Weekly Investment Update (06/04/2021)
Equity markets have remained choppy in the past week, moving higher on days when interest rates have fallen and selling off as rates have moved higher. The technology sector has been most sensitive on both sides to interest-rate moves, with the longer time frame of these business models in focus. Overall, more cyclical-oriented equity sectors are the top performers on the year after underperforming for most of 2020.
At the heart of this trend is the question of how the Fed will react to recent price increases. We note that several factors are at play with regard to recent higher inflation prints: a more robust growth and spending scenario as the economy reopens, base effects from last year’s depressed levels, and supply shortages due to residual COVID-19-related challenges. While we expect modest inflation ahead, we believe the Fed will be very gradual in removing accommodation so as to prolong the recovery in the labor market, an essential part of its mandate. With the economy still in the earlier stages of recovery and the Fed unlikely to inhibit its growth, the backdrop remains supportive of risk assets, despite the daily gyrations. We have added cyclical exposure within equity portfolios yet maintain our focus on quality names and structural growth stories, which we expect to come back into favor as interest rates settle in the coming weeks.
U.S. Manufacturing Sector Accelerates While Service Sector Hits Record High in May
The ISM Manufacturing PMI, a monthly indicator of U.S. economic activity based on surveying purchasing managers, increased from 60.7 to 61.2 in May, indicating further expansion in the manufacturing sector for the 12th consecutive month. The report also said that companies and suppliers “continue to struggle to meet increasing levels of demand” and are having trouble hiring and retaining labor.
The Markit Services PMI also came in at a new record high after being revised up from 70.1 to 70.4, and the ISM Services PMI increased in May from 62.7 to 64.0. The improvement in business activity was a large driver behind the ISM services increase, which is especially notable as this area of the economy was particularly hard-hit last year. Looking ahead, the services-focused industries are poised to benefit further from the reopening of the economy both domestically and abroad.
Activity continued to recover despite challenges in supply chains. In prior months, shortages were primarily focused on raw materials and cost inputs, but labor shortages, especially for low-skill, hourly wage workers, have increasingly been affecting the services and manufacturing sectors.
There are cost pressures continuing to build: More than 80% of respondents described paying higher costs. The prices paid index increased from 76.8 to 80.6, a 16-year high. It would not be surprising to see this increase in the prices paid index reflected in higher CPI inflation readings in the coming month or so.
Labor Market Recovery Progressing
This week’s labor market data signals that the labor market is continuing to recover from the COVID-19-induced shock, albeit more gradually than other areas of the economy. The ADP employment report beat expectations, showing booming job growth in the private sector with 978,000 jobs added in May. Additionally, initial jobless claims hit their lowest post-pandemic level with headline claims falling 20,000 to 385,000 during the week ending May 29. We would expect to see claims numbers continue to fall as the vaccination rollout proceeds, states further ease restrictions, and the federal government’s extended and expanded unemployment insurance benefits come to an end. As noted, however, we have seen some fraud and other distortions in the claims data and so have focused more on other series.
Friday’s May employment report paints a similar picture. Nonfarm payrolls increased by 559,000, which was below the consensus forecast for 675,000 and “whisper” numbers for a much higher print. It was, however, a notable acceleration from the 278,000 increase in April. The unemployment rate declined from 6.1% to 5.8%.
Indicators of labor market slack remain elevated from February 2020 levels. Some examples include long-term unemployment, the number of marginally attached workers, and people working part-time for economic reasons. There are also still 7.6 million fewer employed workers today in comparison to the pre-pandemic level of total employment. At the May pace of job growth, it would still take more than 12 months to close the employment gap with pre-pandemic times. At the current pace of job growth, it is clear that additional time is needed before the Fed’s “substantial further progress” requirement for the labor market will be met.
Fed May Be Starting to Think About Thinking About Tapering
The overwhelming tone of the Fed Beige Book, which includes economic anecdotes from across the country for early April to late May, was supportive of the notion that the recovery is picking up, price pressures are increasing, and overall employment growth is modest. Given the strong economic recovery in addition to rising price pressures, the Fed is coming under pressure to begin providing guidance regarding when it will start removing monetary accommodation.
In recent weeks, comments from some FOMC members have suggested that tapering of the Fed’s asset purchase program, which totals $120 billion per month, may be on the table in the foreseeable future. This week, Philadelphia Fed President Harker, who is not a voting member of FOMC, indicated that while the Fed plans to keep the fed funds rate low for long, it may be time to think about tapering, even though it will be a gradual process. It is unclear that this is a view held consistently among Fed members. Brainard, one of the more dovish members, recently emphasized that the economy is still far from the Fed’s goals and highlighted the downside as well as upside risks to the fulfillment of these goals. Still, the overall tone from FOMC members appears to be slowly shifting relative to two months ago, when Fed Chairman Powell claimed the Fed wasn’t “even thinking about thinking about tapering.”
Following the Global Financial Crisis, the Fed began to tighten its monetary policy first by tapering its asset purchase program in 2013 and thereafter by gradually raising the federal funds rate starting in 2015. In the aftermath of the COVID-19 pandemic and subsequent economic recovery, we would expect the Fed to similarly move first to taper asset purchasing before raising interest rates. We will be watching closely for indications that the FOMC, in its upcoming meetings, may be moving toward conversations about potential tapering.
Separately, the Federal Reserve has indicated it will soon begin selling assets from its Secondary Market Corporate Credit Facility (SMCCF). Through this emergency-lending vehicle that was set up during the pandemic, the Fed purchased roughly $14 billion in corporate bonds and ETFs. Even though the SMCCF did not ultimately need to be deployed at a large scale as its creation alone served to reassure markets in the depths of the pandemic, the Fed’s announcing it intends to sell SMCCF assets reflects a withdrawal of a pandemic policy. Lastly, the Fed deliberately stated that this action is unrelated to monetary policy.
— Bessemer Investment Team
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