Throw Out the Models?

It is common practice to look at the past to help forecast the future. Economists do it. Market analysts do it. But right now, the first answer that many are giving to questions about prospects for the economy is: I just don’t know.

That was what a senior central banker in Europe said when asked privately last week which side he was on in the great inflation debate. It is what some of those parsing stock market moves for risk/reward models say — to themselves if not publicly. The problem? Put simply: there are just not many ways to compare the current confluence of pandemic, policy and politics with anything in the past. Think of how many times people have used the word “unprecedented” to describe events of the past year: the lockdown of the world economy almost overnight; overwhelmed hospitals and morgues in major global cities; vast quantities of liquidity needed to calm supposedly risk-free US Treasury markets; fiscal stimulus agreed and enacted in record time, in the US and other countries. And then the astonishing speed with which safe and effective vaccines against SARS-CoV-2 were discovered. Even after that, the rollercoaster continued this year. Unexpected surges in infections swept countries where vaccines were in shorter supply, first in Europe and now Asia. Meanwhile, the US is rushing headlong back to the office, sometimes upsetting those summer plans that many people have been making (see below).

Models are notoriously bad at predicting turning points.
The ups and downs of the past year translate into lots of hard-to-forecast turning points. Some of the contours of the next few quarters are clear — notably a rapid economic recovery in the US, with Europe gradually catching up and China staying strong. But, as Singapore Foreign Minister Vivian Balakrishnan warned an Asia Society audience last week, it may take two years for the world to work through the pandemic. He also expects that other dangerous viruses will emerge and require coordinated global action to control.

For investors, it is important to stay on your toes in this changing and uncertain world. But flexibility should be balanced with longer-term goals that look through the noise. Nobel prize winner Daniel Kahneman with co-authors Cass Sunstein and Olivier Sibony have made crystal clear in the new book Noise how flawed human judgment and decision-making is without deliberate attempts to weed out “noise”. Much of the noise for long-term investors is coming right now from attempts to interpret the Fed and debate whether it is “right” or “wrong” about downplaying inflation risks. Other central banks are wrestling with decisions too. But, as the world has learned, the Fed’s actions have global consequences and drive markets worldwide.
Observations and takeaways for investors:
Even if market participants were certain of an incipient high inflation regime, how should they position their portfolios? Over the past fifty years, we identified three high inflationary periods: 1973-74, 1979-80, and 1990. In every period, the impact on longer-dated treasuries is negative with the ten-year note posting negative returns. This intuitively makes sense as rising prices force investors to demand a higher rate of return — so they sell bonds, lower their price and raise yields. This was what markets witnessed in Q1 this year as investors were driven by expectations of higher inflation. The equity story is more mixed. In the early 1970s and 1990s, equities fell by 23 percent and 19 percent respectively, but during 1979-80 equities rallied 10 percent. Given the unprecedented nature of the period we are in today, equities remain an unknown factor. Today (versus previous time periods), the equity market composition is also very different given the weight of Big Tech unheard of during past regime changes. Somewhat analogous is the influence of oil companies in those periods. After booming prices in the inflationary ’70s, oil companies grew to be a significant part of the S&P 500 in 1979. In June 1979, six of the top 10 companies in the index were oil or oil-related businesses and accounted for 14 percent of the index. Today, the entire energy sector accounts for just under 3 percent of the S&P 500.

Last week highlighted the volatility that is punctuating global markets recently. Major equity indices finished the week in plus or minus 50 bps territory disguising shorter-term rallies and sell offs intraweek. The S&P 500 and NASDAQ both registered significant drawdowns during the week of as much as -2.7 percent at one point. But they ended the week close to where they began: 40 bps lower and 30 bps higher respectively. Fed minutes showing members of the FOMC were thinking about talking about modifying policy if the recovery continued at such a strong clip temporarily exacerbated selling in the markets. That reversed as traders mulled the context in which those comments were made, and how the economy has evolved since then. Lower jobless claims on Thursday further helped erase much of the earlier losses. By Friday, risk appetite was waning again although strong manufacturing data helped support cyclicals. Price action was similar in Europe and the UK where the Stoxx Europe 600 and FTSE 100 registered returns of +0.6 percent and -0.4 percent, respectively, for the week.

In developed markets, speculative growth and technology have clearly lost momentum since mid-February, but a pullback seemed overdue irrespective of other factors. It was inevitable that as the global economy reopened, investors in developed markets would look to take profits from 2020 winners and diversify into forgotten sectors exhibiting improving fundamentals. At the same time, expectations for many stocks with the most enticing growth stories were becoming unrealistic. Given recent price moves we are seeing reduced expectations which could help establish a bottom in these stocks before too long. Lower price targets from sell side research analysts but buy ratings on many of the leading companies are helping to set a floor for the market. Software valuations have contracted 19 percent year-to-date, but that was after expanding 56 percent in 2020 and overall valuations are still one standard deviation above average, indicating potentially some further near-term risk to the downside.

Interestingly, emerging markets witnessed gains in tech-related growth stocks in the consumer discretionary and IT sectors last week — driven in large part by Chinese and Taiwan. Given the dismal start to 2021 in these stocks, a bounce-back was to be expected after an overdue pullback. For the second week in a row, foreign flows into emerging markets equities were negative, albeit marginally so. Emerging Asia led outflows, including sizable exits from the ASEAN region. The precarious public health picture and the region’s sensitivity to US interest rate moves loomed over markets.

Emerging Asia outflows were countered by inflows into Brazil which extended its streak to six weeks, the only major emerging market that saw foreign inflows last week. Non-commodity names started to receive more attention as a combination of fiscal stimulus, a record high current account surplus, and lower infection rates act as a strong tailwind for the economy. Brazilian travel, e-commerce, omni-channel retailers, and logistics companies have all seen stronger activity. The Government’s privatization reforms have gained momentum which bodes well for several of the country’s largest utility companies.

Brazil bullishness contrasts with Chilean markets that sold off by 10 percent last week. Contrary to market expectations, the results of the Constitutional Convention election saw the center-right coalition fail to win more than a third of the vote, while the more progressive leftist coalition gained more seats than the center-left coalition. Making matters worse, the traditional buyers of last resort, i.e., domestic pension plans, were nowhere to be found in the market route. Indeed, most pension plans in the country have been raising liquidity as plan participants look to cash in on their investments. The results of the election have forced a reassessment of the risks ahead, as changes to the country’s constitution will likely be less business friendly.

As a reminder that life is never boring, Belarus bonds are plunging. Over the weekend, the government enticed a Ryanair plane flying from Athens to Lithuania to land in Belarus, saying there may be a bomb on board, and then promptly arrested a journalist on the flight.

The Fed versus fiscal: the bumpy way to a new equilibrium

The early warnings sounded about inflation this year focused on fiscal policy. Swift passage of President Biden’s first $1.9 trillion spending proposal, even as the government was pushing out spending of almost $1 trillion approved in December, looked to some as overkill. Surely the economy would overheat, with wages and prices bid up as demand outstripped supply. Simple economic modeling. The fact that many consumers had built up savings during a year of restricted activity suggested even more spending power might soon be unleashed.

The Administration’s subsequent push for two more packages totaling another $4 trillion of spending — albeit with some offset over the years from higher taxation — seemed downright scary to those worried about debt and deficits, even if there is broad recognition of the need to upgrade America’s aging infrastructure and get serious about acting on climate change. Those proposals are now being debated in Congress. Republicans came out swinging against both the size and contents of the plans, and the idea of paying for them by reversing some of the 2017 Trump tax cuts. President Biden last week offered to downsize the infrastructure package by $550 billion, to $1.8 trillion. This is still far from Republican suggestions of $600 to $900 billion of (mostly traditional) infrastructure spending. Over the weekend, a bipartisan group of senators put forward a still smaller spending proposal, just $300 billion focused only on highways, roads and bridges. That will not be enough for this White House, which is set on transformative rather than marginal spending. But the end result of the legislative push and pull — whether Democrats go it alone again or compromise — will undoubtedly be smaller than the initial price tag. New spending will, in any event, be spread out over 8-10 years. Fiscal hawks should breathe more easily.

The focus of economists is now shifting more squarely to the actions of central banks. After all, controlling inflation is supposed to be their job. As we have been describing for some months, the Fed is trying to execute a complicated shift in policy. One former Fed official last week described this maneuver as “shifting to a new equilibrium.” In the old equilibrium, easy money was relied on by markets and policymakers alike to support the economy. Government spending was restrained and, recently, business taxes were cut. As we now know, that policy mix, while beneficial for corporations, investors and the wealthy, came alongside stagnant real wages for many Americans and increasing inequality. It complicated monetary policymaking, as interest rates flirted with the zero bound — and became negative in some countries — and quantitative easing threatened to create asset bubbles and distort valuations. More fundamentally, that policy mix upset political equilibrium in the US and many other advanced nations.

The Fed is now striving to reset policy so that inflation averages out at the 2 percent target, instead of undershooting year after year, and employment rises, to bring in the previously marginalized. This argues for continued easy money. But part of the reason for the policy reset is to shift away from the policy mix of tighter fiscal and easy money, which helped investors more than workers. President Biden talks explicitly about shifting to an economy where workers earn better wages and get a bigger share of the (he hopes — growing) pie. The losers, in relative terms, would be capital and owners of capital. Hence the proposed rise in taxes on businesses and higher earners to pay for new government spending to repair infrastructure and help families. A deep dive by Bloomberg shows that big companies can afford it. Profit margins of the top 50 companies worldwide are now equivalent to 28 percent of global GDP, compared to less than 5 percent three decades ago. Meanwhile, their effective tax rate has halved from 35 percent in 1990 to 17 percent today.

At some point, the Fed will want to leave it to fiscal policy to keep demand up, while monetary policy tightens and real interest rates “normalize.” Financial markets are not yet ready. Hints last week about tapering asset purchases — very gentle hints from Fed minutes that it may sooner than later become time to think about talking about reducing asset purchases — knocked stocks and bonds. The Fed won’t move immediately. But it will be watching the data carefully: including this week’s release of the Fed’s preferred inflation measure, core PCE (personal consumption expenditure).

What happens in Washington, doesn’t stay in Washington

The Fed is sometimes referred to as the global central bank. In times of stress, other central banks turn to the Fed for help. Its actions to calm markets and provide liquidity drive results everywhere. This works in both directions. Last week, in Europe, ECB President Lagarde put a damper on the idea that Europe was ready for tighter financial conditions. Yes, the economy is now looking up, with vaccine delivery speeding up and the holiday season starting. The ECB also acknowledged that there were “pockets” of excess. But officials there, as in other central banks, know that when the Fed signals a shift from accommodation, their markets will also feel the impact. Lagarde was telling markets that the ECB will lean against tightening if that occurs. Peripheral spreads eased as a result.

It is not just monetary policy that spills over US borders. Rising consumer spending, and to a lesser extent business investment, pulls in imports. The expectations of strong US growth, led by consumption, has foreign exporters rubbing their hands with glee. For nations that depend on exports, including in Europe and Japan, a booming US will bring a better summer this year.

Back to work, or summer break

Five months ago, the FDA granted emergency use authorization to the Pfizer vaccine, and the first doses rolled off trucks and into arms. Last week, the Centers for Disease Control announced that more than 60 percent of adults in the U.S. — more than 160 million people — have received at least one vaccination shot. Cases and deaths continue to drop in the US; however, the severity of the pandemic can still be seen in topline figures: nearly 32 million cases of Covid-19 and 585,000 people killed by the disease.

More than 279 million doses have been administered in the last 5 months, but that still leaves more than half the US population — including those under 18 this time — unvaccinated. The CDC only recently approved the vaccine for adolescents, and an approved vaccine for elementary school-aged children is still months away.

The swift vaccine rollout appears to have spurred some large employers to order their employees back to the office. In April, JPMorgan Chase told its roughly 165,000 US-based employees to expect to be in the office by early July. Goldman Sachs is eyeing opening in mid-June in New York and late June in London. Salesforce, with 50,000 employees around the world, announced a phased reopening, gradually moving from 20 percent to 75 percent of employees coming into the office.

Such orders are apparently causing consternation among some. New Yorkers who planned to keep working remotely through the summer from places outside the city (with conveniently located beaches) reportedly hate changing plans. Others may too. Los Angeles-based writer Tracy Moore likely speaks for many office workers facing potential returns to commutes, team-building exercises, and wearing “hard pants” once again, declaring: “I would prefer not to.”

Some CEOs aren’t ready to order their employees back to the office, not yet and — perhaps for some — not ever (at least full time). Of 100 executives Fortune recently surveyed, only 10 percent said they expect their office workers to spend 80 percent of their time in the office. At the same time, 80 percent of executives said they expect hybrid work to continue; however, a working definition of “hybrid” is somewhat fluid — anywhere from 1 to 4 days (out of a 5-day workweek) in the office.

That could be tough news for big city mayors who are clearly ready to kick start downtown economies after a brutal blow to spending on lunches, coffees, bar tabs, and taxis, which help drive the engine of urban economies. It will take time to see the long-term effects, and much will depend on creative ideas to capture the new normal. For instance, offices and hotels — some of the earlier areas of Covid-19 collateral damage — could see a second life in the form of apartment buildings. Right now, it seems likely that they should be designed for working from home.

While the US debates reopening, the IMF delivered a reminder on Friday that much of the rest of the world is still fighting the global pandemic. At a meeting of global health ministers, chaired by G20 host Italy, the Fund announced a $50 billion proposal to end the pandemic. The plan calls for vaccinating at least 40 percent of the population in all countries by the end of the year and at least 60 percent of the world’s people by the first half of 2022. To get there, rich countries, and the development institutions that they largely control, must dig much deeper into their pockets. That effort would pay off.

The prospect of halting a disease that has taken the lives of more than 3.5 million people around the world may seem worth just about any price. But $50 billion would clearly end up being a bargain. The IMF estimates that ending the pandemic would deliver the equivalent of $9 trillion into the global economy by 2025. With vaccination rates across Africa still in the single digits, global leadership will be critical, and the Bretton Woods institution traditionally designed to focus on balance of payments and fiscal policies is stepping into the void.

Jobs: plentiful or still scarce?

Last week’s unemployment claims showed that while many Americans are still losing their jobs, the pandemic toll is easing. New claims declined to 440,000 in the week ended May 15, from 478,000 the week before. While this is a pandemic low, it is still above the worst weeks of the Global Financial Crisis. Last week, we talked about puzzling economic signals — on both employment and inflation. On jobs, two opposite views emerged on what the low April payroll numbers signified. On the one hand, a still depressed economy, with Covid-19 related difficulties in returning to work. Alternatively, excessively generous unemployment benefits that held many Americans back from looking for work. Models didn’t help. An experiment is now going on that may clarify things, albeit at the cost of putting some individuals and families in a more precarious economic position. Republican governors in Texas, Indiana and Oklahoma last week announced that they would join others in ending early the temporary unemployment benefits from the American Rescue Plan that were due to expire in September. There are now 22 states where governors, believing in the second argument, hope to boost local employment and payrolls by halting the federal programs paying for an additional $300 in temporary benefits for those eligible for state unemployment and extending benefits to gig workers and others traditionally ineligible.

The shift will make it harder to interpret the weekly figures for unemployment claims. But it will also allow a real-time examination of the impact of the federal program on labor supply.
RockCreek Update
On this forthcoming Memorial Day, we remember and thank all those who have served and continue to serve our country.

Team RockCreek

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