What I Care About This Week | 2021 Oct 25

Photo by Alexander Tiupa on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • Investors will be watching this week for earnings from several big-name companies across various industries. Facebook reports today, Google, 3M, Eli LIlly, General Electric, Twitter, Texas Instruments, and many others report later in the week. Needless to say, there will be plenty for investors to digest this week. Many CEOs are addressing questions of supply constraints, inflation, labor shortages, and whether demand has slowed. Per usual, earnings guidance will be important. So far, earnings have been quite strong, with total earnings growth for the quarter expected to be around 30%+.

  • On Friday, Fed chairman Powell made a nod to both tapering asset purchases in November and that supply constraints are keeping prices elevated for longer than they anticipated. He said, “the Fed will need to makes sure our policy is positioned for a range of possible outcomes.” In other words, all past and future guidance should be taken with a grain of salt. This may mean tapering faster than previously anticipated. Faster-than-anticipated Fed action may mean markets price interest-rate hikes sooner rather than later—what was a summer-ish downswing could be a springtime downswing. Again, flexibility and adaptability will be key over the coming years.

  • Inflation has been on the minds of investors and executives, with large companies like Nestle, P&G, and Chipotle saying they plan to continue raising prices in response to higher input costs (labor, transportation, and raw materials). To date, higher prices have not deterred US consumers, although some consumption may be from people buying things today in anticipation that they will be more expensive in the future. Energy companies are reaping gains from higher oil and natural gas prices. Inflation is a legitimate concern for investors, for many reasons, not the least of which is curtailed consumer demand and the response of the Federal Reserve. Keeping a close eye on the developing figures is sensible.

The Details

With the Fed now contemplating a policy response to what can be described as high inflation figures, investors need to have some concept of what tools the Fed will use to combat it. Though expressed through various specific mechanisms, the Fed actually has two tools to control inflation:

  • the amount of money it keeps in circulation and
  • how fast that money can move around.

Slowing either of these slows inflationary pressure, at least in theory. Supply constraints are outside of the Federal Reserve’s control, and there is little they can do about that.

First, and most obvious, the Federal Reserve can push interest rates higher, namely the Federal Funds rate. The Fed Funds rate is the rate is pays member banks to put cash on deposit with the Federal Reserve. By paying a higher rate to take deposits, banks pull cash out of the economy via deposits, then place that cash with the Federal Reserve. By offering an attractive investment to banks other than loans, the Fed is pulling cash out of the economy, hence it is the first tool.

Second, the Federal Reserve can sell assets from its balance sheet (like US Treasuries or mortgage securities) back into the marketplace. When banks buy these securities, they trade cash and the ability to make loans for them. This serves to pull cash from banks and the broader economy. Of course, selling bonds into the marketplace pushes interest rates across the economy higher, and higher rates slow the number of loans being made. This mechanism, then, applies both tools.

Third, the Federal Reserve can adjust bank reserve requirements. Reserve requirements are the amount of cash a bank must keep on hand relative to each type of loan it makes. We can think of this tool as a cash multiplier—the less banks are required to keep in reserve, the more cash they have to lend out. In 2020, the Fed removed all reserve requirements for banks. While considerably less well known, this tool has considerable power to change the flow of cash in the economy. By increasing reserve requirements, the Fed decreases a bank’s ability to make loans thereby slowing the velocity of money through the economy.

How the Fed responds to higher inflation has direct bearing on investment portfolios. Less cash in the economy means lower asset prices, all else being equal. Higher interest rates also curtails corporate earnings growth, all else equal. And higher rates tends to slow consumption (consumers spend more on debt service and housing).

A close eye on Fed policy is required as we transition to a more “normal” policy. Though, it may well be that the Fed cannot fully transition back, and that would be important to observe, as well.

Chart of the Week

Our intuition would tell us that higher prices would slow retail sales, but that has not been the case. Sometimes inflation can show up as increased consumer spending (as people spend more money on the same goods and services). However, as the chart below demonstrates, this may not be the case in our current environment. It appears that higher retail sales came first, and inflation came after. This may mean that increased demand is fueling inflation—at least partly. If that is the case, inflation may well be out of the Federal Reserve’s control.

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.

%d bloggers like this: