Covid-19 Still Biggest Risk
A lot of the worries can be traced back to the Delta variant. We certainly saw the impact in this latest jobs print here in the US. The leisure and hospitality segment of the workforce saw almost no jobs added for the month of August. Not surprisingly, August also saw a surge in case counts related to the Delta variant. It’s easy to see the spillover impact from Covid, but let’s keep it in perspective:
- Note that each subsequent surge in case counts has seen less and less of an economic impact.
- Companies and the economy have broadly learned to cope with the virus, and earnings have been nothing short of spectacular.
- Policy makers are shifting tack with a greater focus on vaccinations, understanding that coexisting with the virus is the likely path forward.
- The private sector is leading the charge as vaccination mandates become more the norm than the exception. This should help those vaccination penetration rates push higher.
We’ve heard worries that a back-to-school surge and its spillover effects may adversely impact the real economy once again. We continue to point to Florida as the key state to monitor. Why? Because it was one of the first states in the US to see a sharp rise in Delta-variant-related case counts. More importantly, Florida took the fewest steps to mitigate the spread, highlighted by the signing of an executive order barring mask mandates. Lastly, back-to-school season started several weeks ago, marking a key barometer for the future path of in-person learning. What are we seeing? A cresting in case counts and no real discernible difference in the Covid-related data in school districts that are open and engaging full in-person learning versus those still not open or leveraging some version of a hybrid policy.Boosters:
The risk we do want to highlight is the need for booster shots. If mRNA vaccine efficacy is deteriorating faster than anticipated, the ability to completely win the battle against the virus will become that much harder. And if we assume mutations will remain the norm, this battle becomes even more complex. The strategy going forward will certainly be coexisting if this is the case.
Taper, No Tantrum
We do not expect the Fed “withdrawing liquidity” (i.e. tapering) to become a major headwind. Rate hikes will matter more. We believe tapering is more a matter of misunderstood monetary policy than anything else. Because of experiences like that of 2013, many of us think Taper Tantrum whenever there is talk of the Fed reducing its asset purchases. However, there are a few major differences in today’s economy versus other tapering times. For example, in 2013 there was slack in the economy. The output gap back in 2013 was still pointing to an economy running well below potential. Withdrawing marginal support at a time when the economy was still in recovery mode should certainly elicit an adverse reaction. Currently, the Congressional Budget Office estimates the output gap has closed, indicating a lack of slack in the US economy. Also, recall that asset purchases during the Great Financial Crisis were all about removing illiquid mortgage-related assets from banks’ balance sheets in an attempt to free up capital and restart lending. This is not an issue today.
Learn Your Liquidity
Liquidity is a word that gets thrown around quite a bit. But it’s often used in a manner that is misguided. There are three forms of liquidity:
- Systemic Liquidity – the resources within the banking system that are used to settle inter-bank payments. This system is actively managed by the Fed and is not fungible outside of the banking system in any way. Only the Fed can add or withdraw liquidity from this system.
- Credit Liquidity – the ability of individuals and corporations to increase debt or roll over existing liabilities. Banks create credit and this credit creation is independent of reserves. Our fractional reserves-based system is often misunderstood within this context and often creates confusion with this concept. Sure, banks have regulatory issues that can constrain lending. But if banks want to lend, they will lend. If I have the risk appetite to borrow and you have the risk appetite to lend, credit liquidity will find a way to make this happen – independent of the Fed’s balance sheet or systemic liquidity.
- Transactional Liquidity – the ease with which investors can buy and sell financial assets. This backdrop is often influenced by market structure or regulatory issues. But in the end, the Fed’s balance sheet has little to do with it. This form of liquidity is often pro-cyclical, but ultimately, transactional liquidity is a function of risk appetite from you and me.
Why run through all of this? Two of the three forms of liquidity that we often conflate are a product of risk appetite. A risk appetite that is driven by you and me, independent of the Fed’s balance sheet. The third – systemic liquidity – is an endogenous issue. One that cannot find its way directly into the equity, currency or bond markets. So if the Fed’s balance sheet really isn’t a driver of liquidity, then why all of the hoopla surrounding tapering? Because tapering matters to the extent that market participants believe it matters. A placebo effect. We are conditioned to think it matters. So as long as we believe this, then it matters.
Here is one other point to highlight regarding tapering concerns: Chair Powell and the Fed have been very articulate in their forward guidance. Tapering is coming – that has been made crystal clear. The timing and size are still up for debate. But more importantly, they made a concerted effort to de-link the relationship between tapering and interest rate hikes during their Jackson Hole meeting comments. These two events are disconnected and mutually exclusive. The Fed will taper and step back and reassess the economy. Rate hikes will follow accordingly should they be appropriate. Rate hikes matter far more than tapering and the commencement of any hiking cycle is still quite a ways off in the future.
More Demand, Less Supply of Treasuries
Who will buy all of these Treasuries once the Fed steps away? Central banks have certainly been significant buyers of bonds over the years. Tapering leads to a drop in this marginal buyer, implying that interest rates will shoot up from a lack of demand. This has been a rallying cry of interest rate bears for several years, and this simply has never panned out. Gross Treasury issuance projections are expected to decline meaningfully in 2022. This decline in issuance will far outpace the expected reduction in net purchases by the Fed, meaning that supply will be falling at a faster pace than demand. Moreover, the marginal buyer coming from the price-insensitive camp is growing by leaps and bounds. There are still plenty of factions – think insurance companies, pension funds, banks and their regulatory related requirements, etc. – that have to own high quality fixed income assets for one reason or another. There is simply not enough supply of high quality liquid assets out there to satiate this need. “Who is going to buy all of these Treasuries?” has been a fool’s errand trade.
Peak Momentum Doesn’t Mean Peak Growth
Sure, the policy/reopening impulse may have peaked. But it’s far from over. We certainly cannot extrapolate growth going up and to the right forever. However, don’t confuse slowing momentum with a lower absolute level of growth. The recent Delta surge has put a near-term damper on growth prospects. But we are simply trading more Covid risk now for less in the future. We think this directly translates to the real economy: fatter and flatter (think of a sine wave). A little less near-term strength (flatter) for a little longer expansion (fatter). Delayed but not derailed.
Government policy-response impulse is certainly fading from a rate of change perspective. China is tightening and the Fed will be tapering. Fiscal tailwinds in almost every country will turn to headwinds in 2022. But while these fiscal tailwinds fade, they are far from over. Note the Child Tax Credit payments, back-to-school spending, rising wages (especially for the cohorts with the strongest marginal propensity to consume), European recovery-fund payments, and infrastructure spending. Add in inventory restocking, an emerging capital expenditure1 (CapEx) cycle, increased vaccination penetration rates, and further progress on the economic reopening, and it’s clear that the impulse may have peaked but it’s far from over. And we remind our readers that all of this US fiscal cliff talk is occurring at a time when the US is effectively operating with a closed output gap. This is a very different economic context from previous cycles, which typically saw slack still in the economy.
Shift from Demand Side to Supply Side?
Might we finally see a shift from demand side policies towards supply side catalysts? Will the strains that have emerged and magnified in the heart of the Covid crisis prove to be the catalyst for this handoff? While a true CapEx cycle has always been wishful thinking, might this time be any different? It’s quite possible that this time around, corporations have adjusted and learned to deal with this new demand environment. Companies certainly learned a thing or two in the past 18 months. These efficiency gains do not simply go away. Rather, they should improve operating leverage and become permanent. And if this shift from demand side support to supply side growth manifests in a real CapEx expansion, might growth expectations be too low for 2022? And remember, one man’s CapEx is another’s earnings per share2 (EPS). Economic and earnings growth expectations may still be underappreciated.
As we stated earlier, Covid-19 is the new enemy. We are trained to assume a reversion to the mean in terms of past experiences with peak growth. However, this time could very well prove different. We could see a durably higher level of nominal growth.3 Of course, this is certainly not a base case scenario for the markets in 2022. But remember: Corporate America’s earnings performance has been genuinely spectacular for the second quarter. They’ve learned a thing or two in the Covid economy. Never bet against the US consumer. Never bet against the dynamic and flexible US private sector.
A September to Remember?
September is shaping up to be quite a month in the US capital. Below is a list of key DC happenings that will certainly provide some interesting headlines:
- September 6 – $300 unemployment benefits expire
- September 13 – Senate returns from break
- September 15 – Committees deadline for input on the $3.5T reconciliation bill
- September 20 – House returns from break
- September 27 – Pelosi commitment to hold a vote on the $1.2T bipartisan infrastructure deal
- September 30 – Fiscal year 2021 ends and a continuing resolution is needed to avoid a government shutdown
- September – Decision on Powell replacement and Fed picks expected
- October – Debt limit needs to be addressed
The political theater kicked into high gear at the end of August when ten moderate House Democrats threatened to withhold their votes on the $3.5T budget resolution that had been previously approved by the Senate. This is important as it was needed to unlock the budget reconciliation process. Moderates demanded that the Speaker of the House, Nancy Pelosi, have a vote on the bipartisan Senate-approved infrastructure bill before any vote on the $3.5T budget resolution, which has been also approved by the Senate. Speaker Pelosi acquiesced and made a commitment to hold a vote on the Senate-passed bipartisan infrastructure bill no later than September 27. In return, moderates supported the budget resolution as part of the give and take.
Congressional approval of the budget resolution has enabled the $3.5T human infrastructure proposal to move forward, but the road ahead will certainly be a slog. The budget resolution is a non-binding one, giving cover to moderate Democrats who voted to support the procedure but who may not support the final act due at the end of the month. With only a four-seat majority there are at least nine moderate House Democrats who won’t support the entire $3.5T package. Complicating the issue even more, the reconciliation bill must also pass the Senate where Senators Manchin and Sinema have made it clear they won’t support the entire $3.5T bill. In addition, when the House calls for a vote on the bipartisan infrastructure package later this month, the Speaker could get some pushback from progressive members of her caucus who have been demanding action on the large package prior to a vote on the bipartisan bill. If the Speaker keeps to her commitment to the moderates, it’s hard to see the progressives tanking a $1T proposal, which represents not only a major step forward for the USA’s crumbling infrastructure, but also what will be a big win for President Biden.
Plenty of political tape bombs could come out of September. And we did not even discuss the debt ceiling and the government shutdown. While we view these two events as headline risk, markets have grown accustomed to the political theater involved with these two issues. With Democrats in charge of Washington, DC (House, Senate and White House), the last thing they need is to be blamed for a default and shutdown of the US government in front of the 2022 midterms. We expect any market-related weakness from a knee-jerk reaction to a headline to prove short-lived. Political gamesmanship is rarely lasting on the markets.
In Summary: Stay the Course
The market’s stretch run until the end of the year certainly will face some challenges. We have not seen a proper correction at all this year and history suggests at least three should occur, on average. Might we finally get at least one? “Buy the dip” has certainly been the modus operandi all year. We aren’t in the business of calling short-term market corrections. Rather, we are in the business of looking for cyclical shifts that lead to an end to economic expansions and market upcycles. Given the worries outlined above and the supportive measures still acting as tailwinds, we believe markets are still poised to grind higher.
Sure, the ride may be a bit bumpier as we weave through a political battlefield and a world where we need to learn to coexist with a virus that may never leave us. But we don’t find enough evidence to flip bearish risk assets. Stay the course for the rest of the year. It’s all about earnings. Sure, they will ease. They have to. But we don’t see them underwhelming just yet.