A considerable gulf has opened up between the Fed’s stated monetary policy path and the market’s expectations. Ed Yardeni recently conducted a LinkedIn poll of interest rate expectations. While the poll is unscientific in its methodology, the results roughly parallel market expectations that the Fed would begin to raise rates in late 2022, and raise them several times in 2023. By contrast, the Fed’s own Summary of Economic Projections doesn’t see any rate hike until late 2023.
The roots of the market’s skepticism
Interpreting the FOMC minutes
Following those transitory pressures associated with reopening it’s more likely that the entrenched inflation dynamics that we’ve seen for well over a decade will take over then that there will be a sustained surge in inflation for a persistent period.
The FOMC minutes also makes it very clear that it believes higher bond yields is reflective of my reflation scenario of a better economic outlook. This means no yield curve control or another QE Operation Twist, where the Fed directs more Treasury purchases to the belly or long end of the yield curve. Brainard qualified that view by stating that the Fed would intervene should the bond market become disorderly.
Powell’s Great Policy reversal
Given the growing gulf between the Powell Fed and market expectations, it occurred to me that Jerome Powell may be the Un-Volcker. During the 1980’s, Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. In light of the Fed’s new framework, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove.
An Un-Volcker stance may be entirely appropriate in light of the economy’s anemic growth and weak inflation outlook. Former ECB board member Vitor Constâncio pushed back against the inflationistas who believe that runaway inflation is just around the corner and central bankers need to act soon to stamp that out. Constâncio observed that inflation in the US and Euro Area has been stable for the last 25 years. Past episodes of inflation spikes were linked to either wars or oil shocks. A major war is not on the horizon, and the window for another oil shock is narrow as the world transitions away from hydrocarbons to renewable energy in the next 10 years.
What about all the money growth (PQ=MV) as outlined by Milton Friedman and the monetary economists? Constâncio observed that despite the recent episodes of “runaway” money growth, inflation has been tame.
Portfolio manager Conor Sen argued in a Bloomberg Opinion article that “a Fed rate hike next year won’t be because of 2022 inflation”.
But what we know is that the Fed will largely look past any price increases this year. Even if inflation were to accelerate enough to concern them, Chairman Jerome Powell has said that before the Fed raises rates, it would need to slow down asset purchases, and before that it would give the public plenty of notice. So there won’t be a rate hike in 2021.
And that means it’s inflation in 2022 that will determine whether or not we get an interest rate increase. Merely maintaining elevated 2021 prices wouldn’t be enough — it would require additional price increases to reach a concerning rise in the rate inflation. But there’s a reasonable chance that as auto production catches up to demand, used vehicle prices will fall. Sawmills will have time to ramp up, putting downward pressure on lumber, and so on.
Even in a scenario where 2022 economic growth remains robust, the dynamic of production catching up to consumer demand would lead to slowing price growth on a year-over-year basis — and that’s true even if price increases look strong on a trailing two or three-year basis.
It might take until 2023 to get past these pandemic-related pricing math quirks, making that the year inflation could become more of an issue should vigorous expansion continue. It may depend more on how the numbers get calculated, but the cycle should keep measures of inflation in check while the Fed evaluates the state of the expansion in 2022.
If my assessment of Powell as the Un-Volcker is correct, what does that mean for investors?
The most obvious implication of the Un-Volcker thesis is the bond market’s inflation expectations may be too high. While the 2s10s yield curve has steepened in anticipation of better economic growth, the spread between the 2-year and 3-month T-Bills has also edged up in anticipation of higher Fed Funds rates. At a minimum, expect lower 2-year Treasury yields and possibly lower 10-year yields.
From a big picture perspective, steepening yield curves have been equity bullish especially when the economy recovers from a recession. As well, BoA found that small caps perform well during periods of strong GDP growth. Stay with small-cap exposure as the economy recovers from the COVID recession.
Indeed, GDP growth is expected to be strong. The Atlanta Fed’s GDPNow estimate is 6.2% and the IMF has upgraded global growth to 6.0% in 2021 and 4.4% in 2022.
Strong economic growth is propelling EPS estimates upwards. Forward 12-month EPS estimates have been rising across the board. Small and mid-cap estimates have recovered more strongly than the large-cap S&P 500, which is supportive of my bullish small cap call.
Equity price gains in the last year are mainly attributable to rising EPS estimates. The forward P/E ratio has remained steady during this period while the S&P 500 has risen in line with estimates. As the main source of earnings gains have come from cyclical stocks, this argues for an overweight exposure to cyclical sectors, which tend to be more categorizes as value such as financials, industrials, energy, and materials.
Despite evidence of positive momentum, the cyclical trade is not crowded. Hedge funds are still excessively positioned in defensive sectors and their cyclical exposure is still low.
For what it’s worth, FactSet reported that bottom-up derived S&P 500 one-year price target is +9.8% even after the recent advance. In the past, analysts have overestimated the price target by 1.3% in the last 5 years, by 2.1% in the last 10 years, and by 9.1% in the last 15 years. However, they underestimated the price target by a whopping 16% a year ago. Based on the experience of the 5 and 10 year overshoots, my expected one-year price return is about 8%.
Lastly, the potential effects of Biden’s tax proposals are expected to fall heavily on the communication services, technology, and healthcare sectors. For the uninitiated, GILTI stands for Global Intangible Low-Tax Income, and it is a tax intended to prevent erosion of the tax base by discouraging multinationals from shifting profits from intellectual property low-tax jurisdictions such as Ireland. The most affected sectors tend to be comprised of growth companies, and this argues against an overweight position in growth.
In conclusion, Powell is turning out to be the Un-Volcker Fed Chair. Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. By contrast, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove. For investors, this has several implications:
- The bond market’s inflation expectations are too high, expect lower yields, especially at the short end of the yield curve.
- Barring any pandemic hiccups, this is a V-shaped recovery. Small caps perform especially well in such environments.
- Similarly, cyclical and value exposure is expected to outperform.