Inflation is front-and-center for the Fed … earnings continue to help support the market … green shoots for supply chain headaches
It’s all about inflation now.
On Wednesday, the Fed officially announced the end to its $120 billion-per-month asset purchase program that it’s had in place since June 2020.
The tapering begins “this later month,” trimming purchases by $15 billion per month ($10 billion from Treasurys and $5 billion from mortgage-backed securities).
Federal Reserve Chair Jerome Powell has stressed that the end of the bond-buying program does not signal the beginning of a new rate hike cycle. However, he’s in an increasingly difficult position and the issue of when to raise rates might be forced upon him.
For more on this, let’s turn to our technical experts, John Jagerson and Wade Hansen, of Strategic Trader.
From their Wednesday update:
The Fed is in a tough spot.
Because the Federal Reserve has amassed such a huge portfolio of bonds (more than $8 trillion), there is essentially no other trader in the income markets that matters.
On the one hand, that’s good because the Fed doesn’t have to fight the market to keep interest rates way below inflation levels, but it increases the potential for unexpected shocks.
In prior decades, the Fed or the government’s spending plans would have been thwarted by traders driving bond prices lower in similar circumstances. This would have spiked interest rates and prevented the Fed/Treasury from running the kind of quantitative and fiscal easing policies that they have over the last two years.
However, the success of this program all rests on the odds that inflation will start to decline next year.
If inflation continues to rise, the Fed will have to reverse their plan and start moving interest rates higher very quickly to tamp down an inflationary spiral.
We repeat, it’s all about inflation.
***On Wednesday, the Fed stuck to its long-held narrative about “transitory” inflation
From FOMC statement:
Inflation is elevated, largely reflecting factors that are expected to be transitory.
Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.
Of course, the Fed had no alternative in its messaging. Had it changed its tune, saying we should now expect permanently higher inflation, the markets would have melted down.
That said, the Fed did a good job of aligning words with actions – meaning it limited its bond reduction amount to a dovish $15 billion per month versus the more hawkish option that traders feared of $30 billion per month.
Back to John and Wade on the significance of this:
Clearly, the Fed feels that the risk of slowing the economy by tapering too fast is greater than the risk of inflation continuing to rise in 2022.
For now, we are willing to give that view the benefit of the doubt. Even if we were more skeptical of that view, there isn’t much that prudent investors can do about it.
For now, whether the Fed is right or wrong, they are moving the bond market (and therefore stocks) in the direction they want it to go.
That may not last forever, but based on the market’s reaction to the Fed announcement, we don’t recommend fighting the Fed – yet.
So, the market survived the official tapering announcement without an implosion – obviously good news. But that’s not the only good news.
***John and Wade see strong earnings as another market tailwind
FactSet is the go-to data analytics company used by the pros. During earnings season, it provides weekly Friday updates on how earnings are shaping up.
Today’s update isn’t available at the time of this writing, so we’re using last Friday’s data. Here’s how it’s shaping up:
Earnings Scorecard: For Q3 2021 (with 56% of S&P 500 companies reporting actual results), 82% of S&P 500 companies have reported a positive EPS surprise and 75% of S&P 500 companies have reported a positive revenue surprise.
Earnings Growth: For Q3 2021, the blended earnings growth rate for the S&P 500 is 36.6%. If 36.6% is the actual growth rate for the quarter, it will mark the third-highest (year-over-year) earnings growth rate reported by the index since 2010.
And here’s what FactSet is anticipating for the end of the year:
Analysts also expect earnings growth of more than 20% for the fourth quarter and earnings growth of more than 40% for the full year.
These above average growth rates are due to a combination of higher earnings for 2021 and an easier comparison to weaker earnings in 2020 due to the negative impact of COVID-19 on a number of industries.
Not bad!
Here’s John and Wade’s take:
If we compare earnings this year with 2019 (skipping the low numbers in 2020), the compounded earnings growth rate for all companies is still 16.4% per year, which is exceptional.
We haven’t seen growth rates like that since 2012.
This is an important point. Bearish-leaning investors are quick to discredit strong earnings because of easy comparison from last year’s anemic numbers.
But John and Wade’s analysis, which skips last year, reveals there’s underlying earnings growth in the economy regardless.
***A final dose of good news
As we’ve said frequently in recent weeks, in this type of market, a focus on fundamental strength – think quality earnings – is what matters.
One of the biggest headwinds for earnings has been the global supply chain bottleneck. After all, if your product doesn’t make it to market, you can’t generate any revenue selling it.
Beyond that, as you’re well-aware, the Fed has repeatedly pointed at supply chain bottlenecks as the source of today’s inflation.
So, the easing of global bottlenecks should pack a one-two punch of increased revenues and decreased inflationary pressures.
Well, there’s good news. Back to John and Wade:
This week, the CEO of the largest shipping logistics company, GXO Logistics, said that supply issues have started to ease and that we may have hit the “peak” of this problem already.
That’s good news for retail and should also be a positive for shipping companies that have already benefited from rising prices and supply constraints. If shipping prices remain relatively high but quantity shipped increased, these are two sectors that would be good for new entries.
Here’s more from Barron’s:
…problems in the supply chain appear to be easing.
Freight costs are coming down, which indicates that bottlenecks are easing. The WCI Composite Freight Benchmark rate indicates the cost of a 40-foot shipping container fell about 9.5% from $10,500 in September to about $9,500 in October, according to RBC Capital Markets.
And the Baltic Dry Index, a benchmark for the cost of shipping raw materials such as grain by sea, has fallen almost 40% since early October.
Unclogging the supply chain mess will hardly be an overnight fix. But it’s encouraging to see signs of green shoots. It’s another reason why we believe stocks will end the year higher.
We’ll give John and Wade the final word:
Earnings growth rates are positive, and the market didn’t crash following the Fed’s announced taper of -$15 per month in bond purchases.
As long as this remains the case, the portfolio should be performing well, and we will be glad to have increased our risk exposure over the last two weeks.
Have a good evening,
Jeff Remsburg
