Earnings, Inflation and The Fed

Fall is here, which in our house means outdoor excursions, watching football and traveling to ninja warrior competitions for my older two boys. On that note my 14 year old son, Tate, was picked for season 3 of American Ninja Warrior Junior. This show airs on the Peacock Network, which is NBC/Comcast Universal's streaming service. He is on episode 7 which is streaming now and after winning his group he will be on again for episode 12 next month. Tate finished 2nd place on season 1 and 3rd place on season 2.

That said, there is a lot happening in the financial markets so let's take a quick look at a few of the important developments.

Third Quarter Earnings

The S&P 500 hit a high this past week after recovering from a challenging September. We are heading into the heart of earnings season and so far companies have reported a mixed picture. Demand has been very strong, especially on the consumer side with households flush with cash. However, the supply side is a different story. Supply chains are a mess, both here and around the world. Product and labor shortages are continuing to be a problem for businesses. Over the last month companies like Nike, Honeywell and Lockheed Martin have slashed revenue forecasts due to these challenges.

This week is important as the big tech companies report earnings. Their results will go a long way towards determining if the recent market rally will continue.

Inflation

The Consumer Price Index (CPI) increased 5.4% year-over-year continuing a trend of prices rising at the fastest pace in over 30 years. From Marketwatch:

Broad shortages of labor and supplies are raising costs for companies and the are charging customers higher prices to maintain their profits. These shortages in some cases have gotten worse and there’s little end in sight. The ongoing bottlenecks have forced the Fed to reconsider its view that inflation was “transitory” and would fade by the end of the year.

Chairman Jerome Powell recently conceded inflation would stay higher for longer than he had expected. And Atlanta Federal Reserve President Raphael Bostic said central bank officials should stop calling inflation transitory.

Virtually everyone has seen surging prices for food, clothes, gasoline and housing. If you look deeper, shipping container costs have risen six-fold from last summer and natural gas prices have doubled from last winter as the charts below show.

A measure of investors’ inflation expectations over the next five years has risen to 2.91%, its highest level since 2005. This expectation is not high enough to be alarming, but many economists do not want to see this rate continue the rapid accent from the last 18 months.

The Federal Reserve

Fed Chair Jay Powell said Friday that it is time for the Fed to taper (aka reduce) their monthly asset purchases. They have continued buying $120 billion of Treasury Bonds and Mortgage-Backed Bonds monthly. This program was implemented in April 2020 as Covid was shutting down the economy. We believe the Fed should have done this a long time ago. This activity, along with the massive government spending that has taken place, has thrown gasoline on the inflation fire. Only recently have more Fed policymakers acknowledged they are concerned that inflation has been much higher, and for much longer, than their original forecasts.

A risk to the market that we are watching closely is if the Fed has to get more aggressive in 2022 in withdrawing their asset purchases and then follow that with multiple interest rate hikes. Since 2008, the stock market has seen declines ranging from 10%-20% when the Fed has been more aggressive than expected.

We will continue to exercise some caution in our client portfolios over the next month as more companies report earnings and the Fed shares the details of their plan to taper their asset purchases. That said, consumers are flush with cash and retail sales have been very strong. We were able to capitalize on some great investment opportunities on the stock sell-off in the first quarter and will keep our eyes open for more opportunities if there is a significant market decline in the next few months.