Fueling the Fire

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The rise of the delta variant certainly weighed on the minds of Fed officials last month. At the Jackson Hole Symposium, Fed Chair Powell noted the near-term risks posed by Delta in what was considered a dovish speech that suggested that he is in no rush to taper. Expectations remain that Fed taper will be announced formally in November or December of this year, assuming that the variant begins to fade in coming months. 

With a potential taper by the Fed on the horizon, this month we look at the relationship between the Fed balance sheet and S&P 500 market returns.

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No Doublethink Here

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The Fed’s balance sheet has nearly doubled in size to $4 trillion since the beginning of the COVID-19 pandemic and money supply has risen by a commensurate amount. As a result of this bond-buying and a further commitment to keep rates near zero, yields declined significantly in the early months of the pandemic with the 10-year yield dropping as low as 0.52% at its trough in July 2020.

But this move quickly reversed in 2021, and yields retraced almost the entirety of the post-pandemic move back towards the levels of Q4 2019 and Q1 2020. 

This was not to last. Since their Q1 2021 peak, yields reversed course again, falling by about -0.41%. This has happened despite macroeconomic indicators that would suggest investors would prefer riskier assets. Falling yields caught market participants off-guard, leaving many scratching their head. This month we look at this conundrum to see what it may be telling us about the outlook for the economy.

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Fast and/or Furious?

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“If you wish to see the truth, then hold no opinions for, or against, anything” – Third Chinese Patriarch of Zen

The COVID-19 market crash and subsequent recovery has been atypical of previous recessions. Government lockdown brought economic activity to an abrupt standstill, but reopening as well as the fiscal and monetary response were just as decisive. In just a little over a year from lockdown, economic activity in the U.S. is expected to have exceeded pre-pandemic levels this past June and equity markets are well above pre-pandemic highs. This V-shaped recovery has the market running at a torrid +45% per annum rate since March 2020, with the S&P 500 up a robust +65% from its March 2020 close. Despite elevated unemployment in the U.S., many are warning of speculative “bubbles” based on the rapid rise of stretched valuations.

While the current market rally is impressive on its face, this month we look at historical trough-to-peak rallies to see how the current market compares with previous cycles.

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Just a Fad?

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May was generally quiet, and economic data continued to suggest strong momentum. In Europe, the pace of vaccinations caught up quickly and the heightened COVID restrictions originally imposed in April were relaxed. In the U.S., April CPI (released in May) showed a 4.2% year over year increase in CPI inflation, the fastest pace since 2008, though the Fed continues to hold that the rise is temporary and attributable to base effects from depressed readings a year ago due to COVID-19. With central banks and market participants debating whether recent inflation will prove transitory or persistent, this month we examine the performance of equities under various inflation regimes.

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Eyeing the Exit

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April was a relatively quiet month. The Fed reiterated its commitment to continue bond purchases and hold rates steady for “some time” until “substantial further progress” is evidenced in the economic data. President Biden released additional details on his $2 trillion infrastructure spending plan and made a strong push in his speech to Congress last week, focusing on maintaining U.S. competitiveness in the global economy and jobs.

During his April speech before a joint session of Congress, President Biden proposed raising the maximum capital gains tax rate from 20% to 39.6%. While it is likely that any hike will be less than proposed, some form of increase is likely to be implemented for fiscal year 2022. This month, we look at historical changes to the capital gains tax rate and its impact on equity market returns.

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Tsunami Watch in the Financial Markets

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The speed and magnitude with which fiscal stimulus was implemented in response to the COVID-19 pandemic was unprecedented. As shown in the chart below, Q1 2020 saw the year-over-year change in fiscal outlays increase 160% from the year prior (an 8 standard deviation increase) boosted by a $2.2 trillion stimulus package. Q4 2020 (not included in the chart) saw an additional $900 billion stimulus, followed by an additional $1.9 trillion passed into law last month. Attention now turns toward President Biden’s $2 trillion infrastructure and jobs plan and how that wave of spending may impact financial markets when it hits.

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A Persistent Conundrum

Imagine being told on January 1, 2020 that the coming year would be plagued by a highly infectious global pandemic leading to global lockdowns, 14% unemployment at the peak, and over 22 million jobs lost. Very few would have guessed that the S&P 500 would end the year in the black, much less above its average long-run return of 10%. Yet as of writing, the S&P 500 total return index stands at +16.27% year-to-date, defying all expectations. This month we explain why we believe this to be the case and propose allocation strategies for the coming year.

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Cutting to the Bone

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February saw the COVID-19 epidemic progress into a global pandemic that now touches every continent except Antarctica. The virus is expected to take a toll on growth not only in Asia, but also in developed markets in Europe and North America. Equities dropped steeply in response to this grim outlook, with the S&P 500 down nearly 16% at the extremes. In response, the Federal Reserve stepped in on March 3 with an unscheduled cut of 50 bps to the overnight federal funds rate (known as an “intermeeting cut” because it occurred between scheduled Fed meetings). Markets rallied briefly on this news before moving on quickly to continue their journey downwards. Lower interest rates may help corporate investment, but they will not get consumers back out to the movies or onto cruise ships.

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A Market Diagnosis for the Wuhan Coronavirus

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January saw the markets bedeviled by macro risks, with inflamed U.S.-Iran tensions followed by revelations regarding the spread and nature of the Wuhan coronavirus (also known as 2019-nCoV). The Federal Reserve committed to supporting “inflation returning to the Committee’s 2% target” (emphasis added), a pivot from previous statements that merely committed to supporting inflation “near” the 2% target. This was interpreted by the markets as a dovish tilt in the Fed’s policy stance.

A challenge that’s been seen before?

With the Wuhan coronavirus showing little sign of abating, we chose this month to analyze the impact of emerging market epidemics. We assume trends in Google searches for specific terms (e.g., “avian flu”, “ebola”, “zika”, and “coronavirus”) are indicative of media coverage and market anxiety. To that end, we use Google Trends, which indexes the number of Google searches for a particular term over time.

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What the Current U.S.-Iran Tensions Could Mean for Asset Allocation: Lessons from Past Conflicts

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The opening days of 2020 saw the news dominated by coverage of the U.S. attack on Iranian Major General Qasem Suleimani, with markets focused on the attack’s implications and Iran’s response. As of writing, U.S.-Iran hostilities appear to have stabilized for the time being, with Iran facing domestic protests following its admission that it mistakenly shot down a Ukrainian airliner.

In light of these circumstances, we look to prior instances of U.S. military involvement in the Middle East and subsequent performance across U.S. equities, crude oil, gold, 10-year yields, and the U.S. dollar. Specifically, we analyze the days following the 1986 U.S. bombing of Libya, the 1990 inception of the First Iraq War (Gulf War), and the 2003 American invasion of Iraq. Our findings are summarized in the table below.

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