Inflation, Tightening, & Taxes
There are several reasons for the lack of market direction and daily swings since early May. Most of these are ongoing themes, but there have been new deployments which bear mentioning:
1) Inflation: The Fed has frequently used terms such as “transitory” and “base effects” to convince the investing public that the increase in inflation will not last or swing beyond the Fed’s control. However, as we pointed out last month, the Fed is walking a tightrope and this is going to be tough challenge. Core Personal Consumption Expenditures, which is the Fed’s preferred gauge of inflation, increased faster than expected for the 12 months ended April (3.1%). The more publicized number, the headline Consumer Index (CPI) rose 4.2% for the 30 days in April, almost three-quarters of a percent above expectations. The consensus view is that inflation numbers will get worse before they get better.
2) Fed policy: We discussed this in detail in last month’s issue. The central bank’s approach is certainly a cause for market consternation. The big questions is, “when will the tapering of stimulative bond buying start?” At this point, it looks like it won’t be until later this year. The Fed is proceeding conservatively, which is consistent with past Feds. Digging deeper into that point, Richard Bernstein Advisors put out an interesting special report recently. It asks if the current Fed’s lagging policy will lead to them losing control of inflation like the 1960s and 1970s. We don’t see a double-dip recession and 20% money fund yields like in the days of Fed Chair Paul Volker of course, but it doesn’t have to get that bad to cause market volatility. We expect Fed participants to float the idea of tapering their bond buying at their June meeting (later today), but no action. They will get into further details in July and potentially Wyoming symposium or at their regular September meeting. Since all of this is well publicized, we do not expect a “taper - tantrum” like the one we saw in 2013. But as we move forward, the equity markets will still be wondering if the Fed has done enough and quickly enough, to keep inflation under control.
3) Taxes: Normally the threat of higher taxes, such as what the Biden Administration has proposed, would cause pockets of the stock market upheaval. After all, increases in capital gains, corporate and individual tax rates (even if it’s only for high earners) will potentially affect a majority of Americans in some way. But the markets have not reacted as negatively as you would think for several reasons. First, it is quite clear already that any tax rate increases will be more modest once they go through the Congressional meat grinder. Second, it is important to remember that a large percentage of assets in the equity markets are removed from the clutches of the taxman such as 401Ks, IRAs and other tax deferred plans.