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Fed Rate Liftoff and Balance Sheet Runoff (QT) Difficult to Pull off in Parallel — Produces Heightened Policy Risks — QT Could Reduce Market Liquidity — Earnings Growth Then Key to Equity Performance Rather Than Multiples — Negative Real Rates Remain — Result Limited Economic Restraint — Consensus Expects Inflation to Moderate Around Mid-Year — Risk to That Consensus Potential Extended Wage Pressures

Date Posted: January 25, 2022

COVID Variants Lower Forecast Confidence — Greater Market Volatility

Americans entered 2021 with the hope that the miracle of vaccines would lead to an “end” to COVID as a major concern. A year later, with Omicron spreading rapidly, albeit a milder variant, that hope remains unanswered (see Figure 1). With that, government leaders suggest Americans will need to prudently live with unpredictable outbreaks of new variants – hopefully no more dangerous than Omicron. Such uncertainty will predictably produce greater volatility in financial and commodity markets.

Figure 1

Daily Reported COVID-19 Cases Per 100,000 People

Source: Opportunity Insights, CDC, U.S. Department of Health & Human Services

Past Fed Forecasts Led to Proactive Policy Errors — Now Fed Data Dependent Also Led to Policy Errors — Confidence in Fed Eroding

In the past, the Fed used inflation forecasts to proactively initiate policy changes. Unfortunately, their forecasts erred, leading to major policy mistakes. With that experience, the Fed then shifted to basing their policies on real-time data rather than forecasts. Based on their readings of 2020-21 data, they expected inflation would prove “transitory.” Once again, the Fed erred, but this time using current data — not forecasts. That mistake led to a tardy response to higher inflation.

Fed Rate Liftoff — Real Rates Will Still Remain Negative — Leading to Only a Limited Restraint on Economic Growth

By the end of March, the Fed will likely accelerate both liftoff — increasing the funds rate — and tapering — ending incremental purchases of government and agency mortgage debt. Financial markets currently look for four 25bps funds rate increases over the next 12 months (see Figure 2). No doubt, interest costs on $29 trillion of Federal government debt will ultimately limit how high the Fed can raise rates. Therefore, even if nominal funds increase by 1% over the next twelve months, at current levels of inflation, real rates will still remain at historically negative levels. At those levels, negative real rates will continue to offer financial incentives for businesses to borrow and earn attractive levels of returns if the economic outlook remains positive. That being the case, negative real interest rates, likely across the curve, will not materially restrain corporate investments early in the rate hiking cycle.

Figure 2
Implied Funds Rate Change from Current Level

Potential Fed Balance Sheet Runoff – Quantitative Tightening — Impact Less Certain Than Rate Liftoff — Managing Two Policy Changes at the Same Time — Greater Chance for Policy Errors

The Fed surprised financial markets by not only looking to raise rates but also to reduce — runoff — the size of their balance sheet. More certainty exists from the economic and financial effects of rate increases than from balance sheet reduction — or quantitative tightening (QT). Since the beginning of 2020, the Fed has more than doubled the size of its balance sheet from $4.2 trillion to $8.8 trillion (see Figure 3). By not incrementally purchasing new Treasury debt each month ($60 billion this month), the Fed puts additional pressure on debt markets to absorb that total. That pressure would increase even more if and when the Fed stops rolling over some of its debt holdings, leading to higher rates. The Fed’s reversal of their two key monetary policies, nearly at the same time, greatly increases chances for error — adding to the likelihood for greater financial market volatility.

Figure 3

Federal Reserve Total Assets – $ Millions – (7/2007—1/2022)

Source: Board of Governors of the Federal Reserve System

Balance Sheet Runoff Likely Closer to Rate Liftoff Than In 2018

The Fed waited roughly two years from liftoff in 2015-16 until 2018 before reducing its, then, much smaller balance sheet. The Fed now expects to begin balance sheet runoff somewhat closer to the expected March liftoff. Compared to 2018, the Fed’s apparent willingness to runoff its balance sheet this year, rather than waiting, reflects a much stronger economy with tighter labor markets and higher inflation rates.

Fed’s Runoff Will Also Attempt to Steepen Yield Curve — Not Easy to Pull Off

With the shorter average maturity weightings of the Fed’s treasury holdings, the runoff could prove faster than in 2018 (see Figure 4). That speed depends on the size of the Fed’s runoff cap. In addition, the effort will likely be made to sharply reduce or eliminate the Fed’s mortgage-backed securities holdings. The Fed’s normalization policies will also attempt to steepen the yield curve by reducing its mix of longer-dated treasuries — in part to avoid an inverted yield curve. Even a small level of success in steepening the yield curve will work to the advantage of financial industry companies.

Figure 4

Treasury/ Agency Mortgage Maturities (12/31/2021)

Source: Schwab Economic Research, Bloomberg, Federal Reserve

Inflation — Initially Demand Driven — Then Choked Supply Chains Piled on Inflationary Pressures

Congress passed three income replacement acts during 2020-21, sending out over $5 trillion in checks – 25% of GDP — to Americans. At the same time, COVID lockdowns limited consumers spending to principally goods rather than services — and spend they did (see Figure 5). Exploding goods demand choked supply chains, cooking the inflation stew the Fed now seeks to cool down.

Figure 5

Consumer Spending — Goods vs. Services


Potential Inventory Surpluses in 2022 Could Lead Later this Year to Moderating Inflation — West Coast Ports Longshore Union Strike and China’s Zero COVID Policy Could Disrupt That Moderation

Optimistically, inflation may begin moderating around mid-year or shortly thereafter. This possibility reflects both absence of fiscal policy stimulus and “hoped for” supply chain loosening — now still backed up (see Figures 6 and 7). The “hoped for” improved supply chain throughput, however, face at least two uncertainties. First, China’s zero COVID policy could lead to both broad domestic lockdowns and global supply chain backup. Second, west coast port operators face potential labor unrest this summer. Contracts with the International Longshore and Warehouse Union (ILWU) terminate this July. Past labor negotiations proved difficult, and some slowdown activities could precede contract termination. Assuming these two issues do not restrain gradual supply chain loosening, then inventories could rebuild from current historic low inventory to sales ratios. Consensus economic forecasts call for inflation to moderate about mid-year or shortly thereafter — the risk to that forecast may come from wage pressures.

Figure 6

Global Supply Chain Pressure Index

Standard Deviations from Average Value

Source: Federal Reserve Bank of New York

Figure 7

When Will Supply Chain Issues Ease?

Source: Evercore LSI Research, Daily Shot

Wage Pressures or Not — Key to Whether Inflationary Pressures Extend — Risk to Moderate Inflation Forecasts

Whether tight labor markets result in longer-term wage pressures will likely determine whether inflationary forces will diminish longer-term. (See Figures 8 and 9). Demographic changes and increased retirements in this decade will result in the slowest labor force growth in over fifty years (see Figure 10). More specifically, workforce growth this decade will likely reach just 6 million compared to 10 million in the prior decade. If this labor shortage produces wage pressures, higher service sector inflation may prove longer-lasting than most economists currently expect. In our view, potential wage pressures rather than goods inflation will receive the Fed’s greater concern. With that possibility, labor-intense companies, such as services, will likely prove less attractive investments.

Figure 8

Average Hourly Earnings (US$)

Figure 9

Wage Growth Tracker

Three-Month Moving Average of Median Hourly Wage Growth (%) — Prime Age

Source: Federal Reserve Bank of Atlanta, the Daily Shot

Figure 10

Growth In U.S. Labor Force (Change in Decade Average)

Source: Bureau of Labor Statistics, Bloomberg

Labor Force Shortages Shifts Focus to Greater Productivity Improvement Using New Tools and Systems

Adapting to the growing labor shortages will require businesses to make a greater substitution of capital for labor. The United States seems far behind in adopting automation to do just that. To illustrate, according to Geopolitical Futures, Germany operates 7.6 robots per 1,000 workers compared to 1.5 robots per 1,000 workers in this country. The pandemic brought and will bring about significant operating changes for businesses. The result should enable businesses to offset slower labor force growth and improve productivity. Very simply, a growing number of employees, both working from home and more broadly, distributed geographically, will require new digitized services to support these changes more efficiently. At a more complex level, labor shortages will also speed up applications of big data to reduce staffing and improve productivity. This only begins to illustrate, at a very low level, the future potential for productivity improvements forced by labor shortages. Beyond the current recovery, economists expect U.S. GDP growth will return to roughly 2% sustained growth annually. If productivity improvement can continue as a result of changes brought about by the pandemic and other forces, then U.S. economic growth could exceed its current 2% trend rate.

Investment Conclusions

Equities— Despite slower first-quarter growth, economists continue to look for U.S. GDP growth to reach 3-4% in 2022. This compares to an estimated 5-6% last year. With the Fed raising interest rates and the likelihood of additional COVID variants, this year’s forecast may prove optimistic. At the same time, the cyclical recovery will likely continue into the first part of the liftoff cycle. Increasing wage pressures reduce the investment attractiveness of labor-intense companies, particularly in selected service industry groups. At the same time, tight labor availability and the resulting higher labor costs will work to the advantage of capital goods suppliers. Substituting capital for labor will improve both productivity and profitability, particularly for service-oriented companies. Adding to the attractiveness of capital goods suppliers, recent global supply chain interruptions could see greater investment in North American production facilities. Last year showed the strongest growth in capital investments since the 1940’s — this should continue. Economic forecasts call for slower GDP growth later in 2022, which also fits in with the attractiveness of capital goods companies as late-cycle stocks. With the Fed attempting to steepen the yield curve, financials should also prove attractive. Further on in the year, if liftoff continues and the economy begins to slow, defensive stocks will likely receive greater focus. Higher rates continue to create difficulties for the so-called FAANG stocks— big cap American technology companies. For investors with longer-term horizons, their current difficulties should provide attractive investment opportunities. These companies certainly exhibit characteristics of quality companies – including strong balance sheets and consistent long-term above-average growth.

The Fed — a Change from the Past Decade — Less Liquidity? – Perhaps what may prove more important to investors this year and longer-term will be how successful and, more importantly, how determined the Fed will prove to be in shifting its policies. Particularly key will be whether the Fed both can and will reduce the size of its balance sheet. Over the last decade, investors rode extremely accommodative policies to new equity market highs. The Fed’s explosive balance sheet growth from under $900 billion before the Great Financial Crisis to over $8 trillion today likely supplied the underlying liquidity that drove this strong financial market performance. At the same time, based on their experiences over the last decade, investors remain highly skeptical that the Fed will/can remove liquidity by running down its balance sheet. However, if it surprises, then stock multiple inflation experienced over the last decade may ultimately be tempered. If by chance liquidity recedes, investors will need to refocus on real earnings growth as multiples may not provide the same support to equity price appreciation as in the past. Not surprisingly, many investors will conclude that no, the Fed will not pursue such a hard road to policy normalization. Nonetheless, investors should be sensitive as to how serious the Fed’s commitment to its policy changes will prove to be.

Fixed Income and Alternatives — Whether inflation proves higher and lasts longer or not, interest rates will remain historically low for some time. With inflation materially higher than nominal interest rates, this combination results in negative real interest rates—inflation less nominal interest rates—for fixed income investors. Therefore, with both low nominal and negative real interest rates, fixed-income investments remain unattractive and should only be used to protect capital. For that portion of the portfolio historically committed to fixed income securities, investors should primarily focus on a diversified group of alternative investments.