by Franklin J. Parker, CFA
The Summary
- This week will be all about inflation. We get headline inflation figures tomorrow which will be closely watched. Investors will want to gauge whether the Fed has a hope of continuing easy monetary policy, or if a quicker end is more likely. Inflation is expected to post around 5.3% year-over-year. This week we also get industrial production figures and retail sales, both important reads on the health and persistence of the recovery. Jobless claims on Thursday will also be closely watched to indicate whether the Delta variant is beginning to affect the labor market.
- Democrats are talking about a tax plan that increases corporate rates to 26.5% and capital gains 25%. While the full details have not been released, investors should largely see this as a non-event. The highest tax bracket has very little bearing on the effective tax rate that companies pay. A slight increase in that bracket is not likely to increase the actual taxes paid by businesses. Increasing the capital gains rate to 25% would have some transient effects on markets (both public and private). More than anything, I would expect this to encourage capital flight from high tax states, but with such a small increase the effect may be minor. In short, investors should watch the process to ensure it remains a minimal concern, but it is not worth worrying about.
The Details
Everyone is talking about how stocks are going to go down.
Bank of America, Morgan Stanley, Deutche Bank, just to name a few, all released research reports in the past couple of weeks detailing their view that stocks have run their course and a correction is coming—or will at best trade sideways for awhile. I find myself scratching my head at this. Not much has really changed over the past couple of weeks. Sure, the Fed is talking about ending their supportive policy, but earnings are still very strong, and the Fed is still printing significant money through the beginning of next year at least. I could well be wrong, of course, and I have advocated being very flexible in this environment. If prices do begin to weaken substantially, we will take appropriate action in our portfolios.
Here is how I see markets evolving over the coming few years. Longer-term forecasting is fraught, of course, but here is my rough framework.
For the next six months, the Fed is still in play and earnings growth is quite strong. Both are tailwinds to equity prices. Yes, investors have begun to price away the Fed, but they have done so by shrinking valuations and earnings growth has, so far, offset that effect, leaving prices mostly flat. This is healthy, in my view.
Next summer, however, the Fed will have ended their support and investors will begin to price-in the rate hikes that are expected in early 2023. In addition, I would expect earnings growth to have moderated by next summer, so that leaves markets in a much more fragile state. A 10% to 15% correction is in the cards around late spring or early summer of 2022.
If history is any guide, the Fed will get a year or two of rate hikes before a recession sets in (see the chart of the week below). That puts a recession in late 2024 or 2025—giving the current business cycle a four/five-year expansion, which is about average.
Again, flexibility is key in this environment, but as the data stands, this is more-or-less how I see the business cycle evolving. So, despite the current hand-wringing from Wall Street analysts, I think investors have some upside yet to harvest. And, for those keen to be more active, there is some genuine opportunity in the coming year.
Chart of the Week
Historically, Fed rate hikes precede recessions by about 24 months. It is not the rate hike itself, however, that is indicative of recessions, but rather the Fed’s reversal. Once the rate hike cycle is complete and the Fed begins to again lower rates, that is when a recession is not far behind. The Fed started lowering rates in June of 1989, one year before the recession of July 1991. In January 2001, the Fed lowered rates one month before the recession that began in February of 2001, a similar circumstance to the recession that began in 2007. Finally, the Fed lowered rates in August of 2019, seven months before the recession that began in March of 2020.
In short, the Fed tends to act like a recession is brewing before one actually starts, but that is typically the last signal we get before the recession hits—markets will price it long before the Fed does. The Fed’s actions, then, tend to be a confirmatory signal rather than a leading indicator.
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