Transitory?
BY: JIM McELROY
The Federal Reserve, following several months of greater-than-2% annual inflation — its stated goal — took to describing the most recent readings in the 4% to 5% range as transitory. For the Fed, transitory means that markets and consumers should not concern themselves over-much, since such numbers should be expected, given the disruptions caused by the pandemic and the economic toll of quarantines and lockdowns. With Covid-19 arguably on the wane — infections appear to be declining and vaccinations are increasing, albeit at a snail’s pace — normal economic activity should eventually return and the low and even negative CPI numbers from 2020 should cease to serve as a base for trailing twelve-month price increases. At least, that’s the theory and, to be honest, there’s a good bit of truth to the argument.
The pandemic drove the unemployment rate from a low of 3.5% in February of 2020 to a high of 13.3% in May of the same year; since then, the rate has declined to 5.2% (August 2021), which is lower, but still above pre-pandemic levels. GDP after inflation fell almost 10.1% in the first two quarters of 2020; since then, real GDP has turned positive — the recession officially ended in April 2020 after only two months (the shortest recession in history) — and has gained 12.2% over the last four quarters. The severity and speed of the recession and the subsequent rapid return to pre-pandemic levels was certain to cause disruptions in the demand and supply of labor, commodities, parts, intermediate goods and finished products. And so it did: companies that had laid off employees and cut production in the face of what looked to be a long and debilitating recession, found themselves short of employees and products when the rebound occurred. And although the government’s decision to subsidize payrolls certainly mitigated the destructive force of the pandemic, it also kept consumer dollar-demand at a relatively high level. The combination of unexpectedly stable demand and zealous diminution of supply was a near perfect setting for demand-pull inflation.
The Fed has described the current inflationary condition as transitory because of its confidence that companies will increase production quickly, repair the supply chain, eliminate bottlenecks and provide goods and services to meet consumer demand at stable prices. The Fed is also not above employing one of the less appreciated tools in its arsenal, jawboning, to keep markets from overreacting to inflationary signals. And, given the stimulative path that the Fed has pursued since the outbreak of Covid-19, an overreaction to signs of incipient inflation would not be unexpected.
The Fed’s responsibility, as outlined by Congress, is to ensure price stability and maintain full employment. This has been always a balancing act between the two goals with the “sweet spot” a constantly moving target. At the end of 2019 and the beginning of 2020, when it became clear that a pandemic was underway, the Fed pushed short-term interest rates to zero and began buying Treasuries and mortgage-backed securities at a feverish pace; the balancing act was jettisoned in favor of bolstering employment. As we noted above, the strategy was successful. Now the Fed is hoping that it can continue reducing unemployment while keeping inflation in check. It is certainly hoping that the recent bumps in inflation are transitory. But everyone knows that hope is not a plan. In the minutes of the latest FOMC meeting (September 21-22), the Fed dropped the use of the word “transitory” in its written communication.
The above mentioned FOMC meeting perhaps marked a subtle shift in the mind-set of the Federal Reserve. In earlier communications, the Fed has been insistent that it was not even thinking about raising short-term rates and that its purchase of US Treasury Bonds and mortgage-backed securities would continue for the foreseeable future. In press conference remarks and responses to questions following this latest meeting, Chairman Powell reiterated that an increase in overnight rates was still not even on the horizon. However, in describing what might trigger a slowdown, or taper, in Fed purchases, he did provide a “heads up” that tapering may come soon:
“So the test for beginning our taper [would be] that we’ve achieved substantial further progress toward our goals
of inflation and maximum employment. And for inflation we appear to have achieved more than significant
progress …. So the question is really on the maximum employment test. Many on the Committee feel that the
substantial further progress test for employment has been met. Others feel that it’s close, but they want to see
a little more progress. … I guess my own view would be that the test, the substantial further progress test for
employment is all but met. And so once we’ve met those two tests … once the Committee decides that they’ve
met, and that could come as soon as the next meeting …. The Committee will consider that test, and we’ll also
look at the broader environment at that time and make a decision whether to taper.”
It’s a subtle shift and we may be reading between the lines, but this is nevertheless a signal that the Fed may not be as blasé about inflation as its earlier “transitory” language suggested. We’ll see. Barring significant deterioration in the employment numbers and/or an extreme movement in either direction on inflation, the Fed intends to start the long process of returning to a more normal interest rate environment as early as their next meeting (November 2-3). Tapering would be the first “baby step.”
We expect that the stock and fixed income markets will overreact in the short term to any hint of higher interest rates. Although a repeat of the “taper tantrum” of 2013 is possible, we should remember that, despite all the rhetorical hand wringing at the time, the tantrum was only a decline of 5.6%, only lasted about a month, and disappeared within two months when the S&P hit new highs.
Currently, equities offer a higher expected rate of return than fixed income. This statement is based on a comparison between the yield to maturity for fixed income and the expected rate of return for equities. Yield to maturity on bonds is relatively straightforward: it’s quoted in the newspapers on a daily basis. Stocks, though, have a much more indefinite return profile. Nevertheless, there are several popular calculations, approximations or “seat-of-the-pants” guesses for arriving at an expected return for equities: the two most elementary of these are earnings yield or the inverse of the P/E ratio (expected annual earnings divided by price) and dividend yield plus expected growth. Currently, the yield to maturity for a ten-year and a thirty-year Treasury is 1.49% and 2.04% respectively; the earnings yield on stocks (based on the estimated 2021 earnings for the S&P 500) is 4.69%. The dividend yield on the S&P 500 is 1.34%; assuming a dividend growth rate of 5.9% (average for S&P 500 dividends) yields a return estimate of 7.2%. The question for investors, however, is whether the higher expected return on equities is worth the added risk of return uncertainty. And, transitory or not, higher inflation only adds to that uncertainty.
Inflation not only shrinks the purchasing power of current dollars, but it also raises the return requirement for long-term investments. High inflation expectations lift interest rates for fixed coupon bonds by lowering their prices. They have the same directional impact on stocks: a higher required return coincides with a lower current purchase price. The negative impact on stocks, however, is somewhat mitigated by the hope that companies will generate earnings growth that matches or exceeds the expected rate of inflation. For this reason, equities historically have been a better protection against moderate inflation than bonds.
When we compare the relative return expectations between equities and fixed income in today’s environment, equities are a clear winner. When we consider inflation risks to those return assumptions, equities continue to maintain their edge, but at a diminished margin. In an environment where there is very little room for interest rates to decline in a meaningful way, fixed income investors should maintain positions on the shorter end of the yield curve — five years or less — and higher positions in cash. In balanced accounts, we continue to recommend equity weightings near the upper end and fixed income weightings near the lower end of permissible ranges. All equity accounts should stay the course and, if possible, maintain a cash reserve.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.
