The Fed: Too little, Too Late or Just Right?
by Richard Lerch
As I am in the process of writing this month’s Partner Talk, the Federal Reserve is concluding its latest two-day policy setting meeting. The central bank approved plans to wind down its pandemic-era bond purchases this month and step away from a historic level of support for the economy. Since June 2020, the Fed has been buying $120B in monthly asset purchases, including $80B in Treasury bonds and $40B in mortgage-backed securities.
Perhaps more consequential were the comments from the Fed’s Chairman, Jerome Powell, on the surge in inflation, which is lasting longer than was initially anticipated, as well as future potential interest rate hikes. He assured investors the central bank wouldn’t be overly aggressive with rate hikes and stated that the central bank believes inflation will dip by the second or third quarter of next year, as businesses increase the production of goods and supply-chain snarls ease.
Headline inflation rates are currently running at twice the Fed’s 2% target, while rising prices, low business inventories and a growing labor shortage may mean the higher than expected pace of increases will continue. The biggest concern is likely to be whether, if inflation is less transitory and more persistent, the Fed will be able to get in front of that negative development before it’s too late? Once inflationary pressures start to broaden they can be increasingly difficult to contain.
While these developments are certainly important, they will likely be analyzed and hyped to death in the days to come by the financial press which is much more focused on short-term developments in the markets that affect Wall Street traders than on what will affect and makes sense for the long-term investor.
As many of you know, my first job out of college was on a Wall Street bond trading desk. One of the first mantras I learned as a bond trader was “Don’t Fight the Fed!” This suggested that using the firm’s capital to buy securities that would perform poorly given the actions the Fed was currently taking to influence interest rates, etc. was a losing proposition. The Fed has unlimited resources and the firm’s patience to maintain a losing position until the market turned around was much shorter than the Fed’s ability to influence or move the markets when it so desired.
The difference, however, between what Wall Street traders are concerned with – short-term trading profits – and what PMA clients are concerned with – long-term, risk-controlled wealth creation – is vast. Therefore, at PMA, we focus on developments which could potentially be a risk to our clients’ portfolios and resulting wealth creation over a medium to longer-term time horizon. Inflation is a phenomenon to which we pay very careful attention. As a factual matter, the annual inflation rate moves up and down a fair amount over short periods of time, but the recent increase in the inflation rate is noticeable. The key issue, however, is whether or not the current increased rate of inflation is transitory or if the increased rate reflects a longer-term trend that the Fed is slow to react to.
At our most recent Investment Committee meeting, which took place on October 13th, the nature of the current increase in inflation was a primary topic of discussion. Our investment strategy team made a case, and the Investment Committee agreed, that we should currently view inflation as a two-sided risk, in that it is reasonably likely the rate of inflation may overshoot current market expectations while it is also reasonably likely that it may fall short. With this context in mind, we had to decide whether or not we should change our portfolios and, if so, how.
After reviewing many potential options, we approved adding a 10% allocation to the Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX) in our taxable fixed income portfolio. Consequently, clients who own taxable fixed income bonds should expect to see this mutual fund added to their portfolios between now and the end of the year. If higher than expected inflation does occur, this allocation, in addition to the short duration of the bonds we already own, should provide down-side protection for the fixed income portfolio within clients’ total portfolios.
Additional topics of discussion at the Investment Committee meeting included our customary review of the economy and the markets and a short summary follows below.
Overall, economic activity remains strong. Though the annualized economic growth rate, as measured by GDP, is lower than forecasted last quarter it is forecasted to grow at an annual real rate of 5.8% for the full year 2021. The lower growth rate is largely due to the impact COVID-19 continues to have on the economy, especially supply chain constraints.
The employment report for September was a disappointment to the market. Total nonfarm payroll employment increased by 194,000 in September, and the unemployment rate dropped to 4.8%, according to the U.S. Bureau of Labor Statistics report on October 8. The consensus forecast for the payroll increase was 500,000. Additionally, the low unemployment rate is not as positive as some reports suggest since the decline was driven by workers leaving the workforce. Going forward, a reasonable assumption is that as vaccination rates increase the role of the pandemic will lessen and future employment levels will increase.
Looking forward to 2022 and 2023, GDP growth is expected to moderate to about 3% to 3.5%. While this growth level is lower than what is expected for 2021, it should be adequate to support decent market performance. However, the ongoing impact of COVID-19 on the economy and the effect of a potential substantial increase in government spending are definitely concerns. An unexpected increase in COVID-19 will negatively impact economic activity and, if proposed spending bills are passed, large deficits are likely on the horizon. Such deficits are likely to put downward pressure on market values and upward pressure on inflation and interest rates. Additionally, proposed increases on the rates of both personal and business taxes could also decrease consumer demand, consumer spending and corporate earnings which would slow economic growth in the future.
Performance for the third quarter of 2021 was weak for both equities and fixed income. The S&P 500 Index had a third quarter return of -0.58% while the fixed income market as measured by the Bloomberg Barclay US Aggregate Bond Index increased by only 0.05%. For large cap stocks, growth stocks outperformed value stocks in the third quarter. In contrast, small cap growth stocks had the weakest quarter of all included indices. While positive year-to-date, international stocks declined in the third quarter driven by a weak September. With upward pressure on interest rates, bonds declined late in the quarter leading to a flat quarter overall.
The combination of the continued pandemic related concerns, potential inflation concerns and the current political environment does leave open the possibility of higher future volatility. This is why we counsel clients to maintain portfolios that are diversified and balanced across all market sectors with broad representation within each market sector and that preserving value in a down market can have a greater long-term impact than the gains a portfolio may have in an up market. Knowing how to measure risk and how to build properly diversified portfolios is what we have strived to do at PMA for over thirty-nine years. We thank you for the continued confidence you place in PMA to manage your assets and you can rest assured that it is not taken for granted.