Fiscal policy tantrum
A steady Fed leaves worries about inflation and yields to the market.
I stole that title from my esteemed colleague, R.J. Gallo. (Clever, don’t you think?) The past few weeks have been all about the runup in yields, with bond volatility driving equity volatility. Chair Powell this week firmly indicated, again, that the Fed sees no reason to act on long yields. Why should he? Short rates remain firmly anchored, and the 10-year is still roughly 30 basis points below pre-pandemic levels and far short of the 2.5% inflation the Fed says it’s willing to tolerate. The move in bonds has been rooted in growth optimism, not some perceived Fed hawkishness. Isn’t that a good thing? It’s a “fiscal policy tantrum,” R.J. says, not a “taper tantrum.” If anything, the Fed likely sees the equity sell-off as a good thing. It’s taking froth out of the market, which means it can leave rates at zero without having to worry about bubble risk. The move in yields has been all in the government end. In the credit market, “you need a magnifying glass to see the move in high yield corporate,’’ Renaissance Macro says—a clear sign the macro environment is strong. Again, rates rising for the right reasons. The challenge may be how quickly might inflation move in an economy with a wide-open monetary spigot and war-time fiscal policy. We are living Modern Monetary Theory (more below). A structurally inflationary environment, which Gavekal Research ponders as a possibility in this ultra-charged backdrop, historically has hurt stocks. But how real is the threat, and how soon? True, the 5-year breakeven inflation rate has jumped to a 12.5-year high (more below). But that’s against the post-global financial crisis backdrop of disinflation and deflation. The 10-year rate remains below the 2.3%-2.5% range consistent with the Fed’s target, with the diversion between 5- and 10-year rates causing a rare inversion in the TIPS breakeven curve. It’s real yields that matter most and while they have risen, they’re still negative. Even if the 10-year reaches 2%, they’d still be negative. Being short the S&P 500 at these levels doesn’t seem to be a good idea.
Tech weakness is feeding worries about a market top. But breadth remains strong. The average stock (the equal-weighted version of the cap-weighted S&P) is outperforming the S&P by 450 basis points year-to-date, with leadership in areas that benefit most from a reopening. Small-cap discretionary stocks are at absolute and multiyear relative highs vs. large-cap discretionary, and energy, banks, transports and services are exhibiting healthy trends. This all suggests the current market upheaval is rotational in nature. Indeed, discretionary names historically deteriorate before the cycle ends, and they’re improving, indicating we’re in the middle, if not early innings of the cycle. On an equal-weighted buy-and-hold basis, value stocks have returned 158% since last year's March 18 bottom, matching the performance of Empirical Research’s basket of growth stocks and topping the broader S&P by 96 percentage points—the second-best run in a modern-era year. It sees room for continued outperformance as the global recovery picks up steam. Much like a post-war rebuild, the world is emerging in sync from a year of lockdowns and losses with a lot of money at its disposal. Despite the recent disruption, the S&P as of this writing is only 3% off its all-time high and the earnings outlook keeps strengthening. Q4 capped a remarkable three-quarter run in which index constituents beat consensus by a respective 23%, 17% and 16.5%—multiple standard-deviation beats that help explain why estimates keep rising. Consensus now expects 2021 EPS to best 2019’s record by 7%. S&P margins expanded in Q4 for the first time since 2018, when they were buoyed by the tax cuts—a sign Covid-forced efficiencies should carry forward as the world reemerges from its self-imposed caves.
It looks like President Biden’s going to get most of his $1.9 trillion, pushing so-called Covid-related fiscal spending since last March to a breathtaking $7.8 trillion. Even before December’s $900 billion, combined fiscal and monetary stimulus accounted for around 50% of U.S. GDP, unparalleled in our history. But that was OK. It was in line with our partners (except Japan at around 74% of its economy and China at just 18% of its). Everyone has been printing money. With the Biden package, we’d be around 64%, tops among peers save Japan. Problematic inflation on the way? I know of only two ways this can happen. One is through a wage-price spiral. Yes, pent-up demand will be unleashed as the pandemic fades. But think of the social-distancing parts of the economy hardest hit by it. Travel. Restaurants. Hotels. Sports. We’re a consumer-led economy—we spend more than $17 trillion annually. But social-distancing industries only account for 4% of that consumer wallet. And of that, 63% is dining out. The vast majority of our economy has been doing fine. Manufacturing’s humming (more below). Housing’s booming—TIS Group says Hilton Head is so hot that a house going on the market at 6 a.m. draws multiple above-listing bids by noon. So far, a white-hot housing market hasn’t caused an inflation problem, so how can dining out or flying on vacay do it? The only other way to get problematic inflation is to crush the dollar. We have been printing along with the rest of the world. The dollar weakened somewhat last year but has been rising since early January. So, Biden gets his $1.9 trillion even as Strategas Research notes the jobs recovery is looking like a V (more below). What if the rest of the world sees no need to ante up more? Perhaps this is the bond market’s concern; it certainly is mine. No taper tantrum. What we’ve got on our hands is a fiscal policy tantrum!
- It’s a V U.S. employers posted a big beat for February, adding 379K nonfarm jobs vs. 200K expected, with prior months revised up and private payrolls jumping 465K as large chunks of the socially distant portions of the economy began to reopen. The jobless rate ticked down to 6.2% while the participation rate held steady.
- It’s a V February’s ISM manufacturing survey rebounded to a 3-year high in the U.S. on broad-based improvement, and January factory orders jumped the most in six months, lifting year-over-year (y/y) orders into positive territory. After coast-to-coast storms waylaid activity, Evercore ISI’s proprietary measure of trucking activity bounced back, more than fully recovering the prior week’s drop-off to match its highest level since 2000.
- It’s a global V Led by the U.S.’s highest reading in the world, the global composite PMI, which includes both the services and manufacturing sectors, rose in February for the first time in four months to its second-highest level since August 2018. Ned Davis calculates that the reading equates to above-average 3.2% annualized global growth. All countries and sectors reported overwhelmingly positive 12-month expectations.
- Google searches for inflation are spiking Rising prices dominated this week’s ISM manufacturing and services reports, with the prices-paid component in each their highest in more than a dozen years. And on a y/y trend basis, nonfarm unit labor costs surged 3.9% in last year’s fourth quarter, their fastest pace since Q3 1991, consistent with a potential buildup in core inflationary pressures. Powell insist its “temporary.”
- How do you know you’re in a global boom? When it feels like a big miss when the ISM non-manufacturing gauge comes in “only” at 55.3, Trend Macro says. The drop-off to its lowest level since last May was driven by crumbling new orders. Markit’s separate services survey was nowhere near as “gloomy,’’ rising to its highest level since July 2014.
- Still a lot of work to do on jobs Even with this morning’s surprise, there are still about 10 million unemployed workers who would like to work, and weekly jobless claims continue at nearly triple their level before the pandemic. It’s this area that will drive Fed policy for the foreseeable future.
It’s a seller’s market In its February housing update, real estate brokerage Redfin reported 55% of homes that went under contract had accepted offers within their first two weeks on the market, well above their 44% rate the same period a year ago. Supply's a big reason: new listings of homes were down 17% y/y, and active listings fell 40% from 2020 to a new all-time low. The tight market keeps pushing up prices, with U.S. home values up $3.1 trillion the past year to $32.4 trillion.
Are rising rates really a threat to growth? Not as much as the market may think. Applied Global Macro Research notes household debt relative to income has fallen significantly since 2008, with household balance sheets in healthy shape, buttressed by pandemic-fed stimulus that has helped lift excess household savings to $1.8 trillion. While corporate debt has been on a long run upward trend, the bulk reflects corporate net equity buybacks. With more companies canceling buybacks, businesses have more flexibility to trim debt without cutting down on capital expenditures.
This makes 1.5% on the 10-year look high Negative-yield debt plunges (!) … to just $12.7 trillion, thanks to the backup of rates that has reduced the amount by $5.5 trillion.