The non-transitory nature of inflation was the backbone for many aspects of life in the 4th quarter. Politically, it was a significant contributor to the uncertain status of the Biden administration’s signature legislative program (the social infrastructure package). The possible addition of gas on the fire (that is the painful aspects of the current state of inflation) has moderate Democrats calling for a pause to additional fiscal stimulus. Given the divided nature of Congress, at a minimum, the size of the final package will need to be less than half of what was initially discussed (and it would be a third of what progressive Democrats wanted). Although negotiations between moderate democrats and the White House have stalled, there is a political need to deliver for constituents ahead of midterm elections, so we continue to expect something north of $1.5 Trillion will eventually pass.
The pain of inflation has hurt many people as wage growth has not outpaced the cost increases in some unavoidable areas, such as energy, food, and shelter. Many economists look at “core” inflation numbers, which strips out food and energy costs, due to their occasional volatility. The (not so) funny thing is that food, energy, and shelter costs absorb about half of the disposable income for many households (Source: USDA and Investopedia). According to the Atlanta Fed’s Wage Growth Tracker, as of November 2021, annual wage growth spiked to 4.3%. Although this sounds great, the annual rate of inflation in November, as measured by the consumer price index (CPI) increased a whopping 6.8%, so the average American lost purchasing power. Using the less volatile core CPI, the rate of inflation was 4.9% (Source: Bloomberg). Core inflation posted the largest jump in 30 years while the headline number (6.8%) exhibited the highest rate of growth since 1982! The net effect of all of this is that many people just earned a pay cut of 2.5% (on a real basis). It is no wonder why people are discussing the impacts of inflation and clearly the politicians and central bankers have taken note.
"Although allowing the employment market to 'run hot' may push up wages for low and moderately skilled workers... it will very likely stoke the inflation fire."
At the Fed meeting in mid-December, they made a rapid policy shift, “the Powell Pivot,” to combat levels of inflation not seen in a generation. Even though the Fed expects inflation to naturally decelerate to 2.6% in 2022 and settle just over 2% in 2023, they retired the term “transitory” to describe inflation. Of note, the Federal Reserve expects unemployment to drop to 3.5% in 2022, below the long-term neutral rate of 4%. Just recently, the rate fell to 3.9%. Although allowing the employment market to “run hot” may push up wages for low and moderately skilled workers, and especially for the recently targeted minority groups by the central bank, it will very likely stoke the inflation fire. The CEO of Cargill recently said that although he hoped the recent 6.1% annual increase in food costs was transitory, he feels there will be continued food inflation pressures due to continued shortages in labor markets. Either people have to decide they need to go back to work, or wages have to rise such that they can be enticed back into the food processing plants and slaughterhouses. The Powell Pivot may go through a policy meatgrinder as a tight employment environment feeds into inflation and price pressures. As a reminder, the Fed’s dual mandate is full employment and price stability. Inflation in its various forms may continue to be the main discussion of the financial markets, politics, and at kitchen tables in 2022.
The Powell Pivot occurred in at least a couple of ways. First, the Fed announced that they were doubling the pace of the reduction in their program to purchase Treasury and mortgage-backed securities. Specifically, they are reducing the pace of purchases by $30 billion a month, so that the purchases will stop in March of 2022. Previously, the program was going to end mid-year. Second, the Fed telegraphed to the market, through the “Dot Plot” which depicts each FOMC member’s expectation for where they anticipate the Fed Funds Rate will be in each calendar year. Currently, the average of the “Dots” suggests that the short-term rate will be raised three times in 2022, to roughly 0.75%, followed by another two or three hikes in 2023 to a level that may exceed 1.50% in 2023. It isn’t until roughly 2024 that the Fed expects they will be approaching a neutral rate (where the Fed Funds Rate is in line with the rate of inflation). Perhaps a third way the pivot occurred was in the messaging following the Fed’s most recent meeting. They appeared to leave a window of opportunity to be more hawkish to fight inflation than what the market was expecting by announcing that they could hike before reaching full employment.
Observations and Outlook – Rates are Rising, Right?
The Fed’s guidance offers a high degree of certainty that rates will rise. The Fed Funds Rate has anchored the short part of the yield curve near zero for nearly two years. A change in policy and increase in the Fed Funds Rate means short rates will rise. On the longer end of the yield curve, the largest balance sheet on planet Earth (the Fed) is stepping away from massive Treasury and agency-backed mortgage-backed security purchases, putting temporary upward pressure on yields. To elaborate, the Fed had been purchasing $120 Billion per month of US Treasury and mortgage-backed securities. The need for the purchases came during the liquidity freeze that occurred in the bond market in March of 2020 (the start of the pandemic). Liquidity has returned to the fixed-income markets and yield spreads have narrowed dramatically (spread is the incremental yield earned for holding bonds with some degree of credit risk as compared to similar-term US Treasuries). Broadly, the quantitative easing program has outlived its usefulness, but we remained concerned that volatility will return to the bond market as the largest buyer quickly leaves the market. That is certainly not to say that free markets shouldn’t operate without training wheels at some point, but investors who have benefited from well-behaved (managed) markets will need to gain comfort operating in a more volatile market. Volatility often offers opportunity.
As mentioned last quarter, convexity hedging may cause a feedback loop that following a spat of rising rates, may act to push yields even higher. It could very well send a false signal to bond market investors that the “smart money” expects growth rates to be elevated for the long term, justifying higher longer-term bond yields. In the past we have discussed the idea of regime switching models, the idea that people often think interest rates are either going up or we are going down (a switching of regimes). The extrapolation of data into an imagined trend is an example of a behavioral economic decision-making flaw that could further extend the false signal identified above. Between the Fed walking away from the bond market, technical influences, and behavioral flaws, we anticipate that there is tinder to drive yields higher in 2022.
"The adage, 'don’t fight the Fed' often is good advice."
Currently, many market experts think the Fed is behind the curve in their fight against painful degrees of inflation. We might offer that the Fed may find itself to be pinned by the curve, the yield curve. As they start to raise the Fed Funds Rate, conversations may turn from aggressive back-patting about how rates have risen, and we are on our way to 3% 10-year Treasury yields to cries that “the Fed is going to kill the recovery.” The adage, “don’t fight the Fed” often is good advice. The Fed raises rates to cool down the economy. They have many tools to accomplish their goal and the memory of a long period of disinflationary expectations is fresh in many people’s minds (and it is all that many people have ever known during their adult lives). ACG expects that when the concerns about Fed tightening are expressed, long yields will fall, and the Fed may find itself in the unenviable position of trying to rase rates against the headwinds of a flattening yield curve. The Fed will be loath to push short rates to the point where fixed-income investors start to worry about a yield curve inversion (where short-term rates are higher than longer-term yields). This challenge for the Fed is likely more of a 2023 issue than a 2022 concern and it is worth mentioning that asset sales by the Fed may be able to influence the longer end of the yield curve for a time.
Near term, base effects, and the removal of unprecedented levels of fiscal stimulus are the greatest threat to an orderly path to the Fed’s current expected policy path. Gas prices increased approximately 50% on a year over basis, which has been a particularly painful source of inflation for many people. It is not very reasonable to expect that gas prices can increase at a rate of 50% per annum for any meaningful period of time, because out of necessity, people would find transportation substitutes, consolidate trips or simply choose to be less mobile (the concept is demand destruction, when a good’s cost increases to the point people chose not to buy it). Trees don’t grow to the sky and commodity price increases are very likely dampened by their own gravitational force. With such outsized price increases as of late, subsequent periods are not expected to maintain the pace of increases, which on a comparative basis will look like a deceleration in inflation. The other near-term headwind is the removal of fiscal stimulus from many world economies. UBS estimates that that the removal of fiscal stimulus in 2022 will cause a drag of up to 2.5% from global GDP. That is five times greater than the austerity measures that followed the 2008 financial crisis. These influences may largely be what the Fed is banking on to glide inflation back to manageable and healthier levels.
"A more sustainable path is an educated workforce and encouraging industries that can use moderately skilled workers."
A wildcard that many people are talking about is the state of the employment environment. The good news for many U.S. workers is that compensation grew by the largest amount on record in the third quarter. The bad news, as we detailed earlier, is the increase didn’t keep pace with headline CPI. Data from the ADP Research Institute show that U.S. companies added the most jobs in seven months, this past December. On that basis it appears that Americans are returning to the workforce. While it is possible that the jump in wages has coaxed some people back to work, it may also simply be the case that more people decided that it was time to earn an income. According to the BLS, in November the number of jobs seeking people was over 10 million and the number of people looking for jobs (people who are unemployed) totaled just under 7 million. It suggests that wage inflation may have room to run for 2022. The degree to which this dynamic results in a wage inflation, and broader inflationary updraft, may be the source of risk that could cause the Fed to act in a way that surprises the markets. If the Fed has to slam on the brakes to moderate inflation, it may increase the risk of a recession. If labor force participation does not pick up, we may have another vexing issue (if people simply decide that they don’t want to work but they really want others to support them). Such a bifurcated employment market, those who work and those who are unwilling to work, could result in a head-spinning future with pockets of inflation and an economic drag on broader GDP at the same time. A more sustainable path is an educated workforce and encouraging industries that can use moderately skilled workers. Workers who experienced both the Great Recession and the pandemic during their formative and adult years understandably value a satisfying work/life balance, and employers who want to attract talent will have to address these needs to retain the best employees for the long run. A very real collaboration needs to occur between employers and employees about how to run a profitable and competitive corporation that is made up of satisfied and motivated people. Something must reverse the course of devalued human capital (from both the perspective of disaffected workers who don’t invest in their skill set and corporations who see their human resources as an unfortunate necessity).
Currently the growth of the labor force is roughly in line with the pace of new job openings. The continuation of this delicate dance may be crucial to the Fed being able to proceed with its orderly plan. Too many new jobs being created, relative to the number of people entering the workforce will likely result in inflation. A collapse in the number of new jobs relative to the number of job seekers risks a deflationary wage environment, which could precipitate a downward economic spiral, as people aggressively compete for jobs while experiencing the 2.5% “pay cut” that inflation has effectively handed them. If inflation is too many dollars chasing too few goods, the “job scarcity” environment scenario would be a version of too few dollars pursuing too many goods.
This is a difficult environment in which to make an interest rate forecast. Since we began writing this quarterly strategy, 10-year Treasury yields have risen from approximately 1.50% up to 1.75%. We expect the Fed’s tapering program will end in March and immediately they will posture themselves to raise the Fed Funds Rate at the May meeting, but the market is calling for a 90% chance of a hike in March. We would be onboard with that, but there is a bit of a challenge that the Fed may have created for themselves when they identified equitable wage growth as an expanded tangent to their “full employment” mandate. In the recent jobs report, black American unemployment ticked higher to above 7%, while white American unemployment declined further to roughly 3.2% (Source: CNBC). Given the broadened mandate and the political pressure to incorporate equity into the role of the central bank, it would seem like the bias for the Fed would be to let the employment environment run hotter than the market would prefer. We expect that all of this will result in a mid-year hike with rates broadly rising ahead of the hikes, and possibly into the first hike, with growing market concern that a program of several hikes will “kill the recovery.” We anticipate that 10-year Treasury yields will pass the 2% level. In sympathy with the Treasury market, the muni market should see prices decline modestly, which should cause some retail investors to sell, following the losses, driving muni bond yields to exceed 100% of the yield of their Treasury counterparts, so we may see 10-year high quality muni bonds at 2.20%. 2% 10-year Treasury and comparable muni yields would represent a buying opportunity in our opinion. Longer-term, we expect that the U.S. will mimic aspects of Japan’s experience with debt, deficits, the need for cheap money to be thrown at a population that may start saving more, and low yields for a long time.
Muni Market Developments – Cautious to Start the Year, Opportunity Follows
In 2021, the expectation that tax rates would rise for higher income people likely caused the muni market performance to be mostly positive, while the broader bond market experienced losses. Some version of the social infrastructure spending plan will likely be passed, and the tax increases will go hand-in-hand with that spending. Offsetting that price support for munis will be the generally rising yields of the bond market and the retail muni investor sell-off that we discussed earlier. Muni bond portfolios are best seen as a collection of loans that you are making to municipal entities; they are tax advantaged streams of cashflows. Our advice is not to be concerned when rates rise, or the sell-off occurs. Our plan is to allow cash to build for the first few months of the year and invest it into the expected market turbulence (with the goal of locking in more tax-advantaged income at what we expect will be attractive levels). Despite the odd liquidity crunches the muni market experiences on occasion, keep in mind that munis hold a special place in portfolios due to their tax-advantaged status, generally dampened price volatility, and low correlation to equities (Source: Bloomberg Intelligence).
"..the current quiet in the muni market is probably related to the 'January Effect' that occurs most years."
Investors may look at the losses in fixed income as the year has gotten underway and feel the relative lack of move in the municipal space makes them nearly a magical asset class. Although munis generally outperform broader fixed income investments in a rising rate environment, the current quiet in the muni market is probably related to the “January Effect” that occurs most years. In short, issuers don’t sell as many bonds in January and the lack of supply tends to offer price support for municipal bonds. According to the Bank of America, the muni market’s 10-year average return for the month of January is 0.90%. So, even though municipal bonds are feeling good so far, the yield differential as compared to like-term Treasuries should narrow in the coming months. As indicated earlier, that may result in sellers exiting municipal bond funds and that is the time we will look to invest on more aggressive basis.
We have discussed how well most states and municipalities weathered the pandemic, with many entities experiencing budget surpluses the fiscal year that ended June of 2020. Through October of 2021, sales tax revenue increased by 17% on a year over-year basis. Coincidentally, through the June 2021 fiscal year end for most municipalities, spending by U.S. states grew by 16%, the highest in 35 years, according to a report published by the National Association of State Budget Officers. Many municipalities are financially healthy, and those with structural issues are widely known and the problematic corners of the municipal market (those that are subject to the competitive pressures of a market) will always require a watchful eye and are appropriate only for investors comfortable with risky investments. The important piece of information to derive from the health of municipalities is that on a market pull-back, it may be prudent to be a buyer of municipal bonds in the “A” rating category to capture dramatic yield enhancement. In the event our expectation for higher yields does not come to fruition, buying in the “A” rated space may still be a prudent way to offer incremental yield.
Strategy and Summary
The strategy for 2022 is to allow cash to build, perhaps look at selling some very liquid short bonds, and wait for the Fed to push the short part of the yield curve higher. The Fed leaving the market may act to push the longer end of the yield curve higher, which may precipitate mechanical and behavioral reasons for longer rates to increase further, and that may offer a buying opportunity. The yield curve, inflation, and the employment environment may cause the largest headaches for the Fed. A flat or inverted yield curve may be managed by selling some of the $8 trillion in securities on the Fed’s balance sheet. That is an act that was unthinkable until recently. The Fed also has plenty of blunt tools to crush inflation, but the risk of economic pain is significant. Beyond the broad level of unemployment, the Fed seemingly has limited ability to influence the value of time and human capital that generally has to be determined by providers and seekers of human resources (or substitutes for those capabilities). The delicate mix of the rate of people entering the workforce with the pace of creation of new jobs seems like the metric that needs to be monitored as the year progresses. The whims of this mix will likely tell the Fed and the markets what the next steps will be.
In 2022, we could see 10-year Treasury yields exceed 2.0% that may be coupled with spread widening in corporate bonds, especially as the training wheels (Fed bond purchases) are removed from the market. Asset flows that could follow losses that municipal investors may experience in the coming quarters could take yields past 2.20% for high-grade 10-year muni bonds.
"The scenario where wages grow but inflation becomes tame is nearly an impossibility."
These strategy pieces focus on numbers, returns, and the economy from a sterile perspective. We have mentioned the pain of inflation a few times this quarter. In particular, we are concerned for the quality of life of lower-income and lower-skilled workers. If inflation persists, we don’t expect that on a longer-term basis their wage gains will keep pace. If inflation persists and it forces many people to rush into the workforce, it could be doubly painful in that their wage growth will be modest and their cost of living will rise (which at a point may stall the recovery). In the event inflation is transitory and the Fed tightens, the policy error could cause a recession, in which they will be hurt by unemployment. The scenario where wages grow but inflation becomes tame is nearly an impossibility. Couple that with a less accessible housing market, which has been made worse by investors, zoning law changes, and misguided regulation (one in five U.S. homes is valued under $100,000 and Dodd-Frank imposed fixed costs that dramatically reduced the interest in originating small-dollar mortgages) and the path to wealth accumulation for many lower income people is becoming narrow. Whether the challenge is self-imposed or societally created, this hard place that many people will find themselves in has far-reaching political, economic, and societal implications. It may have always been the case that upward mobility and the possibility of a middle-class existence for everyone was the cornerstone of stable civilizations. It feels like the current culmination of factors has made the current time poised for a complex “reworking” of social contracts. Against that backdrop, we suggest a cautious view towards risk may be prudent.
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