by Franklin J. Parker, CFA
The Summary
- This week we get the usual beginning-of-the-month deluge of data. Weekly initial unemployment claims post (per usual) on Thursday, along with the headline unemployment rate and payroll data on Friday. Headline unemployment is expected to be around 5.7%. Home prices for the month post tomorrow. While the increases in home prices have been aggressive lately, much of that is considered “transient” by both the market and the Fed.
- Last week’s big news was the bipartisan deal reached on a $1.2 trillion infrastructure package. The funds are to be spent over the course of eight years, with a focus on the green economy, and $379 billion slated for “transportation.” The deal hit some trouble over the weekend when President Biden seemingly threatened to veto the deal he had just negotiated if congress failed to pass a larger reconciliation bill, which Republicans oppose. Markets rallied in response to the initial news and have traded sideways on the subsequent political fumble.
The Details
As I have mentioned innumerable times by now, it is my view is that current stock and bond market valuations are largely supported by the Federal Reserve and by fiscal spending from Washington. The upcoming passage of this $1.2 trillion stimulus bill has me mulling how deficit spending is managed with a more hawkish Federal Reserve.
Almost all of the deficit spending done by the federal government over the past 15 months has been finance by the Federal Reserve. Here is how the process has worked:
- Congress approves deficit spending.
- The US Treasury borrows money from primary-dealer banks by issuing bonds.
- The Federal Reserve creates money, then purchases those US Treasury bonds from the primary-dealer banks.
- The US Treasury distributes the cash according to congress’ instructions.
However, as the Fed grows more hawkish, deficit spending will have to be financed by investors. So the process would look like this:
- Congress approves deficit spending.
- The US Treasury borrows money from primary-dealer banks by issuing bonds.
- Investors pull from their stock of cash or other investments to buy those bonds from primary-dealer banks.
- The US Treasury distributes the cash according to congress’ instructions.
The third step has implications for financial markets. In the first process, new cash moves into both the financial system and into the real economy. This tends to push asset prices higher since the Federal Reserve is a price-insensitive lender—they do not care about the yield they receive on US Treasury Bonds.
In the second process, by contrast, cash moves from the financial system into the real economy. Unlike the Federal Reserve: (1) investors require compensation to shift their capital, and (2) this moves cash away from financial assets. The first difference tends to generate higher interest rates, and the second point tends to lower asset valuations, though not necessarily lower prices.
Of course, the increased activity in the real economy can, in turn, generate wealth that then moves back into the financial system. But that assumes that congress has made productive investments, and, more importantly to investors, there is a time lag before that wealth cycles back.
The takeaway here is that, if the Fed does back away from the money-printer, the now-decade-long dynamic between the financial system, the federal government, and the real economy will have to shift. As some of my research has demonstrated, this shift in liquidity has implications for bond prices, stock prices, interest rates, housing prices, currency exchange rates—pretty much everything the financial system touches. Luckily, we have some time to think through our strategy, but assuming the next 15 years will look like the last 15 years seems to be a poor bet to make, at least in my view.
That is, unless the Fed carries current policy into the next 15 years (which is not an unreasonable expectation).
Chart of the Week
The speed of this recessionary cycle is rather staggering. To put some context to that point, we can look at previous recessions and the time it took to get back below 6% unemployment, and we can look at how the S&P 500 performed over those periods.
Prior to the 2020 COVID recession, the shortest time it took for unemployment to dip below 6% was 34 months. That was the 2001 recession, and by then the S&P 500 had not fully recovered the ground it had lost (it was still about 18% below its previous peak). The 2008 recession was a doozy, of course—the longest recessionary cycle in recent memory. It took unemployment 81 months to get below 6%, and stocks did not even recover their price for 62 months!
Contrast that with the current cycle and the surprise becomes clear. First, though unemployment reached the highest it has been in the past four recessions (and probably the highest since the Great Depression), stocks sold off only 20% from March of 2020, which is about what we saw in the mild 1991 recession. In other words, the downside was very, very bad in the real economy, but the financial system remained pretty insulated.
The COVID recovery, however, has been in keeping with the general market recovery from previous recessions. In these previous recessions (except the 2001 recession), by the time unemployment had dipped back below 6%, the S&P 500 sat about 40% higher from where it was when the recession started.
All of that to say, despite the speed of this down-up cycle, the market recovery is more-or-less in keeping with previous cycles, and I find that somewhat reassuring.
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