— 2020 Q3 UPDATE —
As the Presidential election draws nearer, it is important to understand that the political landscape is much more noise than signal when it comes to making investment decisions. If you can block out the political noise, history has shown that if you are invested in the stock market, you’ll likely be rewarded with long-term returns.
Summary:
Will the United States election outcomes affect the markets and your investments?
Despite the economic closures and unemployment that resulted from the COVID-19 pandemic, by all available economic indicators, it appears the economy is recovering in a shape that resembles a V. The vital signs of the economy are complex.
The Federal Reserve (Fed) is employing a new inflationary targeting strategy; even though it is a minor shift in policy, it will cause changes throughout the financial markets and real economy moving forward, making the Fed’s future activities worth paying close attention to.
Read on for our full Q3 market update and how these factors could impact the economy and your investments…
Presidential Elections & Market Performance:
*Disclaimer*: K2 Financial Partners takes no political stance as an organization. Any political biases that may or may not come out in the writing of the section is the Author’s own biases and the Author’s alone.
As the Presidential election comes closer it can be easy to feel like the inherent anxiety surrounding the political landscape will directly translate to the financial markets. Rationally, it makes sense there will be a clear dichotomy between a positive outcome and negative outcome for markets depending on which of the two political parties are elected to govern next. However, as rational as this may be, over the course of approximately the last 90 years, whichever party has been in power has not really been a good estimator of future stock market returns.
Source: Dimensional Fund Advisors
Considering the consistent ideological and public policy differences between the two parties throughout the course of history, how could it be possible that different administrations are not a good estimator of future returns?
We believe there are two main reasons:
First: Financial markets reflect the sum knowledge of all its participants. This means current prices reflect the estimated probability distribution of the potential outcomes from the election. Therefore, whatever the outcome of the election should already be priced in to the market in relation to the estimated probability of that outcome happening and the conditional probability of how that outcome will affect the valuation of an asset.
Second: There are countless other factors that affect the financial markets regardless of which party controls the White House. Everything from a global health crisis, global monetary policy decisions, new technological breakthroughs, oil price changes, and countless other factors can affect markets. Any political administration, whether it is the United States or another country will not have direct control over the myriad of factors affecting financial markets. Even the most powerful seat in the world cannot come close to overwhelming all the other factors that come into play in a globalized financial marketplace. Administrative policies across the globe are constantly influencing the relevant factors that our domestic administration is influencing. In other words, even though an election year may seem like a large deciding factor in estimated future returns, it has generally been a bad predictor because government policy and politics at large are generally much more noise than signal. This is the main reason that many stock market investors who have been able to block out the noise of elections have been historically rewarded with long-term gains from staying invested.
Source: Dimensional Fund Advisors
With those points being made, it would be naïve to say that the administration elected will not influence the markets directly through their policies. Taxes, fiscal spending, regulations, foreign policy and many other decisions will directly affect citizens and companies which will inevitably affect the financial markets. They will also have some level of influence over the exogenous variables they cannot directly control with policy because the variables their policies do directly affect may be variables that also affect other areas. Therefore, whichever administration that comes into office will make ripple effects throughout the global financial markets but that will not be the result of the election. The ripple effect will be the result of long deliberation over different policies administrations will implement over time. That is why it is important for investors to analyze the policies that administrations put into place while they are in office and equally as important to realize that the effects an administration makes will not take place on election night, but over the course of 4-8 years of policy decisions (i.e. In our opinion, there is not any reason to panic sell if the candidate you want to win does not win!)
Regardless of which administration is in power, the United States government and the United States as a whole has been and will continue to be a significant player in the world economy. A new administration is not the same thing as bringing or removing a whole country from that stage it has already been operating in. Therefore, whichever administration is elected in November will probably result in minor changes in financial markets, but those changes probably will not be cataclysmic.
Bottom line, we believe the outcome of the election will not be a black swan event that shocks financial markets (similar to Covid-19.) Market participants have already been valuing assets based on the probability of which party will win and the United States President is only one of countless factors that affects financial markets. Therefore, it is important to understand that the political landscape is much more noise than signal when it comes to making investment decisions. Regardless of who has held the Presidency, over the last 90 years, many of the investors who have blocked out the political noise have been rewarded.
V-Shaped or K-Shaped Recovery?
It seems like half of the alphabet has been thrown in front of the phrase “Shaped Recovery” since the beginning of the pandemic. Would it be a V, W, K, L or maybe it would be the new 27th letter of the alphabet! All jokes aside, by all available economic indicators it appears the economy is recovering in a shape that resembles a V. Below are indicators that are considered akin to the vital signs in the economy.
Source: Yardeni Research
These three lines combine to create total business sales which is known as Manufacturing & Trade Sales. As you can see below, the year-over-year changes in business sales is an excellent leading indicator of GDP.
Source: Yardeni Research
These graphs make it relatively clear that the economy at large is experiencing a V-shaped recovery. Since this is relatively clear based on the data, why has there been a lot of talk about a K-shaped recovery and what does a K-shaped recovery mean?
A K-shaped economic recovery means that there is a split in the recovery process between different groups. A true K-shaped recovery would have one category heading in a negative direction whereas another heads in a positive direction. It has generally been used to talk about the economic recovery for the wealthy versus the poor, however, it can apply to other areas of the economy as well. For example, below is the performance of the FANG (Facebook, Amazon, Netflix, and Google (Alphabet) performance since the end of 2012 against the S&P 500 as a whole and the S&P 500 with the stocks removed from the index.
Source: Yardeni Research
If we take the Y-axis from the graph above into account, the divergence between the FANG stocks and the S&P 500 sort of resembles the shape of the letter K. However, it is not what is truly meant by a K-shaped recovery because the S&P 500 has had a positive return, although sluggish in comparison to FANG stocks. This shape would resemble something in between a K-shaped and L-shaped recovery. When a K-shaped economic recovery is mentioned in context of the pandemic, it is the same concept as above except it is being applied towards different levels of wealth, different levels of income, different levels of education and so on.
Which one are we currently experiencing, a K-shaped recovery or a V-shaped recovery? Well, it depends on the perspective taken with the situation and how an economy is categorized. In the graph above, there is a clear divergence between how the FANG stocks have performed versus the S&P 500, but that still would not be considered a K-shape.
The main issue with classifying an economic recovery as a certain shape is that at every further level of granularity that is investigated, in almost any area of economics, you can find divergence from the mean. For example, according to the U.S. Bureau of Labor Statistics, as of September, 2020, the unemployment rate is 7.9%. This figure is simply the average of any mix of categories that you can break the labor force down into. The labor force can be broken down into education, race, gender, age, experience, etc. Each one of these categories will add up to the same unemployment rate for September, 2020 but each category is likely to be a different unemployment rate that is also changing at a different rate than the whole.
For example, the unemployment rate is 7.9% and we break the categories down by occupation. If there are 20 different occupations and it looks like there is a V-shaped recovery happening in this hypothetical economy. However, only 17 of them are seeing higher employment rates but 3 of them are in worsening labor conditions. In this example, it is difficult to say whether it is truly a K-shaped recovery and not a V-shaped recovery because they are fundamentally linked together and the answer changes based on how the aggregate is broken down. Therefore, to answer the question of whether we are experiencing a V-shaped or K-shaped recovery, the appropriate answer should simply be; “it depends on how we are categorizing the economy.”
Federal Reserve’s New Inflation Mandate:
Since the 2008 financial crises, the Federal Reserve (Fed) has been one of the most closely watched institutions by investors because of the outsized impact they have had on markets through conducting monetary policy. The Fed has a “dual mandate”, of maximum employment and price stability. However, the interest rate they target doesn’t directly affect the inflation rate. Instead, different interest rates change behaviors throughout the real economy and financial markets to incentivize certain activities.
In order to understand why it is important that Fed changed their inflation target, it is important to understand what each mandate actually means on a standalone basis.
The first mandate, maximum employment, does not mean 100% employment because there is a “natural unemployment rate” that has to do with natural friction within the labor market. This mandate stands alone because it is not something the Fed can directly affect through their tools. It’s a derivative of many different factors in the economy, but they can indirectly influence the unemployment rate through the use of open market operations such as interest rate changes and quantitative easing.
The second mandate of price stability can only occur if inflation is stable, which is best described through an example. If a pack of gum costs me $1.00 today, but the inflation rate is 100% per year, then the price of gum will double by next year which would be the antithesis of stable prices. Unstable prices in an economy is a recipe for disaster in an economy for a myriad of reasons, a list of reasons too long to dive into right here. Overall, the two mandates are relatively straightforward on their own. However, the complicated part is understanding how the Fed aims for these mandates and understanding how these mandates are intertwined in the economic engine.
The unemployment rate and inflation are not something the Fed has complete control over in the same way the government has control over how much they spend every year. The Fed does not have a button they can push to raise the inflation rate and they cannot lower the unemployment rate by forcing businesses to hire employees. Instead, they have an indirect process through the use of different tools, a lot of these tools we went over in the Q2 2020 update(we will link this to that update). Their main process for reaching their dual mandate is through targeting interest rates in hopes of reaching a point target inflation rate of 2% (which changed this quarter). This means that whenever inflation was above (below) 2%, the Fed would raise (lower) interest rates, they were always aiming for a point target. Later in this section we will explain how this changed this past quarter.
According to James Bullard, President and CEO of the St. Louis Fed, the reason the Fed has come to target an inflation rate rather than an unemployment rate to achieve their dual mandate is, “Over the years, many policymakers across the globe have found that price stability is the only mandate needed. Central bankers have found that other goals fall into line when the target for inflation is being met.” This means that the first mandate, maximum employment, is a derivative of stable prices and it means that the Fed changing their inflation targeting policy is akin to them changing their only real mandate they possess; in other words, it is pretty important.
Let’s see why this single target of stable prices might work for the dual mandate and then we will go over the changes to the Fed’s policy.
Example (this is a reductionist example in order to illustrate a point):
If the economy is below a 2% inflation rate, the Fed will want to raise inflation. They will attempt to accomplish this by lowering the interest rate to the level they deem necessary. In normal economic conditions where corporate focus is on profit maximization instead of debt minimization, this will spark demand for loans from corporations. Since interest rates are lower, the cost of capital will be lower for companies and more projects will be deemed potentially profitable investment opportunities because the projected return on invested capital (ROIC) will be greater than the costs of capital more often. As these corporations invest their borrowed capital, they will most likely hire more employees to drive forward their expansion. This increase in employment will increase the amount of money that consumers have which will increase aggregate demand of goods and services. This shift in the demand curve from consumers should increase the general price levels of the economy as long as it increases faster than supply does. This increase in price level is inflation. If this increase in inflation actually increases the rate of inflation to the desired target, then the Fed has accomplished their goal.
In our opinion, the Fed hopes the chain of events will look like this:
Fed lowers interest rates -> corporations borrow because it costs less to do so -> increase investment into the real economy because more projects are deemed potentially profitable -> new workers are hired to execute new projects -> increased employment increases money in consumers’ hands which increases disposable income -> increased disposable income from consumers leads to increase in aggregate demand for goods and services -> increased aggregate demand leads to inflation.
In this example, the Fed was able to reach their dual mandate by simply tweaking the interest rate. The Fed hopes this chain of events will turn into a feedback loop where increased aggregate demand from consumers leads to increased profits for companies. These extra profits are reinvested into the economy and further investment by corporations can happen naturally without extra borrowing. Expansion should lower unemployment which will hopefully lead to inflation until the Fed reaches their threshold of 2% annualized inflation and then they reverse the process by raising interest rates. The firms that became profitable during the lower interest rate borrowing period will typically survive and the firms that cannot survive the raise in interest rates will typically die off. This process should lower inflation as the unemployment rate increases and aggregate demand drops.
Previously, this process of point inflation targeting has been relatively straightforward. If inflation is above (below) 2%, interest rates are raised (lowered) to slow (speed up) economic activity.
There has been a growing problem with this process though. The Fed has had to consistently lower interest rates to reach the same inflation rate and there is a lower bound to how low interest rates can go (roughly zero or a bit lower).
Below is the year-over-year quarterly change in the PCE (Personal Consumption Expenditures) which is the inflation measure the Fed uses to gauge policy. There is a clear downtrend from 1990 towards today.
Source: Brookings Institute
This is the 3-Month Treasury Bill rate which is the interest rate the Fed has the most direct control over with their open market operations.
Source: FRED
This is the 10-year and 30-year Treasury maturity rates which are typically an indication of estimated future nominal economic growth. However, with inflation expectations being in secular decline, nominal growth is naturally in secular decline as well (nominal = real + inflation), which means that whole yield curve is being pushed down.
Source: FRED
Another factor pushing long-term interest rates down since 2008 is the Fed’s Quantitative Easing programs which allowed the Fed to inject liquidity, reduce toxic assets on firms’ balance sheets, and lower long-term rates such as mortgages. Below you will see how the Fed has grown its balance sheet over time through quantitative easing.
Source: J.P. Morgan
This persistent undershooting of inflationary targets combined with the Fed heading directly towards the lower bound short-term interest rate has led the Fed to change their policy.
They will no longer use their previous strategy in which Brooking’s Institute says, “some economists call a “bygones” strategy, meaning it does not try to make up for past misses.” The new strategy is an average inflation targeting strategy which according to Brooking’s Institute, “implies that when inflation undershoots the target for a time, then the FOMC will direct monetary policy to push inflation above the target for some time to compensate.” This is a major change in monetary policy because it gives the Fed more flexibility in allowing the economy to steam forward when it has inflationary pressures.
With the Fed allowing the inflation rate to stay above 2% for extended periods of time, they are doing two things. First, they are adjusting inflation expectations for market participants which is one of the most important factors in producing realized inflation. According to Rob Rich, Director of Cleveland Fed’s Center for Inflation Research, “Inflation expectations are what people expect future inflation to be, and they matter because these expectations actually affect people’s behavior.” Second, they are giving themselves flexibility to raise interest rates without worrying about pushing the economy towards deflation, which can be more dangerous for an economy than moderate inflation.
Understanding the reasoning behind the Fed changing their policy is important but it is just as important to understand what this means for investors. In the short-term, it probably means that it will be harder to gauge when the Fed is going to change interest rates because they have not been clear as to what time period they want inflation to average to 2%. For example, if they want average inflation to be 2% over a 5-year period that will change the math of when they change interest rates versus if they want a 3-year period. Medium-term, the change means they are going to let the economy heat up for longer periods of time before raising interest rates than they did before and inflation will be allowed to go above 2% (they have not been clear about a ceiling for how high they would let it go). Long-term, it is difficult to make predictions about how this will affect the markets and real economy long-term without a clear timeline and inflation ceiling. However, basic economics says, increased inflation automatically increases the opportunity cost of cash holdings because the value of a dollar will decrease more over time. Increased inflation hurts lenders as well. For example, if I lend you $1000 at a 5% interest rate for 20 years the $50 I receive back a year is going to be worth less each year because of inflation. Therefore, higher inflation rates could reduce the willingness of lenders to lend long term.
Overall, it is important to watch how the Fed decides to enact this new policy throughout time. Even though it is a minor shift in policy, it will cause changes throughout the financial markets and real economy moving forward.
Conclusion:
Here at K2 Financial Partners, our advisors’ main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when the political noise gets turned up. This is why it is important to have a well-diversified portfolio and CONTACT your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!
SOURCES:
[1] James Bullard, “A Look at the Fed’s Dual Mandate,” Open Vault Blog, Federal Reserve Bank of St. Louis, August 8, 2018, https://www.stlouisfed.org/open-vault/2018/august/federal-reserve-dual-mandate
[2] Dave Skidmore, “The Fed’s review of its monetary policy strategy – and what Brookings’ scholars have to say about it,” Brookings Institute, August 12, 2020, https://www.brookings.edu/blog/up-front/2020/08/12/the-feds-review-of-its-monetary-policy-strategy-and-what-brookings-scholars-have-to-say-about-it/
[3] Dave Skidmore, “The Fed’s review of its monetary policy strategy – and what Brookings’ scholars have to say about it,” Brookings Institute, August 12, 2020, https://www.brookings.edu/blog/up-front/2020/08/12/the-feds-review-of-its-monetary-policy-strategy-and-what-brookings-scholars-have-to-say-about-it/
[4] Rob Rich, “What are inflation expectations, and why do they matter?,” Cleveland Fed Digest, Federal Reserve Bank of Cleveland, May 28, 2019, https://www.clevelandfed.org/en/newsroom-and-events/cleveland-fed-digest/ask-the-expert/ate-20190528-rich.aspx
https://www.stlouisfed.org/open-vault/2018/august/federal-reserve-dual-mandate
https://www.yardeni.com/pub/mtsales.pdf
https://www.bls.gov/news.release/empsit.t04.htm
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.
S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. Investors cannot invest directly in an index.
Gross Domestic Product (GDP) is a measure of output from U.S factories and related consumption in the United States. It does not include products made by U.S. companies in foreign markets.
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. The Federal Reserve System is composed of 12 regional Reserve banks which supervise state member banks. The Federal Reserve System controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Deflation is the decline in the prices of goods and services. Generally, the economic effects of deflation are the opposite of those produced by inflation, with two notable exceptions: (1) prices that increase with inflation do not necessarily decrease with deflation; (2) while inflation may or may not stimulate output and employment, marked deflation has always affected both negatively.