Sunday, June 20, 2021

June Swoon

In my May 29th client email, I said, "I still expect we may see a Summer Swoon. This isn't unusual between Memorial Day and Labor Day and would not be a cause for alarm." And right on cue, a couple of weeks later, we see a June Swoon.

As we get into July, we'll begin to get second-quarter earnings announcements. I expect corporate earnings will continue to be good. Ultimately earnings and earnings expectations are what drive equity prices. Until we get into second-quarter earnings, I expect markets will remain focused on inflation and the Fed. As a result, volatility may continue.

Last Tuesday, the Federal Reserve ended a two-day meeting. In the press conference Jerome Powell, Chair of the Federal Reserve, said, "Inflation has increased notably in recent months." One of the Fed's preferred measures of inflation, (PCE) personal consumption expenditure was up 3.6% in April, and the May (CPI) Consumer Price Index was up 4.99% in May. The Fed's position is that much of the price inflation is transitory and related to the economy reopening. There is some evidence to support this theory. If you dig into the data, about a third of the spike in inflation is transportation-related. We've seen a big jump in used car prices and the cost of airfare which likely won't continue to rise at an elevated rate. Earlier this year, we also saw a spike in lumber and grain prices which have since subsided. These sharp changes will distort the inflation data until supply chains normalize. The Fed also raised its forecast for 2021 GDP to 7%, which would be the fastest growth we've seen in a long time. The Fed moved forward their timeframe for raising interest rates to 2023.

My big takeaway from the Fed meeting is that the economy is recovering faster and growing more than they thought; inflation is running hotter than they thought. As a result, they will have to tighten monetary policy by reducing bond purchases and raising interest rates sooner than they thought. So, if you are considering buying or refinancing a home or financing a large purchase, now is a good time. The Federal Reserve has told us that they plan to begin raising interest rates in 2023 or sooner.

I'm not paying much attention to those sounding the alarm of rising inflation. The reality is that nobody knows. We've never stopped the economy and increased the money supply by a third before. There isn't a playbook that guides us on what happens when you take a large economy from stop to go. The deflationary forces that have been at work for decades are still at work. I pay close attention to the bond market to inform my views on inflation. So far, the bond market is signaling that inflation isn't going to be an issue.

Economic theory tells us that the extraordinary moves central banks have taken; increasing the money supply by printing money and buying bonds, should result in inflation. The reality is that it hasn't. Japan embarked on this policy in the '90s. The rest of the world followed during the financial crisis of '08. The experts have been warning of runaway inflation in the US for more than a decade. It never materialized. My views on inflation have evolved since business school. I don't think inflation is necessarily caused by expanding the money supply but rather by what is done with that money. Inflation can only happen if people's desire and ability to spend exceeds the economy's capacity to deliver goods and services. Suppose central banks distribute currency and people pay down debt, increase savings or purchase non-productive assets like cryptocurrencies. In that case, the new money creates little pressure on the supply or prices of goods and services. The bottom line is we're just too early in the reopening process to determine that inflation trends have made a lasting change.

Nothing in the Fed statement or the economic data suggests a recession or slowing of the economy, which I would be concerned about. Some market participants are reacting to the possibility that the Fed may have to take steps to slow the economy in the future. It gives perspective to say it out loud. The Fed may have to take steps to slow the economy in a year or two. So, our strategy remains the same. Watch the data and adjust accordingly. Ignore the noise and emotion.