As we head into spring, the Federal Reserve has updated its forecast and is now projecting the U.S. economy to recover more quickly than previously projected. The Federal Reserve now expects the results of massive fiscal and monetary stimulus as well as the COVID-19 vaccination program to lead to the fastest economic expansion in many years. While strong economic growth is good for both employment and corporate profits, an overheated economy will be negative for financial markets. Interest rates rise on inflationary pressures in overheated economies, and low interest rates have been the leading reason for the market rebound, as ultra-low rates caused money from bank savings accounts to pour into the stock market seeking better returns. If inflation rises enough, so will interest rates, and investors could then start returning money back to the bank deposits and the bond market as they seek safer, guaranteed returns. In this commentary, we will assess the tight rope the Federal Reserve has to walk in order to foster expansion in the U.S. economy, while not overstimulating the economy, which would lead to inflation. We will also discuss the threat of higher taxes that will likely be needed to pay for the massive stimulus already approved.
Both the Federal Government and Federal Reserve Bank have done everything in their power to create a bridge for the U.S. economy to survive COVID-19 until the pandemic subsides. Fortunately, the end of the pandemic may be in sight. The CDC reports that as of April 9th, nearly 114 million Americans have been vaccinated with at least one dose, with nearly 2.5 million additional vaccinations happening per day. Moreover, it is estimated that nearly 30 million Americans have already had COVID-19 and nearly double that amount have anti-bodies to COVID-19. Thus, assuming new variants don’t render current vaccines ineffective, Wall Street analysts are projecting the second half of 2021 to be strong due to pent up demand as people return to more normal activities. Consumers already seem to be doing better. In a Bloomberg TV interview on March 15th, 2021, Bank of America CEO Brian Moynihan said “consumer credit card delinquencies have returned to below where they were before the [COVID] crisis¹”. In early April, in the JP Morgan annual letter, CEO Jamie Dimon said that “due to the massive monetary and fiscal stimulus that the economy could be strong into 2023”². Furthermore, on an April 11 interview, Federal Reserve Chairman Jerome Powell said the economy can grow quicker due to vaccination and fiscal support. Moreover, Powell feels “like we are at a place where the economy’s about to start growing much more quickly and job creation is coming in much more quickly”.³ The job market is already improving as the economy opens back up. The latest job report showed almost a million people were hired in March (200,000-300,000 jobs generated in a month is usually considered strong). We expect numbers to continue to be strong as we exit COVID-19, just as they were extremely weak when we entered COVID-19. The unemployment level also fell to a more normal level of 6% last month from 15% at the height of the COVID-19 crisis in April 2020 (Congressional Research Service). Bank deposit levels have also increased by $1.34 trillion over the last year according to YCHARTS (an institutional investment research firm), due to reduced consumption and stimulus checks. So, we think that consumers have the ability, and willingness to spend in the coming months as COVID-19 restrictions are lifted, and as a higher percentage of the population gets vaccinated.
Bloomberg TV, “BofA’s Moynihan: Conditions Returning to Pre-Pandemic Levels”, March 15th, 2021, https://www.bloomberg.com/news/videos/2021-03-15/bofa-s-moynihan-conditions-returning-to-pre-pandemic-levels-video (2:45)
JP Morgan Annual Letter to Shareholders, March 2021
CBS News, “Fed Chairman Jerome Powell: The 2021 60 Minutes”, April 11th, 2021, https://www.cbsnews.com/video/jerome-powell-federal-reserve-economy-update-60-minutes-2021-04-11/#x (1:00)
The problem is that the growth may be too strong. Several things have us concerned. First, the Wall Street Journal reports that the looming danger to the economy is that the monetary printing presses have been in overdrive since the pandemic began. The famous economist Milton Freidman once said that “inflation is always and everywhere a monetary phenomenon”.⁴ Well, the growth of money supply, M2 (a measure of money supply that includes cash, checking deposits, and easily convertible assets to money) has been on a tear since March of 2020. The largest source of M2 is the Fed’s purchases of Treasury’s and mortgage-backed securities. By the end of 2020, money supply was up 26% from the end of 2019. Total M2 had grown from $15 trillion to $19 trillion. This is a staggering amount of money in a very short period of time.
4. 1970 Counter-Revolution in Monetary Theory by Milton Friedman
The Federal Government has also had a very robust response to COVID-19. To pay for the financial bridge of COVID-19, the federal debt has ballooned close to 130% of GDP (Gross Domestic Product) (U.S. GDP is $21.5 trillion, and debt is $28 trillion according to Trading Economics). This is before the current $1.9 trillion-dollar stimulus package. Most economist consider any number over 100% to be a red flag as plenty of empirical evidence points to higher debt loads, leading to slower economic growth. The U.S. federal debt has only been this high once before, that was directly after World War II. After WWII, the nation went back to running balance budgets and even some surplus all the way up to the late 1960’s. Those actions caused the U.S. debt to GDP ratio to drop dramatically as the nation grew. In contrast, today, the nonpartisan CBO (Congressional Budget Office) projected the nation’s debt to nearly double again to 202% of GDP by 2051, reflecting higher cost for healthcare and debt service. The CBO doesn’t see a near term problem but states that “higher debt over time raises the risk of a fiscal crisis in the years ahead.”
Why this is important now is that we are already beginning to see signs of inflation. In several surveys released in the end of March, the Wall Street Journal reported “manufactures reported lengthening delivery times for raw materials, rising production backlogs, and a sharp uptick in input prices”⁵. For example, in year over year comparisons, copper prices are up 56%, freight prices are up 215%, soybeans are up 54%, lumber is up 54%, and we are seeing asset inflation as well; the S&P CoreLogic Case-Shiller Home Price Index was up 11.5% last year⁶, and the stock market has been strong. The Federal Reserve expects these inflationary trends to be transitory. Fed Chairman Powell has stated the Fed will be patient, believing that inflation pressures will ease after the economy reopens. The Fed Chairman has even stated that they do not plan to raise interest rates until at least 2023. There is evidence to support the Fed’s view. The largest U.S. ports have been backed up due to COVID-19 and one of the world’s busiest trade routes, the Suez Canal, was blocked during a part of March due to one of the world’s largest container ships running aground and blocking traffic in the canal. Investors also seem to support the Federal Reserve view. Investors’ inflation expectations can be seen in Treasury markets by looking at the difference between the yields on ordinary Treasury bills, and the yields on inflation protected Treasury’s, known as TIPS (Treasury Inflation Protected Securities). This difference is called the break-even rate. What is interesting is that the short-term break-even rates are higher than longer-term ones, an extremely rare situation— known as an inversion of the break-even curve. This phenomenon suggests a spike in inflation that then falls away. So, it seems that investors are anticipating a spike in inflation as the economy reopens and there is a surge in pent up demand as consumers leave their houses in droves, and then over time inflation recedes as the economy fully returns to normal. We hope that the Federal Reserve and the Treasury markets are right and that any inflation we see is only temporary.
The problem is that if the Federal Reserve miscalculates its inflation expectations, it would have a huge impact on financial markets. The Federal Reserve has experience in squashing inflation, mainly by raising interest rates to slow down the economy. However, even a slight miscalculation in inflation expectations would force the Federal Reserve to back off of their quantitative easing. This in turn would cause interest rates to rise which would have negative repercussions for the financial markets.
The market would react negatively to a rise in interest rates because U.S. Treasury bills are used as the risk-free rate in Wall Street financial models used to value companies. Specifically, the risk-free rates (U.S. T-Bills) are used in the calculation of the cost of equity (as used in the Capital Asset Pricing Model) which influences a business weighted average cost of capital. In simple terms, rising interest rates raise the risk-free rate, which raises a business weighted average cost of capital. This in turn lowers the value of a business. Low interest rates do the inverse, causing the value of a business to increase. Low interest rates have been the driving force moving the financial markets higher despite record high federal debt levels and historically high valuations on equities. Rates have become so low that stock dividend yields pay more than bonds and bank deposits (this is very rare, and forces bank deposits into the stock market for higher returns). Virtually every historical valuation measure stands at historic highs, we believe low treasury yields are the key to keep the markets moving higher. However, if inflation rises, interest rates will increase, and every increase in interest rates would cause bond and bank deposits yields to rise. This would cause investors to take money out of risker assets like equities and put them into more secure assets like bonds.
5. The Wall Street Journal, March 24th, 2021
6. Associated Press
Higher interest rates would also have a serious impact on the Federal Government budget. The U.S. Treasury currently reports $28 trillion of gross federal debt. A 1% increase in interest rates on this debt would translate into an extra $280 billion in interest cost. That amount would equal roughly 8.1% of all federal revenue collected in 2020. Making matters worse, the CBO estimates that close to 80% of all federal revenue is already spent on healthcare, defense, and debt service before Congress even debates on how to spend taxes. Thus, even a small increase in interest rates would severely impact the discretionary funds the government has at its disposal. The other large Wall Street worry is taxes. With the amount of spending taking place in Washington, it is getting harder to believe that the coming tax increases will only hit the highest income earning Americans. So far, the new presidential administration has pledged no new taxes on people making less than $400,000 per year. However, First Trust Data’s Chief Economist Brian Wesbury points out that this year the 35% tax rate kicks in at $209,426 for singles and $418,851 for married couples. Moreover, he points out that if the government were to raise both the 35% and the 37% brackets to a 100% tax rate, and people keep working and paying everything they made in taxes, that would have raised about $681 billion using the 2018 tax receipts as a guide⁷. Large money, but still not enough to pay for the recently passed or proposed future stimulus. If future tax increases dig too deep both on the personal side and the corporate side, the government runs the risk of killing the recovery before it really gets started.
In conclusion, the economy has improved and is better, and COVID-19 is being beaten. That is the good news. The risk that monetary and government officials face is to not overstimulate the economy, which would cause inflation to jump more than expected. Higher inflation expectations would cause interest rates to leap and derail the equity and housing markets at a time when equity valuations already stand near all-time highs. An increase in government taxes are also another head wind facing the market. As a result, we believe the best course of action is to continue to focus on large capitalization, brand name companies who are not only returning cash back to investors but who are providing goods and services that consumers need to use on a daily basis to provide the best risk adjusted returns. These same types of companies are also best suited to be able to pass on inflation and maintain their profits in an inflationary time period.
7. Wesbury, Brian S., “Tax Hikes Are Coming”, March 29th, 2021, https://www.ftportfolios.com/blogs/EconBlog/2021/3/29/tax-hikes-are-coming
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Sincerely,
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