Summary
- While inflation might be transitory, there remains a question as to whether it would come all the way down to the pre-pandemic level.
- From 2009 to 2015, the S&P index kept rising after the announcement of tapering, and peaked six months after its conclusion.
- The Fed meeting will be held in late September, which may cover tapering arrangements.
- Investors may expect a rate hike when inflation becomes stable.
- As investors rotate from traditional industries back to the technology sector, the S&P will benefit in the near term as market capitalization of the technology sector is higher than traditional industry companies.
Characterizing the post-pandemic U.S. inflation as transitory, the Federal Reserve (“the Fed”) has put the tapering program in the pipeline intending to support the economic recovery. Indeed, the U.S. inflation might last for a period longer than we expected. With an indispensable impact on the economy and corporate earnings, what investment strategy can we take under the tapering program?
Inflation: Transitory or Long-lasting?
Production of goods has been slowed down as production plants are temporarily shut down due to the COVID-19 pandemic, causing idiosyncratic shocks to the supply chains. It is expected that the labor shortage will come to an end in the fall when unemployment benefits drop. Yet, the new vaccination could become a new bottleneck in production. On the other hand, bottlenecks in trade will be relieved as the impact of previous disruptions fades. Rise in prices is therefore temporary and sector-specific, supporting the “transitory” inflation theory.
When supply improves later, prices will go down. Increase in wages will mainly take place in low-wage jobs to attract workers returning to the market. Income gap might be reduced as a result. However, the link between wage and price inflation has diminished in recent years. Given the high unemployment rate, it is difficult to exert sustainable wage pressure. While inflation might be transitory, there remains a question as to whether it would come all the way down to the pre-pandemic level.
Tapering: Observation from 2008 to 2015
In response to the financial crisis of 2007–2008, the Fed introduced the Quantitative Easing (QE) program to bring down interest rates by purchasing financial assets. In the Congress meeting on 23 May 2013, the then U.S. Fed Chairman Ben Bernanke suggested that the Fed may taper or reduce the scale of the QE program. This was referred to as “tapering”. In the December 2013 meeting, the Fed decided to reduce QE by $10 billion, down to $75 billion per month. Following a series of reductions throughout the year, the tapering was concluded after the Fed meeting on 29–30 October 2014. The end of QE was a positive sign to the U.S. economy, indicating that the Fed had confidence in the recovery to withdraw the QE support.
Fed Balance Sheet Ballooning
Total assets of the Fed had been increasing with the massive QE program since 2008, and at a higher rate after the announcement of tapering in 2013. From Figure 1, total assets of the Fed had grown from around 1 million in 2009 when the first QE program was implemented to over 4.5 million in 2015 after the end of one-year tapering arrangement.
Figure 1: Total assets in the Fed balance sheet had increased from 2009 to 2015.
Source: Federal Reserve Bank St. Louis, Invbots.com
Market Fell After, But Not During Tapering
There is no immediate or significant impact on the market following the Fed tapering announcement. Figure 2 shows the S&P line (blue line) and the 10-year treasury yield (orange line) during the period of 2009 to 2015. As QE fueled the market rally, tapering did not stop the market growth since 2009 which incentified the purchase of stocks and indices. The S&P index kept rising after the announcement and implementation of tapering, and peaked 6 months after the conclusion of tapering.
Figure 2: There was no significant change in the market during tapering.
Source: Federal Reserve Bank St. Louis, Invbots.com
Nonetheless, there were some lagging factors shaping the impact on the market. The yield curve eventually went down with a time-lagged impact. Investors’ reduced purchase of bonds decreased their economic risk and expected inflation rate. When the expected inflation came down fast, real interest rates would go up. This justified the decline in long-term yield thus the lacking correlation between tapering and long-term bond yield, which displayed an inverse relationship as shown in Figure 2.
Tapering: Resuming in 2021
After higher-than-expected inflation numbers in most countries , Central banks all around the world have gradually changed their attitude towards quantitative easing (QE) programmes. Some even raised interest rates. For instance, Brazil’s central bank increased the benchmark rate three times this year to 4.25% . Regarding the U.S., the Secretary of Treasury, Janet Yellen, said that higher interest rates would be a “plus” for the U.S. on 6 June this year. The Jackson Hole Economic Symposium 2021, the Global Central Bank Meeting on 26–28 August, will be crucial to the global economy, as the market expects that Central Bankers will send clearer signals on the monetary policy to banks from all around the world. Then the Fed Meeting will be held in late September, which may cover tapering arrangements.
Rate Hike Unlikely in 2021, But Will Come in 2022/23
After the June 18–19 Fed meeting, the market expected that the Fed should have adjusted their monetary policy. First of all, the Fed increased its inflation expectation in 2021 to 3.4%, 100 basis points higher than their March projections. Secondly, more Fed members have moved forward their first rate hike expectation. Figure 3 demonstrates the FOMC members’ rate hike projections after the Fed meeting on 16 June. There were 7 members expecting a rate hike in 2022, up from 4 in March 2021. For the 2023 forecast, there were 13 members expecting a rate hike, up from 7 in March 2021. When more members expect a higher and earlier rate hike, chances are likely that an earlier rate hike will be even higher.
Figure 3: The FOMC members expected the earlier rate hike to be higher.
Taking a snapshot of the market expectation of the rate hike percentage, Figure 4 shows the substantial decrease in the Fed interest rate hike probability before and after the Fed meeting in June. The decreased short-term rate hike expectation results in improvement of the market sentiment. Yet, the percentage goes up as shown in next year’s data. This means that the Fed could pencil in the first rate hike next year. Articles revealed that the Fed officials projected rate increases in 2023. Investors may also expect a rate hike when inflation becomes stable.
Figure 4: Probability of Fed interest rate hike fell after the Fed meeting in June.
Slower Economic Growth
After the June Fed meeting, the US treasury yield curve has flattened slightly. A flattening yield curve indicates long yield decline and short yield increase, thus the decreasing yield spread between long-term and short-term bonds. Flattening yield curve implies lower inflation expectation thus higher potential for slower economic growth in the future. On the contrary, a steep yield curve indicates an expectation of rising interest rates but slower economic growth.
Figure 5 compares the yield curves of June 2019 (red), June 2020 (light green), March 2021 (light purple) and June 2021 (blue). The 2019 yield curve is flatter than the 2020 one, while the 2021 curve is the steepest among the three yield curves. This signifies a slower economic growth in the future. Compared to 3 months ago, the long-term yield in June has come down. The yield curve in 3Q would be more flattened if the US economy grows more slowly, as the market is pricing in the potential slower market growth in 2021 and 2022. The key economic numbers to influence the expectation on future economic growth include Non-farm payroll (NFP), Michigan consumer sentiment, June/July PMI.
Figure 5: The 2021 yield curve is steeper than that of the previous two years.
Impact on Equity and Opportunity of Tapering
With reference to the previous round of tapering impact on the market from 2009 to 2015, tapering programmes did not pose any direct negative impact on S&P during that time. However, it is expected that the lacking factors will move forward this time. We expect the upcoming tapering program might have some negative effects towards the end of 2021 and 2022.
In general, tapering might have an earlier than expected negative impact on the market. For example, the DXY (USD Index) has exceeded the potential long-term downtrend. If that being the case, the market has priced in a lower inflation ahead.
From the market perspective, lower inflation translates into lower revenue growth. Nonetheless, with decreasing long-term yield and lower near-term interest rate hike probability, technology sector will be one of the potential outperforming sectors in the 3Q21 as compared to other sectors including finance and energy. Lower long-term yield will lead to lower cost of capital and boost the DCF valuation of technology companies, which are expected to deliver higher earnings in the future.
As investors rotate from traditional industries back to the technology sector, S&P will benefit in the near-term as market capitalization of the technology sector is higher than traditional industries companies. This near-term index rally would be short-term if technology companies cannot deliver higher and better than expected earnings as valuation premium cannot be sustained. Thus, we are a buyer in July, in particular high growth technology stocks, and will be more cautious for the rest of 3Q21.
Figure 6: The DXY has already exceeded its potential long-term downtrend.
