Waiting for Jerome…..
Our story opens today with two men seated on a bench outside the New York Stock Exchange. They are dressed in the “Covid” uniform of a white dressed shirt and tie. The younger man matched his tie to a pair of wrinkled shorts. The older man had selected a pair of Where’s Waldo pajama bottoms and flip flops to complete his attire.
Younger man: Why are we here?
Older man: We are waiting for Jerome Powell – head of the U.S. Federal Reserve.
Younger man: Yes, but why are we waiting for Jerome?
The older man gives the younger a look of disgust before answering: Jerome will tell us when the stock market is going to crash!
Younger man: How does Jerome know when it will crash?
The older man stands and begins pacing: He makes it crash! He either puts money into financial markets or takes money out of financial markets. When he puts it in, prices go up. Therefore, when he takes it out markets will go down.
The younger man scratches his head in confusion: But didn’t markets go down in 2008 and in 2020 without the central bank taking money out of the market?
The older man waves his hand frustration: Those weren’t market crashes! In 2008, I was sitting on this bench, I had a wee nap and when I woke up, it was all over. I had missed the whole thing! I was determined not to let that happen again. But in 2020, I slipped away for a minute to go to that hot dog stand on the corner – you know the one with the good sauerkraut. When I got back, the market had fallen, Jerome had sent a flood of money into the system, and everything was already coming back. This time, I’m not leaving! I’m going to wait right here until Jerome comes. (The older man flops onto the bench crossing his arms across his chest defiantly.)
The below chart reflects the increasing level of engagement of the U.S. Federal Reserve in financial markets beginning in 2008.
https://fred.stlouisfed.org/series/WALCL
The younger man thinks for a moment: Why does the money have to be pulled out of financial markets?
Older man: It just does! They can’t keep doing this forever. It doesn’t make sense. The federal government spends money, piling up massive debts and the central bank creates money to buy the debt, loading up the central bank balance sheet. The U.S. money supply has already grown by approximately 30% in just over a year. Something has to make it stop!
Younger man: Uh, what?
Older man slumps in his seat: I don’t know.
Younger man: Why does it need to stop?
Older man jumps to his feet reinvigorated: It’s all about inflation, lad. You are too young to have lived through the 60’s and 70’s – but I was there. In the 60’s, the central banks prioritized jobs over containing inflation and for a while it seemed to work. Inflation rose a little, but the economy was doing well, and no one seemed to care. But it gained momentum in the 1970’s and become an almost untamable beast.
The younger man scratches his head: Besides the return of high-waisted, bell-bottom pants, I don’t see much that looks like the 70’s. My book on economic history says that in the 1970’s, the economies were closed to foreign competition and union power was strong – leading to cost-of-living adjustments built into wage agreements. There were also two oil shocks, which drove short but extreme bursts of inflation. I don’t see any of that today.
The older man wags his finger at the younger: Chips, my boy. It isn’t oil that drives the economy anymore it is computer chips. Until the U.S. can control its own supply of computer chips, we will be subject to price spikes due to shortages that can cripple the economy. Lack of chips can shut down factories and throw people out of work. And chips aren’t the only thing. So much of what we buy today comes from foreign countries, we are dependent on complex supply chains to deliver the goods we need. With ports backlogged, we can’t get goods to market and that is driving prices higher. As more and more ships wait at ports to be unloaded and reloaded, companies can’t find ships to move their goods nor the shipping containers to put their stuff in. Add to that, the pent-up demand as the economy reopens, and inflation is sure to spiral out of control.
The younger man rises: All that talk about hot dogs earlier has made me hungry. I’m going to go buy some lunch while I still can. My government benefits are going to run out in a few weeks and then I will be back to my old standard of living. My friends are all in the same boat. We are going to have to focus on getting jobs now that we won’t be able to earn more, not working than we did working. My buddies and I thought we might make more money as we got jobs, but the increase in wages seem to be easing as more people lose their unemployment benefits. I heard that in Canada, the gap between where incomes would be without government subsidies and where they are, is about $80 billion. When all these benefits go away, I might not be able to afford buying takeout lunches anymore. I think that might hurt some of the “pent-up” demand. I guess as we, and everyone else gets back to work, some of the supply problems should also get fixed.
A young, well-coiffed intern enters the scene humming Stayin’ Alive……
The younger man nudges the older: Where do you think he got that haircut? Do you think I could get one too?
Intern: Are you the gentlemen waiting on Mr. Powell?
Older man: Yes, why yes, we are? Is he coming soon?
Intern: Mr. Powell has asked me to relay to you that he will not be coming today. He is getting his second vaccine. You do understand the importance of vaccination to maintaining this economic recovery?
Younger man: I thought the recovery was all about government money. You know, subsidies and infrastructure spending. Aren’t we building a new economy where everything is green? I keep meaning to ask – will I still be able to get a navy suit once the economy is all redone in green? Green doesn’t really work with my skin tones – makes me look sallow.
Intern: The government money was about jumpstarting the private sector. As a result, we are emerging from this downturn with some of the strongest growth in the last decade. In the first quarter 2021, growth reached 5.6% in Canada and 6.4% in the U.S. We now expect U.S. growth to reach 7% for the full year. Now if you will excuse me gentlemen. I must return to Mr. Powell.
Although the GDP data has been subject to distortions due to the annualizing of extreme short term moves both up and down during the pandemic, GDP growth appears to be strong. Although the chart also demonstrates the challenges of getting a clear read on economic data due to the series lockdowns and re-openings.
Source: Data from Factset
Older man: Yeah sure, we have great growth. One more sign that inflation is coming back, interest rates are going to move higher, and a crash is coming! It is all driving asset prices higher and pushing valuations to levels we haven’t seen since the tech bubble. Now that was a spectacular crash!
Younger man: But if the economy is doing well, doesn’t that mean companies are going to make more money?
Older man: Well, yes.
Younger man: And if companies are going to make more money, doesn’t the market try to anticipate that?
Older man: Well, yes. But that doesn’t mean interest rates won’t go up with everything booming! And once interest rates go up, you can’t justify these valuations any longer.
Younger man: So where are interest rates?
Older man: 10-year bonds are yielding approximately 1.5% in both Canada and the U.S.
Younger man: Where were those rates before the pandemic?
Older man: In Canada, the rates were about where they are now. In the U.S., they were at 1.8%
The chart below shows Canadian 10-year bond yields over the past 5 years as well as the range of interest rates during that period. In the period of 2016 – 2018 when rates peaked, economic growth continued and share prices were rising.
Source: Data from Refinitiv
Younger man: Isn’t it possible that with all this great economic growth, the markets could withstand slightly higher interest rates?
Older man: I guess it’s possible – but I don’t know……. Don’t forget commodity prices – inflation!
Younger man: When I was doing some repairs on my house, I noticed that some of those prices have come down. Lumber is down 45% from it’s peak while copper has come off a bit too, but only about 8%. Oil prices haven’t dropped – I notice that when I’m filling up my tank. Either way, it doesn’t seem likely that prices will keep rising at the same pace they were before. Also, I got an email from my sister-in-law in China, and she says the government there has refocused its efforts on financial stability and deleveraging. They won’t let people speculate on commodity prices and they are trying to curb bank lending. What happens in China is important – right?
Older man slumps: Yeah, China is important. So, you don’t think the system is going to crash?
In 2016 China began to try to rein in the excessive leverage in its financial system. The country reversed course at the beginning of the trade wars, shifting back to economic stimulus. Policy now seems to be moving back towards a deleveraging focus.
Younger man shrugs: Don’t know. I don’t really understand this stuff. I’m just trying to figure out what is going to be so different from before the pandemic until afterwards, once everything settles down.
Older man: There will be a lot more debt.
Younger man: Yeah. I guess that makes it hard to push interest rates up.
Older man: Yeah.
Younger man: I never did get my hot dog. Maybe I will go now. Do you want to come?
Older man: Nah. I’m gonna stay here. Jerome will come and he will tell us when this bull market will end. I’m just gonna wait.
*****
On a final note, our little skit this quarter was designed to point out the futility of trying to determine what will trigger the end of a bull market or when it will happen. As portfolio managers our goal is to try to strike a balance between ensuring our clients benefit from the upside, while recognizing the risks. Today, those risks are primarily in the form of a reduction in the copious liquidity provided by central banks, higher inflation and therefore higher interest rates. It is easy to focus on these risks, but it is important not to ignore the strength of the economic recovery and the surge in corporate earnings growth, that have the potential to allow the bull market to carry on longer than many expect. It is our role, to build a portfolio that allows each of our clients to achieve their long-term objectives, while striving to keep the overall risk in the portfolio at a level that allows you to remain comfortable through both the good days and the bad.
