Markets Fret Over Fear of Change in Monetary Policy.

October 5, 2021

by Mitchell Anthony


The relatively steady rise in equity prices that we experienced the last 1 ½ years has shown some signs of stalling over the last month. The S&P 500’s recent peak was on or about August 31.  It declined about 4% in the first week of September and then quickly recovered back to its August 31 high by September 22. However, commentary from the feds meeting the third week of September caused fear and investors pushed the market down again to where the S&P 500 is now about 6% below the August 31 high. We saw a similar correction like this in March of this year as well as November of last year.  When investors fear the economic cycle is ending they sell stocks and they tend to sell growth stocks first because of their high valuations.  As a result technology has underperformed over the last month and value areas like energy, materials, and financials have done better but still have declined over 2%.

Steady economic data combined with accommodative monetary policy got the markets right back on course during these previous corrections.  Will this correction have the same outcome? We believe so, however we are carefully watching the inflationary environment as well as the dynamics going on in housing for confirmation of our thesis that this market is being driven by Fed liquidity and expectations for modest earnings growth. We believe the Fed’s liquidity pump will remain on for several more years, combined with a strong consumption theme of housing and business and consumer services.  We believe the US economy will ebb and flow with modest to moderate growth. Asset valuations will remain very high as rates stay near Zero.

Will Consolidation in the Housing Sector Derail this Expansion?

Housing is always an area of concern when evaluating an economic cycle.  The strength of this sector almost always dominoes over into several other sectors. Housing has historically been responsible for starting and ending economic cycles. If demand ends when there is excess capacity than the fallout can be broad and deep and affect many sectors of the US economy.  Most notably this happened in 2009 and the fallout lingered for almost 10 years keeping housing from being a problem throughout most of the expansion that occurred from 2010 to 2020. Now we are beginning a new cycle for housing that could be shorter than the last cycle because we have not had strong inventory to offset very strong demand that began doing Covid and continues today.

The strong increases in prices have caused buyer reluctance and consumers as a result have pulled back on purchases just recently.  Residential home prices are up over 20% nationwide over the last 12 months.  Affordability has become a bit of a problem and it could be that prices have to consolidate their gains before further gains can be achieved. It is highly unlikely that prices will fall or cave-in here because of affordability and buyer reluctance.  It is much more likely that prices will stay on a plateau or they might move higher as consumer wealth is still a driver of housing.

Will Inflation Force The Fed To Change Course And Turn Off The Liquidity Pump?

The inflation rate has been over 5% at the consumer level and a bit over 10% at the wholesale level over the last year. These numbers are high and if they persist will be a problem for the economy and the interest rate environment.  Fortunately it’s very likely that these rates of inflation will not continue much longer if at all. There are a few areas that are experiencing inflation that are concerning but most are easily explained as transitory.  The first would be housing.  Housing prices have advanced considerably because of the increased demand during Covid and the lack of capacity because of Covid as well. Increased housing prices have pushed rent and other related areas up causing concern.  Housing is over one third of the CPI index.  The inflation in rent and housing will likely subside soon because affordability has changed dramatically resulting in buyer reluctance.

Wage inflation has been another problem but will likely be resolved as the termination of the government’s aid for unemployed puts more people back in the labor markets allowing employers to hire at fair competitive rates.  The last area of concern has been commodity prices that have risen because of bottlenecks in supply chains.  As these bottlenecks are worked through, as they did in lumber, (causing a 75% decline in lumber prices) we suspect the same will happen with steel, copper, aluminum and other metals.  Energy prices could be more sticky because of the recent cohesiveness from OPEC members.  However $70 a barrel oil will bring new capacity online from U.S. frackers that are profitable above $60 forcing OPEC to compete.

News from the Fed

The Fed has talked about keeping rates at zero for at least another year or more.  The Fed may allow the longer end of the curve to rise a bit over the next six months as he tapers his purchases of intermediate to long-term treasuries. It is unlikely the treasury rates will move much beyond current rates as soft economic data is on the horizon combined with the taming of the inflationary environment.

As interest rate environment calms down money will return to the real earnings leaders in America and leave these growth challenged value areas like energy, banking and metals.  The great secular growth names will return to favor as this temporary problem with inflation and interest rates subsides.

We remain optimistic