Weekly Summary: November 29 – December 3, 2021

 

Key Observations:

1. Federal Reserve (Fed) chair Powell finally admitted that inflation was more persistent than the Fed anticipated and that it was therefore advisable to accelerate its tapering timeline to end its asset purchase program “perhaps a few months sooner” than many investors and analysts had assumed. The term “transitory” inflation was to be “retired.”
2. The Fed’s focus was now clearly on reining in inflation so that it does not become “entrenched.” We suppose that the Fed now is of the opinion that the best path to sustain economic growth is through price stability so as not to discourage consumers any further.
3. The newly discovered Omicron variant of COVID-19 has caused extreme volatility in financial markets recently. More definitive data about the new variant’s virulence and the effectiveness of currently available vaccines is widely expected within no more than two weeks. Any news on Omicron before more clinical data is available could lead to continued market volatility. We assume also that new variants could surface at any time.

The Upshot: The virulence of Omicron, and the extent to which currently available vaccines will be effective in controlling the onset of infections caused by the new variant, will greatly determine economic and inflation trajectories. The ensuing government policies will become ever more dispositive. As with all COVID-19 variants, hospitalization rates and the availability of intensive care beds will greatly influence potential lockdown policies. We assume most people worldwide would be very reluctant to accept any form of lockdowns. We do not anticipate any U.S. general lockdowns. Financial markets should continue to be very sensitive to these issues.

 

Fed Signals Faster Taper In Spite of Omicron

Fed chair Powell finally decided in his testimony to the Senate Banking Committee on November 30 that it was the “end of the line” for the use of the word “transitory” in the Fed’s description of inflation. In Powell’s words, it was time to “retire” the word transitory in this context. Powell also indicated that the “end of the line” for the Fed’s asset purchase program should happen a few months earlier than anticipated. Even given the uncertainty surrounding the newly discovered COVID-19 Omicron variant, Powell made it clear that the Fed is most likely to announce at its next scheduled meeting in mid-December that it would accelerate the tapering of its asset program. Powell is focused now clearly on the need to try to rein in inflation. “We understand that high inflation imposes significant burdens, especially in those less able to meet higher costs of essentials like food, housing and transportation. We are committed to our price stability goal. We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming more entrenched.” Powell appeared emboldened. It was as if he were thinking of the lyrics of the “End of the Line” song of the Traveling Wilburys: “Well, it’s alright, even if they say you’re wrong … sometimes you gotta be strong.”

 

Fed Minutes Anticipated Accelerating Taper

The Fed minutes of its November 2-3 meeting released last week seemed to anticipate Powell’s inclination to accelerate tapering. The Federal Open Market Committee (FOMC) stated that it “would not hesitate to take appropriate action to address inflationary pressures that posed significant risks to its longer run price stability and employment objectives.” The FOMC further acknowledged the importance of maintaining flexibility.

 

Omicron – COVID-19 “Variant of Concern” – Leads to Market Volatility

The world was first introduced to the new COVID-19 variant Omicron the Friday before Powell’s testimony. That day, the World Health Organization (WHO) classified Omicron as a “variant of concern.” This suggested that Omicron had increased levels of transmissibility and/or virulence, as well as that vaccines and/or therapeutics might be less effective against this variant. Chaos ensued in the financial markets that day. All U.S. major equity averages were lower by more than 2%, West Texas Intermediate (WTI) crude plummeted more than 13%, and the 10-year Treasury yield declined 16 basis points (bps) to 1.47%. Numerous foreign markets suffered similar fates. Many of these movements were partially reversed the next trading day. But the rebound was very short-lived when the Moderna CEO expressed clearly his concerns on the effectiveness of vaccines against Omicron the following morning. He warned of a possible “material drop” in vaccine effectiveness. This was because Omicron had many mutations of the spike protein – approximately double compared to the Delta variant. The most effective vaccines against COVID-19 attack the spike protein and might not be effective against all of the mutations. But according to J.P. Morgan on December 2, a number of pharmaceutical companies and/or health organizations including Pfizer and WHO, were much more sanguine with respect to vaccines’ effectiveness against the Omicron variant.

 

Promising Treatments – Awaiting more Data

The not-yet-approved antiviral pill produced by Pfizer is perhaps a promising therapeutic against this new variant since it was designed to inhibit replication of the virus and is not directed at the spike protein. Reuters reported on December 2 that GlaxoSmithKline disclosed that laboratory analysis of its antibody-based COVID-19 therapy under development has indicated that its drug is effective against Omicron. However, the medical community generally acknowledged that it would take a minimum of two weeks before Omicron’s virulence and many other factors could be determined.

 

Encouraging Signs

The market disruptions, which were precipitated by Moderna’s CEO’s worrisome remarks, were exacerbated when Powell’s “hawkish” statements about a quickened pace of tapering became evident to the market. We trust that volatility will continue. The disclosure of the first U.S. case of Omicron – in San Francisco – was enough to send U.S. equities tumbling once again. CNBC reported on December 2 about a second U.S. case in Minnesota by someone who had traveled to New York City. We were rather encouraged that both of these U.S. Omicron cases were characterized by mild symptoms that were fully resolved. Both of these cases were contracted by people who were fully vaccinated. As of December 2, at least 29 countries had reported Omicron infections within their borders.

 

Market Measures of Volatility

Mid-week, the most cited U.S. equity volatility index – the Cboe Volatility Index (VIX) – hit its highest level since late January of this year. It was almost twice as high as its November 12 level. On November 26, the Merrill Lynch Option Volatility Estimate (MOVE) Index – the most cited volatility index for U.S. Treasury securities – hit its highest level since March 2020. As of mid-week, the MOVE index remained at very elevated levels. As we have noted in our prior commentaries, the VIX and MOVE indexes had diverged by historic margins. We trusted that an increase in VIX levels would narrow this gap, as it has transpired recently. Perhaps at least on a short term basis, extremely low volatility of most major U.S. equity averages has also reached the ”end of the line.” The VIX is derived from S&P 500 index options with near term expiration dates and is the most familiar measure of U.S. equity volatility. The MOVE Index is a well-recognized measure of U.S. interest rate volatility implied by current prices of one-month over-the-counter options on two-, five- , 10- and 30-year Treasuries.

 

Not Surprised by Powell’s Hawkish Approach

We were not surprised by Powell’s hawkish approach, especially after reading his prepared testimony the day before. We had been anticipating Powell’s hawkish stance for months, as expressed in our previous commentaries. Many analysts characterized Powell’s expressed approach as a dramatic change. However, we thought that the Fed was clearly headed in this direction as it became increasingly concerned about inflation even as it was characterizing it as “transitory.” Therefore, we did not think that Powell changed his views.

 

Powell “Preparing” Markets

Powell has come under criticism for “surprising” the financial markets with his “ill-timed” indication that the Fed most likely would accelerate its tapering schedule. Many thought that he should have waited for more information about Omicron. We take the opposite side of this argument. We have maintained that the Fed has become more data dependent. Consequently, we thought that the Fed had clearly signaled its intention to accelerate the taper of its asset purchase program because it was “behind the curve” in reining in inflation. We surmise that it was appropriate for the Fed not to change its course until it had more data about Omicron. But why clarify the Fed’s stance at this time? We conclude that Powell in fact wanted to “prepare” the markets. He did not want to surprise the markets at the Fed’s mid-December meeting.

 

Signs of Diminishing Consumer Sentiment/Confidence

As indicated in our prior commentaries, many recent consumer sentiment and/or confidence surveys have started to show declines, some of which were substantial, due to concerns about rising inflation and their perception that nothing was being done to rein in inflation. The U.S. Conference Board’s consumer confidence index revealed early this week was the latest survey to exemplify this trend. The November survey was at a nine-month low, and it showed declines in consumer confidence both with respect to current conditions and expectations components of the index. The senior director of economic indicators of the Conference Board summarized the survey’s findings: “Expectations about short-term growth prospects ticked up, but job and income prospects ticked down. Concerns about rising prices – and to a lesser degree, the Delta variant – were the primary drivers of the slight decline in confidence. Meanwhile, the proportion of consumers planning to purchase homes, automobiles, and major appliances over the next six months decreased.” Clearly, increasing inflationary pressures could be beginning to affect the economy negatively. Powell most likely was becoming fearful that higher inflation expectations could become more “entrenched.”

 

 

Inflation Focus

In his prepared statement to the Senate Banking Committee, Powell stated that increased inflationary pressures “will linger into next year.” He acknowledged the rapid improvement in the labor market and that wages were rising at a “brisk pace.” He also expressed his worry that the Omicron variant posed downside risks to employment and economic activity, as well as increased inflation uncertainty due to possible further supply chain disruptions. Powell believed that Omicron could reduce people’s willingness to work in person. It is our position that Powell believed the U.S. economy was now sufficiently robust to withstand a less accommodative monetary policy. Easy monetary policies could not entice more workers into the labor force over their fear of coronavirus infections, nor could they ease supply chain issues. If anything, easy policies could increase demand which would only serve to exacerbate such issues and enhance inflationary pressures. It was becoming clear that the best way to enhance economic growth was to take the counter-intuitive approach and try to stabilize prices through less easy monetary policies.

 

Robust U.S. Economic Growth

Almost all of the recent economic data supports Powell’s assumption that the U.S. economy is robust and is being constrained mostly by supply chain issues, labor supply shortages, and scarcities of other production inputs. The November manufacturing Purchasing Managers’ Index (PMI) from the U.S. Institute for Supply Management (ISM) expanded for the eighteenth consecutive month. While new orders, production and employment continued to grow, supplier deliveries slowed at lower rates and backlogs continued to grow as well. Price increases continued to be elevated. In the words of the chair of ISM: “The manufacturing sector remains in a demand-driven, supply-chain constrained environment, with some indications of slight labor and supplier delivery improvement.” IHS Markit U.S. manufacturing PMI showed a similar pattern with output growth somewhat subdued by supply and labor shortages. Input costs rose at a record fast pace. However, it was notable that the pace of price increases charged decelerated to the slowest pace in three months amid signs of customers push back against higher prices. This could be a prelude to margin squeeze concerns. Although still expansionary, softer demand and materials shortages drove the Markit PMI for November to an eleven-month low. Higher prices and supply shortages were beginning to affect economic growth. The November ISM Services PMI released at week’s end, beat expectations and hit an all-time high – more of the same.

Other signs of continued U.S. economic growth included the sharp rebound of pending home sales in October and the continued strengthening of the Texas manufacturing sector, as determined by the outlook survey of manufacturing conducted by the Federal Reserve Bank of Dallas. Prices and wages continued their ascent. Similar positive trends were notable in the Dallas Fed’s survey of services sector outlook. Both input and selling prices hit series record highs in November. Wages and benefits maintained their record high levels.

Published this week, one of the eight annual issues of the Fed’s Beige Book confirmed a strong U.S. economy whose growth was constrained by supply chain disruptions and labor shortages. Low inventory levels, especially for light vehicles, further modestly constrained growing consumer spending. The leisure and hospitality sectors continued to “pick up” in most of the 12 Fed Districts. High freight volumes continued to strain distribution systems. “Strong demand generally allowed firms to raise prices with little pushback, though contractual obligations held back some firms from increasing prices.” The Beige Book is a compilation of anecdotal information on current economic conditions compiled by each of the twelve Federal Reserve Banks in their respective districts. The anecdotal information is derived from interviews with key business contacts, economists, market experts and other sources.

 

U.S. November Headline Nonfarm Payrolls Disappoint

Total U.S. nonfarm payroll employment rose by 210,000 in November compared to consensus expectations of over 500,000. October and September employment was revised higher by a combined 82,000. The unemployment rate declined from 4.6% to 4.2% in November versus expected 4.5%. Average hourly earnings increased by 0.26% month-over-month and by 4.8% from a year earlier, both slightly below expectations. The labor force participation rate increased by 0.2% to 61.8%, its highest level since March 2020, but still 1.5% below the pre-pandemic February 2020 rate. It was noteworthy that leisure and hospitality only added 23,000 jobs this month, compared to 170,000 added in October.

The monthly employment report from the Bureau of Labor Statistics is based on two separate surveys. One, polling households, and the other regarding hiring among employers. According to The New York Times on December 3, the household survey showed U.S. employment grew by 1.1 million in November. A possible explanation for the weak headline employment number is the lowest response rate from employers regarding hiring since 2008 (65% compared to 71% in October and 74% a year ago).

We conclude that this data is still supportive of a tight U.S. labor market. This data is also supportive of why the Fed has chosen to look to other measures of what constitutes a tight labor market in lieu of the headline employment number. We trust that this data will not disrupt the Fed’s trajectory of a more hawkish stance.

 

Source: Goldman Sachs, US Daily: November Payrolls Preview (12/2/2021)

 

Time to Accelerate Taper

We agree with Powell that, given the robust U.S. economic growth that continues to be constrained by supply chain issues and labor shortages and continued strong inflationary pressures, it was time to be more hawkish and focus on reining in inflation.

 

Not the “End of the Line” for COVID-19 Variants

The Omicron variant has made it clear that this is NOT the “end of the line” for COVID-19 infections. The world will have to adapt to live with this new virus. Our hope is that this virus will dissipate much like the 1918 epidemic of the Great Influenza, otherwise known as the Spanish flu. Many scientists believe that the 1918 influenza virus mutated to considerably milder forms and that people developed some level of immunity. Perhaps the Omicron variant of COVID-19 will be a less virulent strain of the virus. The best case would be if Omicron turns out to be much less virulent along with its apparent increased transmissibility and that it becomes the new dominant strain. The current dominant variant – the Delta variant – has recently represented as much as 99% of new coronavirus cases. We need more data before we can make any conclusive determination as the extent of Omicron’s virulence. However, we will continue to assume that new COVID-19 variants can appear at any time.

 

Bottom Line

Given the many unknowns that we are confronted with and our expectation of continued volatility in financial markets, we trust that the best equity approach would be only to buy on market downturns. We continue to believe that the best risk/reward opportunities in adding to equity exposure are best represented by Value and Cyclical type stocks as we anticipate a relatively strong U.S. economy into next year. Furthermore, we envisage higher interest rates in the short-to-intermediate term, but in an admittedly very “bumpy” trajectory.

As central banks reconsider their policies, we believe that the biggest economic and financial market risks could very well be policy errors and missteps. We remain concerned that there could be “over-reactions” to new variants – including Omicron – in the form of too broad lockdowns and too many travel restrictions.