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Inflation and The Federal Reserve

Inflation and The Federal Reserve

Published on February 14th, 2022


Financial Market volatility continues in February, with significant drivers of the recent financial market decline including higher inflation and concerns that the Federal Reserve will need to remove policy accommodation in a more aggressive fashion. The inflation report last Thursday was higher than economists had expected. It does suggest the Federal Reserve may have to hike interest rates more forcefully in 2022. Prior to the inflation report, the Treasury market had priced in 5.5 rate hikes, and in the last few days that has increased to 6.3 rate hikes.

While Federal Reserve Chairman Powell said as recently as mid-November that the inflation America is experiencing was likely transitory, the Federal Reserve has apparently shifted in a few short months to a point where it is considering a 50-basis point increase at its next meeting (March 16), as noted by Federal Reserve member Bullard last week. By that date the Federal Reserve should have seen the February monthly inflation report and employment report. The Federal Reserve should also release its Summary of Economic Projections at the March meeting, where it is expected to update its own forecast of year end interest rates. This forecast suggested 3 rate hikes in 2021 when it was released in December. We believe it is likely to show at least 5 to 6 rate hikes when it is updated in March.

The issue, as always with the Federal Reserve and rate hikes, is that the impact takes a while to flow through the economy. For this reason, the Federal Reserve does not know the impact of its action right after a rate hike; it can take up to a year to discern. This means that the chances of making a mistake can be high. Investors are concerned that the Federal Reserve will push the economy into a recession with too many rate hikes – something that may not be known until well after the fact.

We can see this concern by looking at the Treasury curve. Normally investors like to see a steep yield curve, which reflects a healthy, growing economy. Focusing on the 2yr to 10yr treasury spread, at the end of November, this spread was 100bps but has since fallen to 44bps. Over the last two days it flattened by 15bps, a large move. When investors talk about an inverted yield curve, they are usually talking about this 2–10-year spread being negative. So, this is something we are watching closely since inverted yield curves sometimes predict an impending recession.

It is important to note, however, that all of this is occurring in the backdrop of what we believe to be a very strong economy. In the fourth quarter of 2021 GDP saw 6.9% growth, and not only were an impressive 467,000 jobs created in January, but the employment numbers for November and December were revised higher by a cumulative 709,000 jobs created.1 In addition, over 15 million vehicles were sold in the U.S. by automakers in January2 and purchasing manager indices were at levels consistent with solid economic growth.3 January’s strength is notable because it is when the Omicron wave appears to have peaked. One could therefore imagine that the economy might accelerate in the coming months as the Omicron wave recedes. While the Federal Reserve may remove accommodation faster than investors had been expecting, the data show that the economy may be robust enough to handle the tighter financial conditions.

Along with the Federal Reserve’s change in monetary policy, the U.S. economy may be in the process of shifting from early cycle to midcycle. The shift to midcycle suggests improving our equity portfolio’s overall quality, as well as potentially reducing the overall beta. Quality companies by our definition have competitive advantages, high returns on capital, strong balance sheets, trustworthy management, and can compound intrinsic value over time. As the Federal Reserve gradually reduces support for the economy, it is our contention that this matters more for lower quality companies, while higher quality companies can thrive regardless.

We regularly evaluate the companies in our equity portfolios against their ability to withstand a variety of risks, including inflation and tighter monetary conditions. As long-term investors, we tend to favor companies which have strong balance sheets and generate abundant free cash flow, reducing their need to access the capital markets for financing their operations. Regarding inflation, we believe it is important that a company can pass along higher costs they may be experiencing so that they do not experience a margin squeeze. Generally, strong competitive advantages enable companies to do this.

Some investors have asked us whether we might seek to hedge against inflation by owning gold or cryptocurrency. We generally have avoided these investments and consider them as separate asset classes. Cryptocurrency investors had hoped that their investment would offer an uncorrelated asset, but we have seen recently that Bitcoin, for example, fell just as hard as many high-flying Nasdaq stocks so far this year. Gold has declined slightly so far this year. And we have observed over the past two decades that changes in the price of gold have not been correlated with changes in the core CPI, a measure of inflation.

This shift from early to mid-cycle, accompanied by a more aggressive Federal Reserve and greater volatility in the stock market, is a typical progression for our economy as the expansion matures, and not overly concerning to us. We believe the evidence is in favor of a self-sustaining economic expansion, propelled by robust growth and a waning Omicron wave. As always, we continue to seek out all evidence which might suggest a more defensive posture is warranted. We will continue to tweak our equity portfolios as needed in favor of quality and somewhat reduced risk, but for now believe the economy should be our friend.


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