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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Reflation on the Mind


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February saw the swiftest repricing of interest rate risk since 2016, with the 10-year yield rising up to 1.50% from a low of 0.50% in August 2020. The “savage” sell-off of bonds only saw relief on the last trading day of the month. The move was accompanied by impaired market liquidity and a so-called “failed” 7-year auction (with the largest “tail,” or auction concession, on record: 4.4 bp). The 10-year repo rate fell as low as -4.25%, which means holders of 10-year Treasuries were paid 4.25% per annum to borrow cash against the notes as collateral. Commentators have speculated that traders were betting against the 10-year en masse in anticipation of a stronger-than-expected recovery. Anecdotal evidence suggests that the interest rate moves were exacerbated by Japanese investors, which sold $34 billion in foreign bonds ahead of their March fiscal year-end rebalancing.

Given the complexity and fast-moving pace of the current market environment, this month we analyze February’s violent rates market sell-off and what it may mean.

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No Appetite at the Buffet

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Given the magnitude of the Federal Reserve’s monetary easing in 2020, its commitment to holding interest rates low, and the multiple rounds of fiscal stimulus already implemented (with more coming in the pipeline), many are concerned about a rise in inflation in the near future. Conventional commentary focuses primarily on the supply side of the equation and the magnitude of the increase in money supply. The demand side of the equation is often overlooked, and this month we examine it.

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A View from the Yield Curve

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Equity markets are painting a confusing picture, trading at all-time highs despite the ongoing pandemic and its impact on the real economy. Indeed, the jobs report last week posted a larger than expected decline in non-farm payrolls.

This month we seek to situate current markets within historical business/monetary policy easing cycles and evaluate its implications for forward looking market returns.

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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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