June 22, 2021
Darrell L. Cronk, CFA, President of Wells Fargo Investment Institute
--B.C. Forbes end call out
Last week’s Federal Open Market Committee meeting statement took “easy” out of the equation in more ways than one. The Fed didn’t just call into question the future path of “easy” monetary policy — it also removed “easy” from the equation markets use to predict the direction and trajectory of foundational asset price markers. The meeting surprised markets to the hawkish side, leading to a quick rise in the short end of the yield curve and a simultaneous fall in longer-term interest rates. This, along with a rise in the U.S. dollar, left risk assets such as equities and commodities in a precarious state of attempting to chart out the future. It has been apparent since late 2020 that the portfolio strategies investors used to navigate last decade’s markets may not be the same strategies they will need to fight the market battles of tomorrow.
The median Fed dot plots now imply two 25-basis-point1 rate hikes by the end of 2023, according to 13 of 18 members, and 7 of the 18 think a first rate hike is warranted in late 2022. That is a major departure from the view that inflation risks were so limited, the Fed could focus almost exclusively on its mandate to return the economy to full employment —the U.S. is still short of pre-pandemic employment highs by 7 to 8 million Americans. And while 2023 is a long way off to some people who are just now emerging from a 16-month pandemic lockdown, it is apparently not too far away for bond and equity investors to take notice and begin pricing in new expectations.
Ultimately, almost all assets, especially risk assets such as equities and commodities, are forward-looking instruments. Therefore, anything that changes tomorrow’s outlook should impact today’s valuations and valuation models. However, on the back of the Fed’s seemingly greater focus on where inflation is and has been, than on where it might be going, the notion that the Fed may raise rates from 0% to 0.5% over the next two years hardly seems to us that it would have substantial impact at all on the economy. And indeed, some have postulated that the Fed holding rates near zero for most of last decade helped keep the gross domestic product growth rate stubbornly below 2% most of the time.
Perhaps a more salient question to ask today is this — whether holding interest rates at zero, along with $4 billion a day of asset purchases, is compatible with a U.S. economy growing at the fastest two-year clip since 1965-66; assets prices like equities, real estate, and commodities at or close to all-time highs; a consumer price index annualizing at the highest rate in three decades; and fiscal stimulus recently expanding at the fastest clip in modern history. If this is the state of play, it would actually suggest recent Fed actions are quite rational, perhaps even necessary.
Stepping back from recent Fed-generated market gyrations and the great debate about the future path of inflation, investors would be wise to recognize that many of the market trends of the past decade have shifted materially — even if their portfolios may have not. For reference:
- Growth stocks trounced value stocks for 10 years; now, in 2021, value stocks are once again outperforming growth stocks.
- For a decade, large-cap stocks overwhelmed small-cap stocks; now small-cap stocks are consistently beating large-cap stocks.
- International equities underperformed U.S. equities for 10 years; now international stocks are exhibiting strong gains once again.
- Commodities returned negative annualized returns for 10 years; now, they are one of the best performing asset classes with one of strongest starts to a calendar year on record.
- The U.S. dollar for 10 years has generally been strengthening; it has reversed and weakened for much of last year and this year.
- Interest rates and inflation have been low and basically declining for 10 years; now they are both on the rise.
- The largest proposed corporate and individual tax plan changes since 1968 are edging their way through the political engine, with the potential to alter capital market dynamics and positioning for years to come.
As the durable proverb made famous by Winston Churchill states, generals are always prepared to fight the last war. So also, investors facing new situations and changing variables tend to bring along historical baggage, prior battle scars, and strategies they wish they had used during the last market cycle. History teaches us that fighting the last war as a method of winning future wars may make us feel good, but is rarely successful. It is important to recognize that the battle lines have shifted within capital markets — some in rather seismic ways. We view these shifts in market trends as nothing less than a clarion call for investors to ensure that they aren’t marching toward tomorrow’s battles armed with yesterday’s portfolio.
1 100 basis points equal one percent.
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