Walking the Tightrope

Federal Reserve Chair Jerome Powell held his nerve and steadied those of the markets on Friday, when he spoke — virtually — at Jackson Hole. He managed to sound sufficiently alert to concerns about rising prices to calm those worried that inflation may become unanchored, without scaring investors with a warning of early interest rate increases. Tapering of bond purchases will come this year if the economy continues to grow strongly enough to provide a lot more jobs. But Powell made clear that reducing the monthly $140 billion bond purchases will not necessarily signal an early rise in interest rates — which matters more to equity investors. 

A better employment picture will be the key for any increase in US rates. While time will tell on inflation, Fed Chair Powell noted, “We have much ground to cover to reach maximum employment,” one of the criteria the policymaking committee has laid out for interest rate “liftoff.” Powell’s comment buoyed a subdued market for the week, raising the S&P 0.88 percent on Friday. The Nasdaq was up 1.23 percent at the close and the MSCI World finished up 0.75 percent. These represented most of the gains for the week, as the S&P was up 1.52 percent the last 5 days, with the Nasdaq up 2.82 percent and the MSCI World up 1.76 percent. Futures on Monday held their gains going into the new week. We don’t have long to wait for the next jobs report — the August numbers are due on Friday, just ahead of the Labor Day weekend. The July data were strong. But last week, new unemployment insurance claims edged up again. As the Delta variant has spread around the world, it has quashed hopes that the end of summer would bring a “normal” return to work and school. Friday’s jobs data will give an early guide to the impact on the US economy of the summer Covid-19 surge. Globally, the persistence of the virus is weighing on supply chains as well as on travel. 
Observations and takeaways for investors:
Is 2 percent too low?

Most of the inflation debate this year has been about how much inflation would rise and whether the increase — which most did not predict — would prove transitory, as the Fed has said, or become embedded in wage and price expectations. Some analysts have gone so far as to warn of 1970s style inflation, unless the Fed tightens soon. One of the first to call the danger of rising inflation as a result of this year’s combined fiscal and monetary stimulus was former Treasury Secretary Lawrence H Summers. Last week, ahead of Jackson Hole, Summers — still worried about inflation — condemned the Fed’s continued asset purchases, or quantitative easing (QE). He argued that QE is contributing to an unhealthy asset price bubble, worsening inequality, while doing little to boost a supply-constrained economy. The Fed’s latest inflation forecast for this year — 3.4 percent on the median for its preferred measure — indeed looks optimistic. Friday’s release of the personal consumption expenditure (PCE) measure for July showed that prices are already up 3.6 percent on the core measure since December, with five more months of the year still to go. 

Powell laid out five reasons for the Fed’s continued assessment that inflation will return to target. The first four focused on recent developments: the absence of broad-based price increases or of substantial wage rises so far this year, the ebbing of inflation in some of the sectors where pandemic-induced supply shortages had pushed prices sharply upwards in recent months and continued anchored market expectations. Interestingly, he also pointed to the past 25 years of disinflationary pressures that have made it hard for central banks in advanced economies to push inflation up to target, commenting that it was unlikely that such pressures would have evaporated just because of the pandemic. If these pressures reassert themselves as pandemic disruptions ease, and monetary policy is tightened too much, then central banks may be back struggling with the zero bound limit on interest rates that led them to turn to QE in the first place. Afsaneh Beschloss noted on Bloomberg last week, “in general inflation is a slow process. If we see it take off, I think Jay Powell and his colleagues at the Federal Reserve have lots of tools to catch up quickly.” 

A different debate is now unfolding. A number of highly regarded economists, including Adam Posen, President of the Peterson Institute (PIIE), disagree with the Fed’s predictions of a swift return to lower inflation. But they do not recommend early tightening. Instead, they argue for loosening the 2 percent target, perhaps to 3 percent. Some years ago, then Chief Economist of the International Monetary Fund (IMF) Olivier Blanchard, caused a stir by arguing for advanced economies to move to inflation targets of 4 percent rather than 2 percent. The idea was widely panned at the time, when it was only Japan that had long experience of undershooting inflation targets, and where sentiment among central banks was predominantly that inflation was something to be fought not encouraged. 

This time around, there may be more sympathy. Posen and others aligned with his view argue that if the target is unchanged, the Fed will either lose credibility as inflation persists at above 2 percent for longer, or be forced to raise rates and tighten policy prematurely — that is, before the economy reaches full employment. Others, to be sure, believe that the Fed’s new Flexible Average Inflation Targeting (FAIT) regime is already proving too vague and uncertain to anchor policy. The Fed may not have officially moved its target. But by allowing core inflation to reach current levels — 3.6 percent year on year in June and July — without tightening, Powell and his colleagues are certainly permitting more “flexibility” than had been expected when they laid out the FAIT a year ago. Powell has walked the policy tightrope with skill. But he may be forced before too long to choose between upsetting markets with tightening, before his employment goal is reached, or allowing uncertainty to build about what level of inflation is really acceptable. Too much uncertainty will eventually threaten credibility.

Tortoise accelerates?

For most advanced economies, tightening monetary policy is still a way off. European Central Bank President Christine Lagarde has presided over a monetary policy review that in effect shifted the inflation target, by making it symmetric rather than an upper limit. Some of her board members do not like it. But helped with the fiscal spending now being financed by last year’s EU agreement to fund some spending jointly, the European economy has begun to move. And after an agonizingly slow start on vaccinations, European countries have overtaken the US — as vaccinations have stalled here.

Biden’s split screen

Horrifying scenes from Kabul, with the death of more Americans in Afghanistan last week than since 2011, have preoccupied President Biden, who went to view the returning fallen in Dover on Sunday. The foreign crisis has pushed aside the domestic agenda of his young Administration, at least for now. In Europe, the anger and sense of betrayal was palpable, even among those who long opposed the “forever wars.” As others have noted, the debacle of the hasty withdrawal has weakened America in the eyes of the world. Can the US recover by taking a leading role — for good — on other global issues, including climate change and the pandemic? For strength at home, the Administration may be right to believe that this will depend mostly on success in reviving the economy sustainably. 

On the domestic front, Biden’s budget and spending plans took another small step forward with the passage by the House of a $3.5 trillion budget resolution. Right now, markets only care about the Fed and interest rate policy. But solid fiscal support will also be important for company earnings and growth going forward. 

Market reactions

Developed markets continued to march higher last week. In the US, the S&P 500 and Nasdaq Composite both ended at all-time highs after gaining 1.5 percent and 2.8 percent for the week, respectively. Europe’s Euro Stoxx 50 rose 1 percent and Japan’s Nikkei 225 posted a 2.3 percent gain.

Since early June and prior to last week, cyclical stocks had been under quite a bit of pressure from slowing growth in the manufacturing and services sectors and consequently downward revisions to economic growth forecasts as the Delta variant wreaked havoc around the globe. This coincided with investors rotating back into secular growth technology and defensive stocks perceived to be more immune to a slowdown.

Last week saw some reversal in this trend, spurred in part by signs that Covid-19 infections had peaked in China and further supported on Friday by Powell’s comments signaling the Fed’s patience for tapering. Defensive sectors like utilities, consumer staples and health care ended lower for the week as investors showed a clear bias toward cyclicals. Energy shares led the way with notable gains last week of 18 percent and 17 percent from Devon Energy and Occidental Petroleum, respectively.

A major question mark is whether cyclical stocks can build off last week’s momentum and return to their pre-Delta surge. This may depend in large part on the pace of Covid-19 infections peak in other regions, including the US. It will also depend on supply chain bottlenecks resolving and companies attracting enough workers to meet demand.

For emerging markets the story last week was a rebound in Chinese large cap growth stocks — including the much-maligned ADR listings. Chinese juggernauts JD.Com, Meituan and Baidu all rallied double digits, leading Chinese equities to outperform EM ex-China. Valuations have been hitting bargain basement levels, and both foreign and domestic investors engaged in some discount shopping. At the same time, Chinese government edicts have reached lunar regularity. Last week, in the spirit of limiting corrupting influences on China’s youth, Beijing announced a total ban on social media platforms publishing celebrity popularity rankings in addition to announcing regulations on fan merchandise. Entertainment stocks, already reeling from restrictions on concerts and fan events, took a tumble. China’s major entertainment stocks have corrected anywhere from 24 to a staggering 56 percent over one year.
The seesawing performance of Chinese equities in the last few weeks is part of the uncertainty investors will face as Beijing pursues its common prosperity agenda. An agenda which among other things, emphasizes a balance between market efficiency and social quality, and coordination of roles between the government and the market. When and how common prosperity is reached is difficult to discern, even among the most ardent students of Chinese government policies. What is clear is that it will take time and be predicated not just on short term redistributive policies but on China’s growth model and growth expectations going forward. That is, while dividing the pie more evenly is increasingly important, making the pie bigger remains an important precondition.

Elsewhere in emerging markets, Indian equities continued their impressive run last week. The market is one of the best performing year-to-date, on par with the S&P 500 and outperforming the Nasdaq, an achievement that belies the country’s tragic experience with Covid-19. Domestic retail investors have played a key role in maintaining a thriving equity market, dominating trade flows, and increasing their share of participation on the National Stock Exchange from 39 percent to 45 percent in the space of eight months.  
Note: DII: Domestic Institutional Investors, FII: Foreign Institutional Investors, Prop Traders: Proprietary Traders, Individual Investors: individual domestic investors, NRIs, sole proprietorship firms, and HUFs, Others: Partnership Firms/LLP, Trust / Society, AIF, Depositary Receipts, PMS clients, Statutory Bodies, FDI, OCB, FNs, QFIs, VC Funds, NBFC, etc.
Similar to the retail phenomenon in the US, Indian retail investors found an outlet in the markets as travel, dining out, concerts and hotel stays were effectively banned. As India reopens and service sector activity picks up, it’s only logical to expect retail investor activity to normalize. Already, as a percentage of total market float, retail investors have seen their share diminish, quietly being overtaken by foreign flows which tend to represent buy and hold capital. But as recent weeks and months have shown, some pandemic related changes in consumer and investor behavior may yet persist in a post-Covid-19 world. 

Lastly, last week we saw the first of the major Asian economies, Korea, increase rates for the first time in three years, as the effects of the global bottleneck in raw materials and finished goods has begun to affect even one of the largest exporters in the world. 
RockCreek Update
“The big problem if we don’t start tapering in October, November or December — more likely November or December timeframe — is the pressure of inflation,” said RockCreek Founder and CEO Afsaneh Beschloss on Bloomberg Surveillance last week. She discussed Fed tapering, gas pipelines and the economy in Central Asia after the US pullout of Afghanistan, and more. Watch here.

In light of the horrific news coming from Afghanistan, RockCreek team members have been working with nonprofits helping to resettle Afghan refugees and are making a donation to Protect Afghan Women, a project of the Georgetown Institute for Women, Peace and Security. Their mission is to promote a more stable, peaceful and just world by focusing on the important role women play in preventing conflict and building peace, growing economies and addressing global threats like climate change and violent extremism.

Our next commentary will be on September 13, 2021. We wish you a great Labor Day holiday. 

Team RockCreek

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