rate is near zero and is likely to stay there for some time – most likely through 2022 (1 ½ years).
2. The Federal Reserve will continue to buy mortgage-backed securities and treasuries at the rate of $120 billion a month and will provide a long lead time before trimming back.
3. Real rates (nominal interest rate minus the inflation rate) are likely to remain negative for the foreseeable future, a positive factor for the economy and the market.
4. The St. Louis Federal Reserve financial stress index sits at -1.0, an indication of a very liquid and stress-free environment.
5. The yield differentials between high yield bonds and treasuries are very tight (240-250 bps) suggesting an optimistic view of the economic outlook.
6. The yield curve remains positively sloped, another indication of future economic growth.
7. Money supply growth has slowed from the torrid pace of last year (M2 increased 25% from December 2019 to December 2020) but is still increasing at a double-digit rate in the most recent month of May vs. April.
8. The strong rate of real money supply growth (money supply growth minus inflation) provides the real liquidity growth to sustain continued economic activity.
9. Corporate profits should maintain a substantial growth path into 2023. To date, the S&P 500 earning has exceeded expectations and guidance has been generally constructive. The supply chain remains a constraint but should be loosening as the year progresses.
10. Margin pressure should emerge in the most competitive industries, but pricing power does exist in many other sectors. This phenomenon would indicate upside bias to earnings.

A growing economy, strong earnings growth, and tame interest rates provide a favorable backdrop for the equity market. Times like this create opportunities for the INVESTOR and should not foster portfolio restructuring as is being suggested by many pundits. A Federal Reserve meeting did not change the underlying fundamentals.

With the opportunity cost of money near zero and the earnings yield on the S&P 500 is near 5%, the cash hordes in the hands of institutions and individuals is offering them little comfort. The buyers who have been on the other side of the recent intense selling may prove in time to have been quite astute!