Markets at a Crossroad (as Always!)

Summary

• Equity markets fear inflation, while bond markets seem nonchalant. Prominent economists either criticize or praise the Fed. Everyone is unmoored, with no precedent to base a forecast on.
• There is general agreement that the US economy will boom this year – the big debate is whether it is an inflationary boom.
• We offer a backcasting exercise by imagining the boom might be less than expected and how that may happen.

Market Implications

• Even if the recovery turns out to be uneven, we think the combination of fiscal and monetary policy will keep it going.
• We see little risk of major downside for risk assets, although more volatility is likely.
• Maybe this really is the year to go away in May. For our part, we would err on the side of staying long, though!

Markets seem to be at a perplexing crossroad. Admittedly, markets are always at some kind of crossroad. But still, consider all the noise:

• Equities have traded sideways since early April when the 10-year Treasury yield surged above 1.5%, triggering inflation fears and the prospect of a more hawkish Fed. Ongoing data surprises – a much lower than expected nonfarm payroll print and a much higher CPI report – have only added to the confusion.
• Bond markets, meanwhile, have been seemingly unruffled by inflation concerns. Five-year and 10-year breakeven inflation rates rose steadily between the election and March then settled near 2.5% and 2.5% until recent days when they rose another 10 basis points (Chart 1). Bond markets so far seem to accept the Fed’s new strategy of letting inflation average 2% over the business cycle rather than being tethered to a 2% target – albeit with a modest cushion.
• Former US Treasury Secretary and Harvard economics professor Larry Summers has issued numerous calls for the Fed to reduce the monetary stimulus given the powerful fiscal stimulus already in place and potential increases depending on what infrastructure legislation is ultimately enacted.
• Fed Chair Jerome Powell believes recent signs of inflation are transitory and remains committed to the Fed’s current policy stance.

Let us agree: there are many views out there. Various broad markets are reading the same tea leaves and seeing different things. The biggest names in economics have diametrically opposed views. Bottom line, no one really has a clue. The normal frames of reference for judging how the economy is emerging from the recession and pandemic are meaningless, as the recent misses on payroll employment and CPI amply testify. Everyone is flying by the seat of their pants.

It’s the Economy, Stupid!

If there is a rough and ready consensus about anything, it is that the US economy is on track to post GDP growth of 6% or more, and unemployment is likely to fall to the low 5% range. That is assuming, of course, that there is no major resurgence of Covid (due perhaps to some variant) or some major exogenous shock. The big question is whether this growth produces a toxic level of inflation.

But is this scenario really baked in the cake? Here are some ways things might not work out as people expect.

Everyone Is Counting on Schools

One major hope is that schools will reopen come September. That should free up parents (and mothers particularly) who have had to withdraw from the labour force to return to work. But parents can return to work fully only if the whole related after-school infrastructure also reopens – think childcare centres and all manner of afterschool activities (sports, music, theatre, dance, etc.). If schools reopen and much of this infrastructure remains compromised, the hoped-for resurgence of people returning to work will not happen on the scale that current economic forecasts assume.

There is certainly much talk about schools reopening and perhaps even some planning to ensure they do. But no one is talking about everything else returning to normal – most seem to assume it will, but no one seems to be doing anything about it. We can only hope.

Does the Unemployment Rate Matter?

In previous recessions, the labour force participation rate remained steady; so the unemployment rate was relative to a constant benchmark.

This past year has been unprecedented (at least post-war) in that the labour force participation rate collapsed from 63.4% in January 2020 to 61.7% in the April labour report (a topic we have covered often). The net result is that there are still 8.2mn fewer people working today than January 2020, of which 3.5mn are not considered part of the labour force – but surely would be if they could.

We could see a scenario where the unemployment rate falls but labour force participation remains sticky, so millions remain out of work. Or, perhaps many people can return to the labour force but getting rehired takes time, so the unemployment rate rises despite more people working.

What might either of these scenarios mean for GDP growth or inflation or markets? One safe answer is that any forecasts based on the unemployment rate alone (as many are) are meaningless. Even if you try to model both employment and labour force, there is no history or precedent to work with.

The End-of-Summer Cliff

Last but not least is the looming cliff at the end of the summer when extended unemployment benefits and many other features of the American Rescue Plan Act of 2021 conclude. Much depends on how the US economy will do as life support is withdrawn. And that may depend on whether an infrastructure program is in place by then.

So, What Do We Do?

Face it. We are all flying by the seat of our pants. The week-to-week technicals and noise will likely continue to make it a tough market to put on short-term trades.

For macro investors with a more intermediate-term view, we see the economy moving toward recovery, although possibly in fits and starts and with more data surprises to come. And we agree that the current spurt in inflation is transitory. We don’t see it turning into a 1970s-style demand-pull wage-spiral scrouge. If the Fed blinks and starts tightening policy too soon, it may quickly find itself back to desperately trying to rekindle inflation. We do not think it wants to risk that.

The Fed has committed to support the labour market and economy until they recover. Consequently, it is difficult to expect major downside for equities or risk assets in general. Indeed, we think equities fear not inflation per se, but a pre-emptive move by the Fed and other central banks that would crimp the recovery. If equity markets becomes more confident the Fed will stay the course, they could find their mojo again.

Maybe the best advice for now is to just go away for a bit in May. We would err on the side of staying long risk assets, but selling may make the volatility easier to bear.