FINANCIAL MARKET UPDATE 3.16.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

RISING RATES, INFLATION & THE FED

All eyes will be on the Federal Reserve this week when they make their monetary policy announcement on Wednesday. The market typically follows these announcements closely, but this Fed meeting will likely garner even more attention than normal. Roughly a year after the pandemic-related lockdowns began, economic activity appears poised to accelerate, and the market will be looking for clues on how and when the Fed will unwind its emergency interventions. While the outcome of any single Federal Reserve meeting is generally not impactful for long-term investors, these events have the ability to generate some near-term volatility. Here is a high-level overview of some of the important storylines related to the meeting.

Interest Rates Have Been Rising

The Fed has held rates near zero since March of last year, yet longer-term interest rates have increased dramatically over the past six months. How is this possible? The Fed sets interest rates using the ‘Federal Funds Rate,’ which is the rate banks can borrow and lend their excess reserves to each other overnight. Overnight is obviously an extremely short period, so the Fed’s primary policy tool is based on managing short-term rates. The recent increase in rates has primarily occurred in longer-term instruments. This would include the 10-Year Treasury, which is the primary benchmark for a substantial amount of longer-term lending, including residential mortgages. Visit any financial news website, and the interest rate component of the ticker tape at the top of the page will be the 10-Year Treasury.

While long-term rates generally respond to movements in short-term rates, they do not move in lockstep. The term premium, defined as the extra compensation an investor or lender requires for locking up their money for an extended period, changes over time based on growth and inflation expectations. An increase in these expectations can increase the term premium and, therefore, longer-term rates.

Movements in interest rates can extend beyond the bond market and into stocks as well. The manner in which stocks respond is not always straightforward, however. On the one hand, rising rates are a headwind because they represent tighter financial conditions and higher borrowing costs. Additionally, the value of a stock is estimated as the sum of all future cash flows, such as dividends, discounted back to present. Mathematically, the value of those future cash flows decreases as the discount rate increases. For high-growth companies whose actual cash flows are far into the future, the impact of a rising discount rate is felt more severely. This notion has been used to explain the recent underperformance of the high-growth technology sector. On the other hand, rates are still near historically low levels, and if they are rising because the economy is picking up speed, you could argue that stocks should do well in such an environment.

Accelerating Economic Growth and Inflation

As vaccine rollouts progress, social distancing restrictions ease, and the new fiscal stimulus package is dispensed, economic growth is expected to accelerate. Inflation is also expected to accelerate, with both realized and expected inflation at or moving towards the highest levels in years. Inflation is typically measured as the year-over-year price change for a basket of goods. Over the next couple of months, current prices will be compared to the depressed price levels prevalent during the peak of the pandemic-related lockdowns. Sometimes referred to as the ‘base effect,’ these comparisons will provide the appearance of accelerating price increases. The big question is whether these inflation pressures are transitory or here to stay. There are convincing arguments on both sides of the debate.

Those that believe a sustained increase in inflation is approaching typically point to the growth in the money supply. The graph below illustrates the “M2” calculation for the money supply, which includes cash, checking deposits, savings deposits, money market securities, mutual funds, and other time deposits. Essentially cash or other holdings that can quickly be converted to cash. The year-over-year increase in M2 is 25%, which dwarfs the growth in any other period since the 1960s. The growth in the money supply heavily influences inflation in a relationship that can be summarized as “too much money chasing too few goods.”

The argument against sustained inflation generally centers on the “slack” currently evident in the economy. This refers to the high level of unemployment (people who want to work but can’t find a job) and wide output gap (what the economy is producing versus what it is capable of producing). Inflation is not typically an issue in this environment because there are untapped resources available to satisfy increasing demand.

The Fed Announcement

We are approaching a crossroads. The Fed deployed a heavy dose of monetary stimulus to combat the lockdown-induced recession. With the economy well on the way to recovery, the Fed will need to withdrawal the stimulus at some point, but doing so requires a very delicate handoff. If the Fed is too slow, it risks overheating the market, economy and inflation. If the Fed is too aggressive, it could hamper the economic recovery and send shockwaves through the markets as assets reprice to reflect the new path of policy.

The Fed has previously articulated its belief that inflation pressures are transitory. It will maintain some of its non-traditional measures of accommodative policy (bond purchases) and maintain interest rates near zero for the foreseeable future. If the message delivered upon conclusion of the meeting is materially different from what the market is expecting, we could see some volatility.

WEEK IN REVIEW

  • Data published by the commerce department last week showed that retail sales fell more than expected during February (-3.0% vs. -0.5%). The decline was attributable to severe winter weather that gripped much of the country and a slowdown from January’s figure that was augmented by $600 stimulus checks. The January retail sales figure was increased from 5.3% to 7.6%, so the growth in consumption activity remains strong so far in 2021 and will likely get a boost from the recently passed stimulus package.
  • As mentioned in the Story of the Week section, the Fed announcement at 1 PM CT on Wednesday will be the highlight of the week. Investors will heavily scrutinize the official Fed Statement, post-meeting press conference, and updated summary of economic projections (dot plot).
  • Other economic data to watch for during the week includes housing data on Wednesday, and jobless claims and the Index of Leading Economic Indicators on Thursday.

HOT READS

Markets

  • The Pandemic Ignited a Housing Boom – But It’s Different From the Last One (WSJ)
  • Harsh Weather Temporarily Weighs on U.S. Retail Sales in February (CNBC)

Investing

  • Investing: The Greatest Show on Earth (Morgan Housel)
  • Lessons from Charlie Munger at the Daily Journal Meeting (Novel Investor)
  • Four Things Everyone Needs to Know about the Markets (Ben Carlson)

Other

  • The NFL Coach, the Nobel Prize Winner and One Crazy Idea to Fix Overtime (WSJ)
  • The Month Coronavirus Unraveled American Business (WSJ Video Documentary)
  • The U.S. Solar Industry Posted Record Growth in 2020 Despite Covid-19, New Report Finds (CNBC)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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