Higher and Higher

The G7 Summit kicked off today in Great Britain. Atop the agenda is rebuilding the Western alliance and dealing with China. It’s a tall order in the theme of returning to some normalcy. The problem is: What’s normal anyway? The post-Covid world is certain to be different. The pressures and trends already in place seem to have accelerated in speed during the pandemic. The reopening is proving that true too.

The Stock Market seems to be ok with all of the ongoings. The S&P closed the week at a fresh, all-time high. There has been quite a bit of corrective price action below the surface over the last couple of months. It’s been recalibrating the expected surge in growth from recovery while factoring in the inevitable inflation. The threat of inflation has been a drag for stocks. Heading into this week, all eyes were on the Consumer Price Index report. Everyone knew it was going to be big. The only questions were how big and for how much longer? It was indeed big, bigger than expected. Consumer prices soared 5% in May compared with a year ago, marking the biggest monthly increase since the Great Recession.

Pricing pressures have been significant friction for stocks, particularly in Tech, all Spring. But not this time. Something changed. The Tech-heavy Nasdaq re-took the leadership position this week, as the Growth trade outperformed Value. Rising inflation weighs heavy on corporate profits, reduces purchasing power and triggers fear of higher interest rates. That’s not being felt this time around. It’s the opposite. The high inflation number is being absorbed quite well as the Market appears to be looking past the now and doesn’t seem to fear what it sees later in the year. There was a big rally in the Bond Market in the wake of a hotter May CPI report. Interest rates fell. That’s new. Inflation worries may have peaked. It just may prove to be transitory, just as the Fed said. We won’t know for a few months at the earliest and likely a tad longer, but the Market seems to agree with the Fed. It’s taking it all very much in stride. The thing is, the Market rarely sells-off on the same news, especially when the news is well anticipated.

The Bond vigilantes retreated. After calling the Fed’s bluff all Spring, the Bond Market backed down. The sentiment in the Bond Market is the most bearish it’s been in a decade, since after the taper tantrum in 2013. It just got too crowded, in other terms: too many participants have been expecting higher rates and lower prices. When everyone leans on one side of the boat, it tends to tip. The Bond Market tipped in the Bulls’ favor, driving the yield on the 10-Year Treasury to below 1.5%. In addition, foreign investors have rushed into Treasuries on the back of a weaker Dollar. It’s never been cheaper for foreign banks to hedge their Dollar positions. As low as interest rates are in America, they’re even lower overseas. If you missed the refi cycle for your mortgage, you just got another chance.

After the extended lockdown, the reopening of America is inherently inflationary. Travel and leisure prices had nowhere to go but up. Supply chain bottlenecks and labor shortages have also contributed to higher prices. Supplies cannot meet the pent-up demand. The Semiconductor shortage led to a 7.3% increase in used car prices following a 10% surge in April. That was the largest increase in nearly 70 years. But it’s really a one-time thing. The average American doesn’t buy a car every month. As the economy recovers, rising costs will continue until supply chains and consumer demand recalibrate. There is such a thing as manageable inflation. It happens when it’s temporary, or as the Fed puts it, “Transitory.” Keep in mind, these inflationary numbers are compared to the washed-out levels from a year ago. When you compare to 2 years ago, Consumer Prices increased 2.5%. That’s just above the Fed’s targeted level, one that they are prepared to let run hot. Gas prices are only up 7 cents when you compare to 2019. It’s all a matter of context. And the reopening only happens once.

Price matters. It always has and it always will. Companies are facing higher costs. They see it in commodities, labor and distribution. They’re passing it on to customers. Retailers have already raised prices. Hotel rooms have gotten more expensive. Flights are pushing $1,000… in coach! Restaurants are charging more for the menu. You know about food costs rising. Even the price of mayo is higher. Mayonnaise is often made with soybean oil, which has been in tight supply.  The Soybean Market is so tight that some supplies typically destined for human consumption are being redirected to livestock. China has been hoarding huge supplies to feed its expanding hog herd. We are all about field research. The cafe at our office building just raised sandwich prices from $6.75 to $9. And it’s still empty. Office buildings from Coast to Coast are like ghost towns. It’s definitely not the case in malls and other shopping and dining areas. They’re packed. Americans are out and about and spending. Apparently, they’re just not going to the office.

An ongoing issue that continues to concern us is the fraying of free markets. Price discovery has been distorted. The Fed and Washington rushed to the aid during the pandemic in heroic fashion. It worked. Unfortunately, from our vantage point, they’ve overextended their presence. The Fed and other central banks firmly have their feet on the front end of the curve, keeping it near zero. They’ve taken the Bond Market away from retired investors seeking a safe stream of income. They’ve also inflated assets. The price of money is cheap, really cheap, which has bid up asset prices big time. It’s happened in the Stock Market. It’s happened in housing. Cheap money has been chasing assets and inflating prices. When’s it going to end? Something’s got to give, and it might be sooner than you think. A Reuters survey highlighted expectations for the Fed to announce a QE taper in August or September. To announce. The belief is that the Fed will not actually reduce purchases until early next year. This, as the Fed balance sheet topped $8 Trillion this week. It’s never been this high before, ever. Its assets have doubled since March 2020. Compared to all of American history, the speed and size of the financial support from both the Fed and Washington in response to the Covid crisis has no peer. Uncharted territory we’re still in.

For those of you paying close attention to the Washington political games and prospects for infrastructure and higher taxes, here’s an update on what we’re hearing from our Washington sources:

Democrats have been sparring internally as the infrastructure talks drag. President Biden has been pushing for a bipartisan bill, but thus far what Senate Republicans have proposed has been deemed a non-starter. Just yesterday, while the President was in Great Britain, a bipartisan group of 10 Senators reportedly reached an agreement on an infrastructure proposal. Details were sketchy. It’s believed that the deal proposes either $974 Billion over 5 years or $1.2 Trillion over 8 years and includes $579 Billion in new spending. This agreement is believed to not include any formal tax increases, but instead proposes indexing gas tax to inflation. The Gas Tax has not increased since 1993. This is significant because it would violate President Biden’s pledge not to raise taxes on those earning less than $400K.

Our sources say the “Progressives have become increasingly anxious about the lack of progress on their agenda and are pushing the White House to ditch talks with Republicans and move an infrastructure/tax bill on a party-line vote via reconciliation.” A key question is whether enough Democrats would sign on to a bipartisan bill or would the progressives kill a bipartisan compromise because it is insufficiently progressive. Some inside the Beltway argue that Progressives should take “half a loaf” versus getting nothing at all. “The risk to them is that if Congress passes something similar to the bipartisan deal, then it will make it harder to keep the party united to pass a nontraditional infrastructure bill which would include many progressive priorities. Also, progressives may have to walk away from a compromise in order to show that their votes cannot be taken for granted and to preserve their political clout.” So not only is there strong division between Democrats and Republicans; Democrats are divided amongst themselves.

Regarding a tax increase, it’s our sense that a compromise tax hike is still likely. The longer the process goes on, the greater the risk to Democrats that they will be unable to pass a tax hike. Yesterday’s bipartisan agreement likely did just that. Republicans know it. Democrats know it. It’s all part of the political dance in Washington. What would a capital gain hike look like? From our sources: Congress will probably compromise on the Biden proposal and increase the capital gains tax rate but not to the level originally proposed. 28% seems likely. And equally important, the effective date is not likely to be April 28th, which was proposed by the White House.

There’s so much going on. We’re all over it.

Have a nice weekend. We’ll be back, dark and early on Monday.


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