Arguably the most important man in America right now isn’t Joe Biden.
It’s Jay Powell, Chairman of the Federal Reserve.
September is traditionally a month that underperforms the market. Since 1945, according to CFRA, the market has declined by an average of 0.56% during September. The Stock Trader’s Almanac also claims that the S&P 500 averages a 0.4% decline in September, the worst of any month. As we’re firmly in the back half of September, we’re essentially in the eye of the hurricane- i.e., the part of the month where most of these losses take place.
This September, though, appears to be even more gloomy than usual.
Despite COVID numbers that appear to be receding, the virus is still here. It continues to evolve while significantly threatening economic recovery. Meanwhile, we could be seeing a Lehman Brothers situation play out right before our eyes in China, with Evergrande on the verge of defaulting on $300B of debt.
But beyond this, Jay Powell has his hands full within the country. Inflation is still hot, and despite what could be encouraging progress, the U.S. has a debt ceiling crisis that could cause the country’s first default in history. Meanwhile, we have a labor market that is nowhere near recovered amid many questions about how hawkish or dovish the Fed needs to be.
On Monday, September 20, the indices saw their worst sell-off in months. It was the Dow’s worst sell-off since July, with a dip as much as 972 points, or 2.8% on the day’s lows. Both the S&P and Nasdaq also saw their worst declines since mid-May.
Yet after that, the Fed’s September 21-22 policy meeting put investors more at ease. Tapering is inevitable, but the question is how aggressive. Interest rate hikes are also not imminent, and investors like that. The market clawed back much of Monday’s losses, largely thanks to Jay Powell’s statement.
Yet we’re nowhere near out of the clear. The Fed has had its hands full this month and will continue to do so. So let’s go through this challenging September, and break down what the Fed’s had to deal with and what it should still continue to deal with.
What Was Decided During the Fed’s Latest Policy Meeting?
The Federal isn’t ready to outright stop its stimulus or asset purchasing program just yet. However, it may change soon and gradually.
According to the Fed’s policy update from September 22, if the economic recovery continues to progress as it anticipates, the Fed “judges that moderation in the pace of asset purchases may soon be warranted.”
If you had to place a bet, that would mean that tapering could likely begin as soon as November or as late as January. Yet, according to Seema Shah, chief strategist at Principal Global Investors, the market may have already priced in a policy change.
The most important announcement, though, was arguably the Fed’s thoughts on hiking interest rates. It flat-out said that rates could rise as early as next year instead of waiting until 2023 as previous forecasts called for.
Investors clearly appreciated this announcement, as all of the major indices saw some nice gains. The S&P 500 adding nearly 1% and snapped a four-session losing streak. The Dow also added more than 300 points, or 1%, while the Nasdaq rose by roughly the same.
Yet, we are nowhere near in the clear, and the Fed still has many issues to deal with. At home and abroad.
1. Does the Federal Reserve Have an Ethics Problem?
All eyes were on the Fed’s policy meeting this week and for a good reason. But quietly, there was a dark cloud in the background involving the Fed’s ethics.
Throughout history, the Fed has had a relatively squeaky clean reputation. However, all of that could come crashing down based on several news reports over the last few weeks. These reports indicate that Fed officials have been trading stocks and bonds that could be influenced at least indirectly by their policy decisions.
So as already anxious investors attempt to digest the Fed’s policy moves, this only adds to the confusion and mistrust. Primarily because the Fed depends on credibility.
“I think it’s embarrassing for the Fed. It had such a squeaky-clean reputation,” said Greg Valliere, chief U.S. policy strategist at AGF Investments. “But I don’t think it’s going to change policy in any regard at all. I think it will be rearview mirror pretty soon, assuming there’s no other shoe to drop.”
“The ethics here look bad. They should have known better,” said Joseph LaVorgna, chief economist for the Americas at Natixis and former chief economist of the National Economic Council during the Trump administration. “Once you lose that moral authority, it’s a problem.”
A Fed spokesman also added that Jerome Powell ordered Fed staff “to take a fresh and comprehensive look at the ethics rules around permissible financial holdings and activities by senior Fed officials.”
Investors over the summer assumed that the Federal Reserve would taper sooner rather than later, thanks to spiking inflation. The central bank, in their eyes, would have no choice, or else the economy would ultimately overheat.
Yet, signs show that inflation may either be cooler than expected or may have peaked.
The August CPI report, for example, came in way less hot than anticipated and at its lowest level since January.
According to Slate, “Headline inflation increased only 0.3 percent during August, below what economists had projected and just one-third of the blistering pace it set in June. If you take food and energy prices out of the picture, the deceleration has been even more rapid; so-called core inflation inched up by 0.1 percent in August, down from 0.9 percent two months ago.”
Not to mention, the cost of living rose at its slowest pace since January, in part thanks to the falling cost of used cars and travel. Airline and hotel prices also took a tumble thanks to the Delta variant.
If you exclude those “recovery sectors,” though, not a lot has changed. In fact, inflation in other sectors has continued to heat up by an average of 2.8 percentage points to core inflation. While not out of control, this is still way hotter than the Fed would like. Most importantly, based on the latest CPI report, the underlying trends were somewhat worse than the headline, if not worse.
What happens if inflation holds rather than acts as “transitory” like the Fed had told us in the past? Well, prices are already rising faster than wages, making economic inequality even worse than before. We could see household buying power erode as well, which could hurt an already uncertain real estate market.
The bottom line is inflation will likely be higher by year-end than projected in June. It’s taking longer for supply chain bottlenecks and shortages that have driven up prices to cool off. The Federal Reserve preferred measure of inflation, the personal consumption expenditure index, is also expected to end the year at 4.2% rather than the previously estimated 3.4%.
You better believe that the Federal Reserve is monitoring this closely.
3. Labor Market
Over the past few months, Jay Powell said that more progress was needed in the labor market before drastic policy moves were made.
The Federal Reserve already exceeded its inflation goal, and its employment goal, according to Jay Powell’s September 22’s presser, is “all but met.”
“For me, it would not take a knock-out great [September] employment report,” Powell added, even though other members of the policy committee still wanted to see more improvements.
The public has long expected the Fed to eventually taper its stimulus as the recovery progressed. However, based on a disappointing August jobs report, we may be nowhere near a full labor recovery. Only 235,000 positions were added vs. the estimated 720,000.
Employment also remained well below pre-pandemic levels. 5.6 million fewer workers held jobs, and the total workforce was smaller by 2.9 million.
Although jobless claims remain steady at or around pandemic-era lows, August’s jobs report is alarming. We clearly see a gross imbalance in the labor market between government spending, unemployment, and labor growth.
The Delta variant certainly has to be blamed for some of this. It’s unquestionably thrown a wrench in economic projections, with 2021’s GDP now projected to rise 5.9%, compared to the 7% projected in
The Federal Reserve also now expects unemployment to be slightly higher at 4.8% by the end of the year, also higher than previously thought.
Yet the market on September 22nd liked what the Fed had to say.
4. Debt, Debt, and Debt
We have two major debt crises right now- one in China and one in the U.S.
In China, there’s Evergrande, which could be China’s Lehman Brothers event of 2021. China Evergrande Group, once the second-largest property developer in the world’s second-largest economy, is on the verge of defaulting on $300B+ worth of liabilities. You probably think this is great for the U.S. economy because, well, it’s China. Our biggest rival.
But, not so fast. This could drastically affect U.S. monetary policy and rile world markets in a way not seen since 2008 when we had Lehman Brothers and Bear Sterns in a similar predicament.
The ripple effects could be catastrophic for investors worldwide.
If the supposedly “too big to fail” Evergrande were to collapse, it could spread to other property developers and create systemic risks for China’s entire banking system. When the world’s second-largest economy sees its financial system collapse, there will be effects.
Any default by Evergrande could also pose a risk to the international bond markets as foreign investments are essentially the reason why Evergrande got as big as it did. Yet, there is some potentially good news on the horizon. Evergrande will meet a crucial debt deadline on September 23rd and pay the interest due on one of its bonds. However, this crisis is nowhere near over as the company still has more colossal debts to repay.
Meanwhile, in the U.S., we have some debt issues of our own. There is a fierce political debate on raising the debt ceiling. House and Senate members are scrambling to find a way to raise the debt ceiling before it’s too late. If this doesn’t happen, not only will the government will shut down. According to the U.S. Treasury Department, we will entirely run out of cash by some point in October.
It would also mark the first default in U.S. history, yet another stain on a country that already looks like a falling empire struggling with its image.
“It’s just very important that the debt ceiling be raised so that the United States can pay its bills when they come due,” Jay Powell said. He further adds that the damage to the economy and financial markets would be severe if there were defaults.
Most importantly? Powell emphasized that “nobody should assume the Federal Reserve could fully protect the economy against such a failure.”
If this default actually happens, it would shock the American economy and take years to recover from. Moody’s claims that a default would wipe out nearly 6 million jobs and lift the nation’s unemployment rate to almost 9%. It would also cause a crash that could see the market lose up to ⅓ of its value.
Yet, the market does not seem to believe that it could actually happen. Mr. Market has seen this song and dance before in 2011 and 2013. However, the Federal Reserve could be singing a different tune. And it doesn’t sound good.
What’s On The Horizon
The Federal Reserve is preparing to take its first steps to normalize its monetary policy again. Yet, there is no unanimous consensus on what moves to make.
There are both doves and hawks in the Fed. According to Goldman Sachs, six officials have spoken publicly in favor of tapering asset purchases. In contrast, six have spoken out against it.
Powell has said numerous times that he expects inflation to be transitory and price pressures to recede reasonably soon. However, at least six Fed officials have contradicted him, including Governor Christopher Waller.
Not to mention, Jay Powell’s term is set to expire in February. Although President Biden is expected to nominate Powell again, this is far from a foregone conclusion. Powell is a Republican, and Biden could opt to go with someone that more goes with party lines.
Which poses two questions.
One- is now the time to add exposure to gold, commodities, and TIPS?
Two- does the Federal Reserve know what it’s doing?
At least it’s thinking about starting a digital currency!