What I Care About This Week | 2021 Aug 2

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by Franklin J. Parker

The Summary

  • Manufacturing and factory order data posts this week. Also posting (on Friday) is the unemployment rate. Investors are very interested in how the economic recovery is progressing, of course, but much of this data will also be viewed in the context of a Fed that is growing impatient with its ongoing support of the economy. Employment, particularly, will be watched closely as it is a key variable cited by the Fed.

  • Corporate earnings have been quite strong for the past three weeks. With 60% of the S&P 500 companies having reported, earnings growth is estimated to be about 85% over last year. Prices have moved only slightly over the past three weeks, indicating that investors have largely priced this in. This sideways movement is also lowering valuations (when earnings increase but prices do not, the ratio of price to earnings decreases), which is a good thing, at least in my view.

  • Last week the Federal Open Market Committee met and decided to leave rates unchanged, which was no surprise. The key question to Chair Powell was when the Fed will begin tapering and ending their $120 billion/month asset purchase program. The Chairman responded that they have yet to reach “substantial further progress” toward their goals of maximum employment. When questioned on inflation, the Chairman again reiterated the committee’s belief that recent high inflation is a transitory phenomenon driven by pandemic-induced supply constraints.

The Details

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I’m not sure I’ve ever really laid out my market thesis. Here it is.

Under normal circumstances, I look at the big-picture fundamentals of the US economy to try and understand where we are in the business cycle, and how we might best allocate our investable dollars. The objective is to put out full sail when the wind is with us, and to avoid the storms where we can. Of course, these fundamentals exert an influence over the economy, they never give you a perfect picture of exactly what is about to happen. So, while I cannot tell you when the first drop of rain might fall, I can usually tell if there is a storm on the horizon.

In this environment there has been only one economic variable that has mattered: the Federal Reserve. Their response to the Covid recession served to offset the worst of the pain in asset prices. Of course, the Federal Reserve would like to end their support soon, so more traditional economic fundamentals are going to begin to matter again.

My view is that you have two “dials” at work in this environment. One dial is economic fundamentals—the things that usually matter. The other dial is the Federal Reserve. The Fed’s dial has been turned up to 11 for the past 18 months, but as they turn that dial back down, we ought to again “hear” the influence of economic fundamentals.

We are, then, entering a transitionary environment where the influence of the Fed will be waning and the influence of economic fundamentals will be waxing. Investors will need to discern, as best they can, how much influence one dial has vs the other in any given moment. Not an easy ask, to be sure.

For the next six months, however, I see both the Fed and the economic fundamentals keeping an upward bias in prices.

Chart of the Week

The key restriction on the Federal Reserve is inflation. Historically, inflation and employment have been linked: as the economy reaches full employment, inflation tends to increase, and as employment falls inflation tends to decrease. This relationship has been largely broken for the past 20 years, however, and the Fed has struggled to construct a narrative around why (globalization appears to be the central factor).

At any rate, with employment still well below levels the Fed would like to see, inflation is hitting pretty high levels. Producer prices, which are typically seen as an early indication of future inflation, have increased 7.1% over last year. Core prices (excluding food and energy) are up over 4% from last year. If you count food and energy (and for most households, food and energy are big expenses), prices are up 5.3% over last year.

As I see it the Fed will be quite eager to pull back from their money-printing just as soon as the labor market has recovered to acceptable levels. This makes each month’s inflation and employment report increasingly important, and the exact timing of the transition will be important to investors.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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