What I Care About This Week | 2021 May 24

by Franklin J. Parker, CFA

The Summary

• The Federal Open Market Committee’s minutes were posted last week, and markets were a bit surprised at the hawkishness of several members (“hawkishness” = concern about inflation). Several FOMC members said that “it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases” given the recent progress in the economic recovery. This made investors wonder whether the current program of money-printing (also called “quantitative easing,” or QE) would be ending sooner than expected, and a repricing of risk assets resulted.
  
  
• First-time jobless claims fell to their lowest level since the COVID-induced recession began, with 444,000 people claiming weekly benefits. If the Fed can pare market expectations for QE in a gentle way, then economic growth figures will once again be good news. At the moment, however, good economic figures may be bad news for stock prices.
  
  
• Data on durable goods orders are released Thursday, along with consumer sentiment and personal income data on Friday. These are important metrics, though it is expected that personal incomes shrank now that stimulus checks have been distributed. Consumer sentiment will be important to see, as will personal spending data, as both of those directly relate to the “reopening trade.” As the economy reopens fully, and people are willing to go do things, we should see these figures begin to tick upward.
  

The Details

Earnings growth over the past quarter has been an encouraging development. More encouraging is that, rather than further extend prices (and thus valuations), investors have largely kept prices steady. This means that stocks are growing into their high valuations. At first blush this is a frustration for investors. However, if we think of valuations in the context of the commonly-used metric, the P/E ratio (price-to-earnings ratio, or the multiple investors are willing to pay for every dollar of corporate earnings), there are only two ways high valuations can normalize.

The first way is what we are seeing currently—prices remain steady while corporate earnings increase. This means the “E” in the P/E ratio increases while the “P”—price—stays the same. The overall valuation metric contracts because the number in the denominator is bigger while the numerator stays the same.

The second way valuations can contract is that the “P,” or price, can contract. This would also lower valuations, but at the cost of lower prices.

While watching markets stall-out can be frustrating, it is actually healthy because it gives valuations a chance to normalize, at least a little, in a way that doesn’t involve prices dropping. So, while frustrating, it is better than the alternative!

As I mentioned last week, rising interest rates as well as an end to quantitative easing by the Fed will both serve to shrink valuations. Earnings growth, then, is the only mechanism which can stabilize prices. Further progress on that front—espeically over the next two quarters—will be key.

Chart of the Week

There are multiple types of inflation. The first type, which most of us associate with inflation, is the monetary type: all else equal, more cash in circulation leads to higher prices for goods and services. The second type of inflation is demand-pull inflation: wealthier consumers demand more goods and services, and constrained manufacturing capacity creates higher prices. The third type of inflation is cost-push inflation: the inputs to manufacturing (like labor or commodities) get more expensive, leading to an increase in price to consumers.

Over the past 30 years or so, rather than raise prices, globalization has allowed companies to simply shift their production overseas, and this has been a severely overlooked factor holding back inflation. China’s percent of global GDP illustrates this quite well. As China gained more and more global manufacturing marketshare, the prices of consumer goods has been held low because manufacturing supply has grown substantially—holding demand-pull and cost-push inflation at bay. China’s rapid expansion of manufacturing capacity has given global companies a place to shift production to hold down their most expensive input: labor costs, and they have chosen to do this rather than raise prices. That shift peaked in 2015 and has begun to reverse, and as global economies begin to decouple from Chinese manufacturing, a significant deflationary factor may begin to subside. Of course, it may also be replaced by other low-cost manufacturers (like India, Singapore, Viet Nam, etc).

In any case, there is at least an argument to be made that existing deflationary pressures may have peaked and demand-pull/cost-push inflation may begin to exert an influence on consumer prices. Of more interest to me: 30 years is an entire career, so the veterans of finance have never managed money in an inflationary environment, and many will be reluctant to shift their thinking should that become necessary.

As I have often said, mental flexibility is one of the most important attributes investors can have, and I wonder if our current environment may be about to prove me right.

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