CIO Insights

With Rich Weiss


General Investing | October 2022

Latest Rate Hike: Forget About That “Soft Landing”

By Rich Weiss | 5 minutes

For months, Federal Reserve (Fed) Board Chairman Jerome Powell has been aiming for an economic “soft landing,” that is, to bring inflation under control without triggering a recession. But it seems that things will get worse before they get better. In other words, instead of a soft landing, a recession is likely coming.

Fed’s Latest Move

Last month, the Federal Open Market Committee (FOMC, the Fed’s policy-making arm) raised the federal funds rate target by another 75 basis points (0.75%) to 3.25%. The hike, by itself, was no surprise. But the accompanying comments and the FOMC’s so-called “dot plot” of expectations of future rates underscored the Fed’s intent to continue to hike rates.

The dot plot shows that Fed members now expect the rate to top off around 5%, with rate cuts not expected until late 2023 or 2024 at the earliest. Accordingly, federal funds futures contracts (a market measure of interest rate expectations) adjusted upward. The market now expects another 75-basis-point hike at the November FOMC meeting with a 50-basis-point hike to follow that.

The Fed’s stark position on inflation and interest rates came as a shock to markets, which had been expecting a Fed pivot to rate cuts fairly early in 2023. As a result, bond yields rose across the board (bond yields and prices move in opposite directions), and stocks were hit hard again.

The Bank of England also raised rates again, bolstering the notion that the world's central banks are focused on containing inflation at the expense of growth. China’s numbers are also showing weakness. That means the coming slowdown is not unique to the U.S. but is going viral.

The Fed’s Rate-Hiking History

A recent Wall Street research report showed that over the past 50 years, the Fed has never stopped raising rates before its target exceeded the inflation rate. Think about that—the Fed never ended a rate-hiking cycle until the federal funds rate exceeded the rate of inflation.

For example, back in the 1970s and ‘80s, the federal funds rate peaked at 11% and 20%, respectively. Even as recently as 2000 and 2006, the rate didn’t peak until hitting over 5% or 6%, topping the prevailing level of inflation at the time.

Today, the rate stands at 3.25%. The bond market, as expressed in federal funds futures contracts, expects rates to peak at 4.5% in early 2023. Now consider that core CPI (a measure of consumer inflation that excludes volatile food and energy prices) is currently running at over 6%. The Fed’s preferred inflation measure, core personal consumption expenditures, stands at 5.4%.

This means that either inflation is going to have to come down really fast, or the market is seriously underestimating the likelihood that the Fed will raise rates beyond 4.5%.

Rate Policy and the “Taylor Rule”

Many people are wondering how the Fed determines when and by how much to hike interest rates. I think it’s safe to say there is no one specific formula or rule they follow that dictates that process. They have to balance many different economic, financial, political and social factors, which are dynamic and interrelated. Setting appropriate monetary policy is a complicated and difficult task. And let’s remind ourselves, the Fed does not have a crystal ball—there is no clear line of sight to what happens next.

With that said, there are several different guiding principles or rules that inform central bank monetary policy decisions, all of which stem from academic theories. Here we are going to focus on just one, the Taylor Rule. Developed by Stanford economist John Taylor in 1993, the Taylor Rule estimates the federal funds rate based on the divergence of inflation from its target level and the divergence of real gross domestic product (GDP) growth from its target level. This means that if inflation or growth overshoot, the Fed would raise the policy rate under the Taylor Rule; shortfalls would indicate lowering rates.  

This makes perfect sense—if economic growth or inflation is running too hot, then raise rates to cool things off a bit. Conversely, if economic growth or inflation is running too low, then lower rates to spur growth and consumption. If one is hot and the other is not, then it’s a balance of the two competing forces. This is the situation we find ourselves in today, where high inflation demands tighter monetary policy, whereas slowing economic growth argues for looser policy.

Fortunately, the Taylor Rule prescribes a precise formula equating all these terms, which basically boils down to this: The federal funds rate should equal 2% over the current inflation rate, plus one half of one percent for every percent that inflation or GDP is above target.

Right now, with inflation running around 6% (4% over target), and real GDP running at around 1.5% (about 1% below target), that would call for a federal funds rate of roughly 9.5%. The math is pretty stark. I don’t think anyone is expecting a 9% federal funds rate, however, because inflation is expected to come down.

The punchline here is pretty clear—the Taylor rule suggests that rates need to move significantly higher to stave off inflation, despite the fact that the economy is weak. That is the challenge that the Fed is currently facing.

Rates in Europe

The European Central Bank (ECB) raised its policy rate by 75 basis points in September and indicated its willingness to continue rate hikes to bring down inflation.

We see a very high probability that the eurozone will fall into a recession over the next 12 months given the combination of persistently high energy prices and more restrictive monetary policy. The Eurozone Composite Purchasing Managers' Index, an important indicator of manufacturing activity, shows that growth contracted for the second consecutive month in August. In addition, consumer sentiment there is at historically low levels.

On top of already weak economic conditions, we expect the ECB to maintain a very hawkish stance on interest rates until year-end as it seeks to combat inflation. It’s evident that the pass-through effect of higher energy prices into core consumer inflation metrics is increasing.

Additionally, liquidity conditions in European energy markets also argue for higher prices ahead. However, likely government cost controls/caps on energy bills would suggest an implicit cap on inflation from this component in the near term.



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When Rates Rise, What Happens to Stocks?

September 2022

The inverse relationship of bond performance and interest rates is a well-known phenomenon. When interest rates rise, bond prices tend to fall, and vice versa.

Stocks are affected, too, but the type of stock makes a difference. Growth stocks tend to be much more sensitive to interest rate changes than value stocks. To explain why, we’re going to give an example from fixed-income land.

Bonds and Interest Rates: The Basics

Let’s start by thinking about that inverse relationship between bond prices and interest rates for a minute.

Longer-term bonds are more interest rate sensitive than shorter-maturity fixed-income issues. Why? Longer-term bonds have a longer duration, that is, they take a much longer time to pay you back. Duration—when an investor expects to get their money back—turns out to be key when assessing price sensitivity to rate changes.

A higher interest rate eats more heavily into the value of a long-term bond relative to a shorter-term fixed income security. And the same principle applies to coupon-paying bonds versus zero-coupon bonds. Bonds that pay interest all along the way are returning more money to you sooner, compared with bonds that pay all of their interest and principal years in the future.

Applying Bond Logic to Stocks

We can now transfer those same basic principles over to growth and value stocks.

Growth equities—early-stage technology or biotech stocks, for example—typically pay little or no dividends. So, they’re more akin to zero-coupon bonds with the bulk of their cash flows (expected future earnings) occurring further in the future.

Value stocks (such as consumer staples, financial companies) typically pay dividends—some with very large payouts—similar to coupon-paying bonds. As a result, their return stream exhibits a much shorter duration. That means their returns to shareholders are more immediate and (theoretically) more dependable than the uncertain payout offered by, say, a biotech stock.

Looking Ahead

Ultimately, the performance disparity between growth and value stocks as interest rates change is down to the fact that growth stocks are considered longer-duration securities. Growth valuations get punished more heavily than value stocks when rates rise, and vice-versa.

This is a relationship we have witnessed all year long. And as long as the Federal Reserve remains focused on raising rates to fight inflation, we believe it will continue to play out.


The Wealth Effect Is Real—and Increasingly Negative

July 2022

The wealth effect is a behavioral economic theory that suggests people spend more as the value of their assets rises—that is, as they become wealthier.

The idea is that consumers feel more financially secure and spend more freely, specifically when their homes or investment portfolios increase in value. This applies even if their regular monthly income and fixed costs remain the same as before.

Wealth Effect and Economic Growth

The theory holds that rising personal wealth has a positive impact on consumer spending and, therefore, economic growth. That’s a result of:

  • Increased confidence and willingness to spend money
  • Increased investment income from dividends, interest, rent, etc.
  • Increased equity withdrawals, i.e., refinancing or borrowing against the value of a house or stock portfolio

Unfortunately, the wealth effect also works in reverse.

Source: economicshelp.org, American Century Investments


Negative Wealth Effect

When the stock markets lose significant value in a short period of time and/or home prices start stalling (or worse yet, falling), a negative wealth effect may come into play.

Stocks have recently dipped into bear market territory, while the housing market faces challenges of its own. As recently as February, home prices were at record highs in both nominal and inflation-adjusted terms. But such lofty prices at a time when mortgage rates are surging means affordability is falling, leading to a housing market downturn.

At the same time, around $7 trillion has been wiped off stock valuations so far this year. When investors see decreases in stock portfolio values and worry about cuts to stock dividends, they’re more likely to curb spending.

This negative wealth effect is another reason why many economists are reducing their growth forecasts this year.

Gauging Your Own Financial Security

Being comfortable with your financial plan is important during times of market and economic uncertainty. We can help you determine what path may be appropriate for your individual situation, so you can be ready for whatever lies ahead.


Should You Invest for Inflation or Recession?

June 2022

Whether or not you believe a full-fledged recession is coming, the markets seem to be pricing in a potential recession. Economists, too, are cutting their gross domestic product (GDP) forecasts for this year.

In that environment, I think it’s important to differentiate between investing for inflation and investing for a recession. We often talk about what asset classes and sectors of the equity market tend to perform well in inflationary periods. Here we’ll briefly recap the potential winners and losers.

Potential Inflation Winners:

  • Commodities. Inflation is essentially defined by higher commodity prices.
  • Select emerging markets securities. This includes both stocks and bonds.
  • Treasury inflation-protected securities (TIPS). These securities offer returns adjusted for the rate of inflation.
  • Certain equity sectors. Energy typically has done best, and utilities and basic materials (raw materials and related industries, such as mining, forestry, metal refining, etc.) have also historically fared relatively well.

Potential Inflation Losers:

  • U.S. equities.
  • Financials, information technology and consumer discretionary. These stocks have tended to lag as higher interest rates and tighter monetary policy typically weigh on these companies’ earnings and/or valuations.

And with maybe the exception of emerging market equities—which continue to be burdened by the COVID overhang—the asset classes and sectors I just listed generally have lined up reasonably well with performance for the last several months. We’ve seen commodity prices, TIPS and value stocks outperforming significantly. That’s almost textbook inflation investing.

Recession Considerations

But now we may be seeing an evolution away from inflation investing toward recession investing.

Many economically sensitive commodities—with the exception of petroleum-related products—have begun to lose ground. And while equities have continued to decline, sector performance may be changing. For example, health care, a stalwart outperformer in past recessions, is beginning to show strength.

Bonds also have begun to come alive after a difficult stretch. That’s because high-quality, government-backed bonds are considered much more attractive during economic downturns, when investors place a premium on perceived safety.

While Treasury bonds have begun to rebound, corporate-backed securities are lagging. The more pro-cyclical, equity-like junk bonds have been losing value because they’re more sensitive to economic growth.

What else should we expect if the probability of recession overtakes the probability of continued inflation? There are a few things that you may want to consider, if you’re a recession believer:

  1. Financials, industrials, energy and utility stocks generally underperform in recessions.
    To the extent that utilities and energy issues have done well over the last several months, there may be room for those sectors to underperform if a recession is forthcoming.

  2. Energy prices typically decline in recessions.
    This tends to be true of both the commodities themselves and the stocks of companies that produce energy-related products. So, it may make sense to look at taking profits in those areas, if you believe strongly that a recession is likely.

Looking at Your Own Portfolio

Does that mean that you should make changes in anticipation of a shift from inflation to recession concerns? As always, it depends. Rather than wholesale changes, any adjustments to your portfolio—whether that’s asset classes or sector weights—should be made within the context of long-term, strategic diversification. 

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.


Inflation: It’s the Rate of Change That Counts

Inflation is a real concern and investors need to account for it in their portfolios. But it seems to us that much of the inflation discussion misses the point. Rather than focusing on the level of inflation, it’s more important to understand whether inflation is increasing or decreasing from the current level.

A Different Way to Think About Inflation

I recently came across a simple inflation schematic that classifies inflationary environments by the rate or level of inflation:

  • Creeping inflation. Inflation of 3% or less is called “creeping” inflation and is deemed safe for healthy economic growth and consumer demand.
  • Walking inflation. This is where we currently find ourselves. “Walking” inflation is defined as being between 3% and 10%. Wages generally can’t keep up with goods and services prices, potentially creating the dreaded wage-price spiral.
  • Galloping inflation. “Galloping” inflation is when inflation rises by 10% or more and is clearly detrimental to business, consumers and investors. Economies can destabilize and governments may lose credibility quickly in this sort of environment.
  • Hyperinflation. This is the last and worst of the categories. “Hyperinflation” is when prices skyrocket by more than 50% a month. This occurs in only the most extreme cases, usually associated with emerging economies run amok or wartime economies. Germany in the 1920s, Zimbabwe in the 2000s and Venezuela in the 2010s are prime examples. The U.S. also experienced hyperinflation during the Civil War, and it’s possible that something similar might happen in Russia in the coming months.

But Don’t Forget About the Rate of Change

While it’s useful to have an easy-to-understand classification, this framework has flaws. It classifies inflation environments solely by the level of inflation without any reference to the second derivative—that is, the rate of change in inflation.

Remember, inflation itself is already an expression of a rate of change in prices. What is just as important as the rate of change in prices is the rate of change in the rate of change of prices.

In other words, knowing if inflation is above or below a certain level may be helpful. But it’s just as important to know if inflation is accelerating or decelerating. Do things seem to be getting better or worse? That’s what affects the financial markets.

That’s especially true now. Everyone knows that inflation is high. That’s not market-moving news. What we need to focus on is whether the rate of inflation is increasing, stabilizing or decreasing. 

Our Inflation Outlook

We’ve been arguing for some time now that as the pandemic eases, we’ll begin to see the supply chain and transportation network disruptions subside.

Of course, all of this is now complicated by the COVID-19 resurgence in China and Russia's invasion of Ukraine. Higher food and energy costs will undoubtedly contribute to inflation in the near term. It's true though, that such costs aren't typically considered long-term drivers of inflation.

The upshot? Inflation isn't going away anytime soon. But fundamentally, we see the underlying inflation picture improving over time.

Diversification does not assure a profit nor does it protect against loss of principal.


When Conflicts Arise, Should You Invest Differently?

The largest conflict in Europe since World War II has had terrible human and political consequences. In economic and financial terms, it further contributes to uncertainty and inflation, all of which is likely to weigh on economic growth. We don’t believe, however, that there is a lot to do in terms of your portfolio, as long as you are well diversified and were taking appropriate levels of risk before the crisis began.

Planning Starts Before Volatility

The ideal time to build a portfolio is in advance of a crisis. When you do your homework and build a well-diversified portfolio, you’ll be better positioned to handle any market event. Risk tolerance and downside protection (i.e., hedging against market losses) are two issues we really believe should be addressed before you make your first investment, not after the volatility horse has left the barn.

We are not currently making large-scale changes to our emerging markets portfolios or our multi-asset portfolios more broadly. That said, our non-U.S. equity and fixed-income teams have made some individual security adjustments to buffer some of the worst potential effects in our portfolios.

Global Implications

Perhaps the best way to think about the current situation is in terms of the fundamental global economic implications. Russia is a leading energy exporter, as well as providing many industrial metals. Ukraine, for its part, is a large agricultural exporter. Sanctions on Russia and violence in Ukraine threaten both countries’ export capacity. That argues for lower global supply across a range of important products, and therefore even more pressure on inflation going forward.

Higher inflation acts as a tax on consumer spending, which is the largest component of economic growth. Trade disruptions and higher inflation will then pose a direct challenge to global growth. Economists are ratcheting down their gross domestic product (GDP) forecasts for this year by 1-5% or more, depending on the country. European economies and markets are bearing the brunt of these re-ratings so far.

Our Positioning

Slower global growth doesn’t always bode well for riskier assets, so we have positioned our own multi-asset portfolios somewhat defensively in that regard. We remain overweighted in value equities relative to growth and U.S. small-cap equities relative to large, which have more international exposure.

Our emerging markets (EM) overweight got hit on the news of the invasion of Ukraine, however. But we continue to hold that position because of the progress emerging economies had made prior to the crisis. Conditions had been improving—EM lagged the U.S. and developed world recovery because of lack of access to vaccines. More recently, our analysis showed a clear upturn in fundamentals, and we built an overweight position.

Of course, all that changed with the Russian invasion of Ukraine. EM equities do tend to suffer in a “risk-off environment.” But we are maintaining the overweight at least for now because we still believe the fundamental positives remain: Consumer demand is rebounding sharply all over the world, economies are recovering (albeit at a slower pace) and higher commodity prices generally benefit resource-rich developing economies.

Outside of equities, we have avoided underweighting or selling fixed income in the face of rising interest rates, as diversification is a key strategy in such periods.

Think Long Term

To wrap it up, if you’ve done your homework in advance and hold a balanced, well-diversified portfolio, then we think sticking to your long-term strategy (as opposed to over- or underweighting) is a decent position to take. That’s generally true even in these volatile situations.

Think of it this way: Why would you bet on Russia’s intentions in Ukraine or elsewhere? No one really knows where this is going, so it seems to me the best thing to do is to stay calm, hold your positions and not panic.

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.


Cryptocurrency: It’s Not for Everyone

Whether in Super Bowl ads or the financial media, cryptocurrencies are increasingly part of the mainstream. At last count, there are over 1,600 different cryptocurrencies in existence. Further, many major economies around the world are now actively researching, testing or actually implementing their own central bank digital currencies.

Right up front, I have to say that we consider cryptocurrencies to be highly speculative, extremely volatile, relatively illiquid and insufficiently regulated for prudent use in our own multi-asset strategies.

Having said that, there’s still quite a bit of context and useful information we can provide on cryptocurrencies. From an investment perspective, it’s important to understand that not all cryptocurrencies are alike. There are many different types, with different underlying characteristics and objectives.

Crypto Basics

Cryptocurrency is a digital currency for buying and selling goods and services. The transactions from a digital “blockchain” ledger are secured with complex algorithms to prevent potential fraud. Demand for this type of currency is often driven more by speculation than by actual commerce, which results in volatile swings in value.


Types of Cryptocurrencies

Although their size and liquidity vary quite a bit, from Bitcoin on down the line, there are many subtle differences in their makeup. 

Definitions

Stablecoins: Cryptocurrencies whose market value is pegged to a currency like the U.S. dollar or other assets in an attempt to achieve price stability.

Non-fungible tokens (NFTs): Unique digital assets that represent real-world videos, art, music, etc. on a blockchain. They can be bought and sold but not traded or exchanged like fungible assets. (Cryptocurrency tokens are interchangeable or “fungible,” so they can be used for commercial transactions.) 

Exchange tokens: Digital assets that are unique to a cryptocurrency exchange platform.

Utility tokens: Crypto tokens that allow users to perform a specific action (or receive a service) on a specific network.


For example, let’s look at the two largest cryptocurrencies, Bitcoin and Ethereum. Although their price patterns closely track each other in the short term, that may not ultimately be the case over the long term. Bitcoin aspires to be a true currency. Ethereum, on the other hand, functions as a smart contract application platform (think of it as a component or characteristic of the blockchain).

Other cryptos, like Tether, Binance and Digix Gold Token are what’s known as stablecoins. That is, they are cryptocurrencies tied to fiat currencies like the U.S. dollar (fiat currencies are issued by governments and are not backed by commodities, such as gold).

Additionally, there are non-fungible tokens (NFTs) like CryptoKitties and CryptoPunks, exchange tokens like Coinbase Exchange, FTX Exchange and Kraken, and utility tokens like Filecoin, Siacoin and Golem.

Do Your Homework

While I don’t doubt that there’s a future for cryptocurrencies in our economic ecosystem, you absolutely must do your homework before considering an investment in this space. It’s not sufficient to buy a cryptocurrency just because it goes up.

There’s an old adage: If you don’t understand it, don’t invest in it. But to be fair, I own airline stocks and auto stocks, even though I can’t fly a plane or fix my own transmission.

You don’t have to fully understand the inner workings of blockchain technology as a prerequisite to investing in this arena. But crypto is wide-open country without good visibility or established rules of the road, so be very careful about understanding the space before you consider investing your money there.

New Administration, New Policy Impacts?

We’ve written extensively about the folly of betting on political outcomes, so let’s put that right up front. But people do continue to ask us questions about how we factor in policy implications for various segments of the economy and markets.

With that said, I can relay some of the major issues before us, and what the conventional wisdom may tell us. Remember, it’s not what you think is likely to happen that matters most. It’s the likelihood of that actually happening measured against what the market has already priced in (whether market prices appear to reflect these policies).

 

What's Ahead?

The conventional wisdom holds that a unified Democratic government could lead to the following:

More stimulus—including the potential for a $1.9 trillion stimulus package.

That may be good news for the economy, equities, the consumer and municipalities in the near term. However, this may already be priced into the markets to some extent.

Modest tax hikes on corporations and high-income individuals.

We don’t believe this is fully priced in, as the probability and details are still uncertain.

More regulation in some sectors, plus a boost for clean energy and infrastructure spending. 

The Biden administration’s block of the Keystone XL pipeline is the first major example of regulatory changes. The fracking industry and Big Tech may also see some obstacles placed in their way in terms of tighter regulations and/or higher minimum taxes. 


Potential Roadblocks for Policy Initiatives

We think it's important to remember that unified control does not always mean unlimited control. Individual members of Congress have competing interests and agendas that can limit policy options. In 2017, for example, Republicans controlled the White House, Senate and House of Representatives but were unable to pass a repeal of the Affordable Care Act. 

Democrats currently hold the slimmest possible majority. This means that the more extreme or hotly debated measures, such as a Green New Deal, still have a difficult pathway to becoming law given the party’s heavy reliance on moderates who may be up for re-election in 2022.

It’s also important to distinguish between those policy initiatives that require a simple majority vote in Congress versus those that mandate a “supermajority” of 60% or even a two-thirds vote.

 

Updates to Legislative Approval

Last week, Congress passed a budget resolution bill which makes it easier to pass certain legislation. “Budget reconciliation” is the term used to describe the process through which major budget policy objectives can be approved with only a simple majority vote—now much more likely with a 50/50 Senate split and VP Harris as the tie-breaker. These bills can focus on one of three facets of the budget process:

  • Spending
  • Revenues
  • Debt limit

Next, consider that to end a filibuster and bring any new legislation to a vote requires a three-fifths (60 out of 100) majority vote. Changing Senate rules, for example, face an even higher hurdle, requiring two-thirds of the Senate to approve. So, except for certain items which can be handled under the “budget reconciliation” process, many issues before the Senate would require at least 60 votes to pass, lest they be filibustered.

 

Final Word

Even with the White House, House and Senate under Democrat control, the slim margin of power in both Houses puts a lower probability on major, lightening-rod political and economic issues being approved.


Reflation Is Not Inflation

We’ve been getting a lot of questions about the economic recovery, fiscal stimulus and the likelihood of inflation. What are the odds we get past the worst of COVID and its economic repercussions by the end of this summer? Will inflation re-ignite this year as the markets seem to be implying right now?

Thanks to the vaccine rollout, an economic recovery and even more government stimulus on the way, it seems we are finally transitioning to a post-pandemic “normal.” Counterintuitively, though, the stock and bond markets have seen recent selloffs, perhaps because of worries that the economy could overheat and lead to inflation.

The first point we’d make is that “reflation”—rehabbing a damaged economy—is not the same thing as an inflation shock. In our view, reflation refers to the process of stimulating the economy by increasing the money supply and/or using fiscal stimulus to boost activity following a downturn in the business cycle.

Think of it like reinflating your bike tire when it’s flat—adding some air is necessary to get back on the road. That’s a far cry from the inflation that many seem to be fearing.

Continuing with our bicycle analogy, inflation would be akin to continuing to pump up a tire that’s already under pressure. But as we’ve been saying for some time now, we just don’t see evidence that the economic tire is already fully inflated and under significant inflationary pressure.

Could Inflation Reignite in 2021?

Despite what markets are currently pricing in (whether market prices appear to reflect the possibility of inflation), my own belief is that it’s unlikely we see inflation overheating in the near future. A COVID “tail” and aftereffects could well extend into 2022, resulting in a more modest rebound than everyone appears to be envisioning.

To be clear, we’re not donning our doctor’s smock to make this call. We simply think it’s hard to argue that the pandemic will be done and dusted by the summer, and that economic activity will resume exactly as before even once herd immunity is reached.

It seems more reasonable to us to assume a longer, gradual workout and recovery. Just consider the long-term “scarring” effects of the pandemic on the labor market, or the “K-shaped” recovery that is leaving many consumers and parts of the economy behind.

A K-Shaped, Diverging Economic Recovery

Source: Investopedia, November 2020.


Wage Inflation Isn’t on the Horizon

Also consider that the labor market is in no shape to drive wage inflation. It’s really difficult to envision rising inflation with the labor output gap still so large and unemployment so high. Even the recent rebound in industrial commodity prices, we would argue, is recovering lost ground from last year and unlikely to drive meaningful, enduring inflation going forward.

Main Inflation Drivers Just Aren’t Here Yet

Having said that, we recognize that this is a contrarian position. Interest rates are rising and the yield curve is steepening. This is an indication that the bond market is actively concerned about inflation.

And we do not dispute that we will have to deal with the consequences of all the government monetary and fiscal stimulus poured into the economy at some point. The real question is, when?

Without the kick to inflation that comes from rapid economic growth and rising employment, we just don’t think it’s likely inflation will reignite anytime soon. 


Will Current Policies Jumpstart Inflation?

Many factors can drive inflation. But current policies—huge fiscal stimulus and government debt, and even a nudge from “green” energy plans—seem to be creating an environment that’s ripe for price increases. Are these pressures enough to reignite inflation down the road?

“Green” Inflation? Maybe, Maybe Not

It’s possible that “green” policies designed to promote alternative energy may promote inflation. To the extent policies are implemented solely for environmental, social, or governance reasons, they could be detrimental to near-term investment returns, economic growth and/or inflation.

But there’s also an argument that green policies could be beneficial to the economy, especially over longer time periods, and might actually work to tame inflation. More abundant and diverse sources of energy could encourage lower prices by increasing energy supply and market stability. A more robust energy network or diverse energy sources may also help eliminate or reduce the utility network shutdowns seen in California and Texas, for example.

Similarly, rising adoption of alternative energy sources could hasten peak oil demand, when new technology makes alternatives more cost effective than oil. This would suggest a potential transition from oil scarcity to abundance—and likely falling oil prices.

More Immediate Inflation Concerns

My sense is that most investors are concerned with more immediate threats on the inflation front, rather than the impact of green policies.

Some of the biggest near-term inflation risks would come from increasing manufacturing and consumer demand amid a presumed rapid recovery, as well as from a weak dollar (importing inflation).

Labor costs are another major potential driver of inflation, but these haven’t risen significantly given the slack in the labor markets. It’s hard to see inflation being led by labor markets while the participation rate (those employed or looking for work) is so low. Of course, we have to put a big asterisk here because of the potential for an increase in the federal minimum wage over time.

Finally, the threat of a cost-push type of inflation from higher oil and commodity prices is real, though this is chiefly due to increased demand and not the rise of alternative energy sources. (Cost-push inflation is when increased wage and production costs drive increases in overall prices.)

The Economic Inflation Equation

With respect to government spending and increased money supply (from Federal Reserve policies) driving inflation, the basic equation/recipe for monetary inflation is “M * V.” That is, Money Supply times the Velocity of money. 

Money Supply  x  Velocity of Money  =  Monetary Inflation


In other words, without significant economic growth spurring more financial transactions (i.e., more “velocity” or turnover of money in the economy), there isn’t a high likelihood of inflation. Increasing the money supply is a necessary, but not sufficient, condition for inflation.

Is Inflation Coming? Don’t Pencil It in Yet

When will we see inflation? The timing depends on the real economy growing and eventually overheating, which may not occur for some time. For context, consider that many people expected price increases in the 10+ years of economic growth after the global financial crisis. But because the economy never overheated, we never saw much (or any) inflation.

Having said that, we recognize that rates are rising and the yield curve is steepening, suggesting  the bond market is concerned about inflation.

We don’t ignore that or disregard what the market is telling us. We are simply saying that while we can see the argument for higher prices ahead, we can also see all the obstacles on the road to meaningfully and sustainably higher inflation.

Ultimately, we believe investors do well to incorporate a diversified inflation hedge as part of their portfolio allocation. This way, you can add the potential of some inflation protection in the context of your overall portfolio. You also won’t be faced with choices about making wholesale changes into or out of certain asset classes while you try to guess or anticipate changes in inflation expectations.


Higher Taxes, Market Impact? What to Know

To fund their multi-trillion-dollar infrastructure spending plans, the Biden administration is proposing raising taxes on corporations and wealthy individuals. Investors are wondering what effect such a tax increase may have on the markets.

Impact on Stocks

Corporate taxes translate directly to corporate profits, and a change in corporate tax rates would likely show up very quickly in stock prices. Of course, no one knows the magnitude or timeline of any potential tax increase.

The market reaction would likely anticipate actual changes in the level of corporate taxes. During the last round of corporate tax cuts that took effect in early 2018 (the Tax Cut and Jobs Act of 2017), the effect on profits and stock returns was swift.

Individual Taxes and Consumer Spending

Personal income taxes, on the other hand, have a less direct relationship with financial markets. Higher taxes could be expected to limit consumer spending and, therefore, economic growth over time. The effect on growth depends greatly on how any potential tax changes are structured and implemented.

For example, the current proposal would increase taxes on only the highest earners, preserving the after-tax income and purchasing power of the vast majority of Americans.

The Debt Factor

Presumably, though, personal and corporate tax increases will eventually be necessary to pay back the growing federal deficit.

We are looking ahead to a careful balancing act between growth, rates and taxes, all of which will be necessary to pay down that debt over time. 


Is Inflation Rising? Yes. (But for How Long?)

Anyone who’s remotely aware of the financial media knows that inflation is an ongoing concern. The only question: Is it transitory or a permanent shift to higher prices?

Higher Prices, but Temporary Factors

There’s no dispute that inflation is going up, but the debate is over how long it will last.

The current inflation concerns are understandable because recent reports have shown a sharp jump in wholesale and consumer inflation data. We’ve argued extensively in the past about all the long-term factors that we think will keep a lid on inflation over time.

But even short term, we see signs suggesting that inflation may be near a peak and slowing going forward. Many COVID-related disruptions are being resolved—stores and factories are hiring again and are ramping up business. And it’s unlikely wages will move higher when the unemployment rate remains high relative to pre-COVID levels. What’s more, many people gave up looking for work entirely during the pandemic. The implication is that the lower labor participation rate leaves room for more people to come back into the workforce.

Inflation Expectations vs. Realized Inflation

Since the end of last year, inflation and inflation expectations have surged. But now, conditions have changed. Actual, realized inflation as measured by the consumer and producer price indexes (CPI and PPI), has jumped. That reflects all the disruptions to the supply chain caused by COVID in the last year. So as economic activity ramps back up, there just isn’t enough supply of many goods or materials to meet that new demand—limited supply and higher demand mean prices go up.

Enter the Federal Reserve (Fed), whose job it is to fight inflation. The Fed has been saying consistently that this increase in prices is temporary. But the market didn’t appear to believe that argument, at least not at first.

As a result, inflation expectations jumped in late 2020 and early 2021. You can see this in survey data like the University of Michigan: Inflation Expectation Index* and prices for Treasury inflation-protected securities.

But now, it seems financial markets might finally be coming around to the Fed’s point of view, as various measures show expectations for future inflation moderating.

But Investors Are Still Wondering What to Do

Worrying and reacting don’t make good investment strategy; overreacting is even worse. That’s relevant now because investors who are worried about inflation may be overreacting to what we see as a temporary increase in prices.

This is yet another brick in the wall for the argument to include a diversified, strategic inflation hedge as part of your long-term asset allocation. Having said that, we still want to be responsive to people who are concerned about the current spike in inflation.

Inflation “Cocktail” in Our Own Portfolios

To be clear, we don’t believe that the inflation threat is going to be persistent and, therefore, we’re not rushing to add inflation-related products to our own asset allocation portfolios.

That’s especially true now, after many investors have piled into these assets and bid up their prices. Our inflation “cocktail,” if you will, is comprised of TIPS, real estate investment trusts (REITs), commodity-related equities, emerging market securities, and more generally, foreign currency exposure, in case the dollar gets hit.

Others may choose to hedge a specific type or source of inflation, which will influence the sorts of inflation-fighting investments they incorporate into their portfolios.

But our own long-term approach is to favor a diversified inflation hedge comprised of many different assets, reflecting the broad nature of inflation itself.

*Source: Federal Reserve Bank of St. Louis. Data through April 2021, updated May 28, 2021. 


What’s Next for the Economy and Markets?

To us, the economic and financial market glass appears to be at least half full. Unless inflation suddenly gets much worse—which would likely force the Federal Reserve (Fed) to act more quickly than we (and they) currently expect—we believe conditions will be pretty good for a while. That said, we do see potential challenges.

Monetary and Fiscal Support Are at a Turning Point

We’ve likely seen the peak in monetary policy support for the economy and markets, not just in the U.S. but around the world. So one of two things will have to happen: Either the U.S. federal government will provide additional stimulus spending, or the global economy will have to learn to stand on its own two feet.

With respect to fiscal spending, it’s still unclear to us if the bipartisan infrastructure framework will make it through Congress, let alone President Biden’s much larger proposal featuring significant tax hikes, but backed only by Democrats.

As we’ve repeated time and time again, we don’t think it pays to bet on political outcomes. But it is almost certainly true that such massive stimulus spending—depending on the size and focus of the spending packages—will affect the growth outlook for the next several years.

We’re Optimistic About the Markets…

In the short term, we’re relatively optimistic on the current market environment for a number of reasons.

Economic growth.

We’re seeing strong economic growth (domestic and worldwide) as we emerge from the pandemic. This growth is being facilitated by a historically low interest rate environment.

Improvements in underlying economic conditions.

Commodity prices appear to be moderating (reducing inflation risk), the economy is adding jobs at a rapid clip, and global trade and supply chains are gradually returning to some semblance of normalcy.

Finding value.

Finally, we would argue that it’s possible to find markets that are still fairly valued, and not overheated or dramatically overvalued.

…But Risks Remain

In our opinion, the following issues represent the biggest threats to the markets for the foreseeable future (not necessarily in priority or probability order):

Higher interest rates.

Higher rates, either from higher inflation and/or Fed policy action, would undermine equity valuations and, potentially, take the wind out of their sails even if the economy was still growing.

A resurgence of COVID-19.

This could easily transpire due to stronger, more resilient variants (such as the new Delta variant), or simply because there are large swaths of the global population that are still not vaccinated and not likely to get vaccinated. If herd immunity is not reached, that leaves the door open for another surge in cases/deaths and subsequent economic shutdowns. Witness the new lockdown in Sydney, Australia as a result of the Delta variant outbreak.

Recession.

A one- or two-year window could allow for a natural economic recession following the current post-COVID recovery/boom environment. In this scenario, we’d see a peak in economic growth and corporate earnings, a rise in interest rates and higher tax rates that could choke off investment and undermine valuations, and waning consumer demand. 


Cryptocurrency as Investment? Proceed With Caution

Cryptocurrencies have been in the news for their volatility and involvement in some recent high-profile ransomware attacks. It’s important to understand that these are not traditional investments. 

Crypto Basics

Cryptocurrency is a digital currency intended to be used for buying and selling goods and services. Transactions from an online “blockchain” ledger are secured with complex algorithms to prevent fraud. At present, the number of retailers and outlets that accept cryptocurrency as a valid method of exchange is limited. The demand is often driven more by speculation than by actual use for commerce, resulting in significant swings in value.


Bitcoin and other cryptocurrencies are highly volatile investments with very little clarity into how they can actually be valued. Supply and demand rule the day for crypto pricing for the most part, without any real basis for fundamental valuation.

Given no obvious measure of value and only a modest change in crypto supply over time, the price fluctuates almost entirely based on demand for an alternative currency.

Cryptocurrency Crime—And Crackdowns

Cryptocurrencies are currently under government investigation as they relate to high-profile ransomware attacks. Cyber criminals now have a very effective—and increasingly liquid—way of being compensated for their efforts.

Governmental regulatory crackdowns are coming, which may be good for the long-term viability of the space, but are likely to cause significant volatility in the short run. For example, the Chinese government has taken steps to limit crypto usage, including telling banks they cannot be involved in such transactions. These steps may be to blame for the recent decline—approximately 50%—in Bitcoin’s value since peaking above $60,000 in April.

With that said, cryptocurrencies offer ample liquidity, and they may have some diversifying benefits, similar to gold for example. To be clear, our investment teams are not actively investing in, or viewing cryptocurrencies like Bitcoin, as a viable asset class at this time.

Blockchain Opportunities Outside Cryptocurrencies

However, several of our American Century Investments strategies do look for opportunities in companies and industries that actively utilize blockchain technology, which is at the leading edge of many banking, medical and other businesses.

In addition, there are several diversified exchange-traded funds (ETFs) available in the market today that specialize in investing in blockchain technology.

Weighing Cryptocurrency Risks

But, if your risk tolerance permits and you’re so inclined, I would suggest thinking of cryptocurrencies like any other commodity: highly volatile in pricing, subject to large daily swings, but ultimately not tied to any fundamental measure of value.

And so, at most, you could decide to allocate to cryptocurrency as much or as little as you would to any other individual commodity. Think to yourself: How much would I invest in corn futures? Or lean hogs? Is that number 0%, 1%, 5%?

But for a prudent tactical or strategic allocation, it’s likely no more than that. Investors would do well to consider their long-term goals before allocating a significant portion of a portfolio to cryptocurrency.

Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

Diversification does not assure a profit nor does it protect against loss of principal.


Is There a Disconnect Between the Stock and Bond Markets?

One issue hanging over financial markets right now is the apparent disconnect between stock and bond markets. Generally, the stock and bond markets move in different directions, but lately, prices have been rising in both markets. Does that mean one is right and one is wrong?

Our own assessment is that this binary right/wrong framing is short-sighted, and there are valid reasons for the two markets to go up simultaneously, even though that’s not what you might expect.

Market Recap

To understand the current state of confusion, consider that for roughly the last four or five months, stock and bond markets have both been rallying. Specifically, stocks have repeatedly made new record highs, while bond prices rose and yields fell (bond prices and yields move in opposite directions).

These conditions are important for what they tell you about the outlook for future economic growth. Stocks appear to be quite optimistic about the ongoing recovery, while bond investors seem to be positioning for an economic slowdown.

This is striking because over the last several years, stocks and bonds have tended to move in opposite directions. That is, they exhibit negative correlation. For context, it’s worth pointing out that the correlation of stocks and bonds over the long-term is effectively 0%. In plain English, this means that there’s been little or no obvious connection between stock and bond movements over the long term.   

Could Both Markets Be Right?

So far, we’ve presented it as a binary situation, where one market must clearly be right and the other clearly wrong.

For example, the bond market could be correct if the Delta variant continues to take a human and economic toll and disrupts the recovery. Or the federal government grinds to a halt over the coming debt ceiling negotiations. In those cases, then it may well be true that stocks have gotten ahead of themselves and will have to retrench.

On the other hand, the stock market could be correct—bond investors are failing to see the rapid and sustainable recovery in corporate earnings and the job market. If so, then bond yields need to rise (and prices fall) to reflect these stronger economic conditions.

Possible Explanations for the Stock/Bond Market Disparity

  • Different forecast time horizons? One argument we’ve heard is that bonds are reading the current environment, but stocks are more forward looking. That would imply that bonds are indicating a slowdown in the near term, while stocks are more optimistic about longer-term economic prospects.

    We don’t think that’s likely, however, because conditions are actually pretty good now, and arguably the longer-term prospects for growth and the economy are much less certain. So, I don’t believe forecast horizon is a good explanation for why stocks and bonds seem to be indicating very different future economic trajectories.

  • Do market technical factors explain the stock/bond split? Another argument is that outside interference—say, the Federal Reserve’s (Fed’s) massive bond purchase program—is breaking the old stock/bond relationship and leading to current conditions. Or it could be that both markets are in fact simply reacting to zero interest rates and an accommodative Fed.

    In other words, massive liquidity means both stock and bond prices move higher. We don’t buy this argument either—if investors were worried about overly stimulative monetary and fiscal policies, we would expect bond yields to rise, not fall.

  • Could it be foreign capital flows? It turns out that U.S. Treasury securities are relatively more attractive than other government bonds, so it’s possible that non-U.S. demand is throwing the markets out of whack.

    This theory also has the appeal of explaining the strength of the U.S. dollar so far this year. If this theory were correct, then both stock and bond markets would be vulnerable to a pretty severe correction over time. That is, both markets may be overly optimistic and therefore both could be “wrong.”

    These theories have some appeal. For example, according to U.S. government data, foreign purchases of U.S. Treasuries reached an all-time one-month high in March. But foreign accounts have been net sellers of Treasuries ever since. Add it all up, and we don’t think these factors alone are sufficient to explain the disconnect.

Which One Is Correct? It’s a “Couples Compromise”

I believe the answer could be that this is a classic “couples compromise,” where both are correct—to an extent. I think the most plausible explanation is that economic growth might be low or slow going forward, but positive. This makes sense as we emerge from the depths of the pandemic-related shutdowns and the economy makes quick strides toward recovery. Now that those early gains have been achieved, it is only reasonable for the recovery to enter a slower, more mature phase.

Corporate earnings, however, are growing at a much faster clip than the economy. This isn’t that surprising. Since 1990, corporate profits have doubled the rate of growth of gross domestic product (GDP). The reality is that corporate earnings are much more volatile than economic growth as a whole.

We can explain the difference by looking at the fundamental drivers of economic and profit growth. Consumption (consumer purchases) account for about two-thirds of GDP. And personal income/consumption is expected to slow significantly next year. Corporate earnings, on the other hand, are much more reflective of international growth rates and corporate taxes than they are of U.S. GDP growth in isolation.

We Believe Both Markets Are “Correct” in Their Assessment of Future Conditions

Stocks are focusing on double-digit corporate earnings growth that seem to defy the more subdued economic forecasts. Bonds, on the other hand, are anticipating much more modest overall economic growth—maybe 1-2% real GDP growth going forward.

The markets are pretty clear in what they’re calling for, and that is decelerating economic growth going forward, but relatively stronger corporate earnings growth.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

Get perspective on rising interest rates and other market considerations.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.