The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Q2 Update:
- U.S. economy: Looking for a relatively rapid recovery in the second half of 2020.
- Global economy: Europe may begin to outperform the U.S. in Q3.
- Policy watch: Fed to guide the economy even after the country reopens.
- Fixed income: Stay defensive, stay diversified.
- Equities: Focus on quality companies at reasonable valuations.
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
“Invest in inflation. It’s the only thing going up!” – Will Rogers
Inflated expectations for inflation
For years, market participants have debated whether inflation was dead or merely dormant. After all, year-over-year inflation has remained below the Federal Reserve’s 2% target in all but six of the past 95 months (nearly eight years), as measured by the Fed’s preferred inflation barometer, the core PCE index.7 (Core inflation indexes strip out food and energy costs.)
Last week brought further evidence that inflation isn’t likely to heat up quickly. The Consumer Price Index (CPI) fell 0.8% in April—the largest monthly decline since December 2008. This drop reduced the CPI’s year-over-year increase to a mere 0.3%. Meanwhile, core CPI slumped 0.5% and now sits at just 1.4% compared to a year ago.8 Because core inflation excludes energy prices, this meager reading confirms that April’s result was due to plunging demand for goods and services and not to sharply lower oil prices. (The West Texas Intermediate crude benchmark tumbled 8% last month.)9
But now investors are beginning to think that inflation will return with a vengeance—possibly as soon as next year. They’re voting with their pocketbooks, too. Inflows into exchange-traded funds (ETFs) that purchase Treasury Inflation-Protected Securities have increased dramatically over the past month, according to the Wall Street Journal.
Why the change of heart? For starters, the U.S. government recently launched $3 trillion of fiscal stimulus through the CARES Act, and Democrats are calling for a second, similar-sized pandemic relief bill. Moreover, the Fed has purchased $2.2 trillion of U.S. Treasuries and mortgage-backed securities as part of its quantitative easing (QE) program designed to keep the economy afloat.10 And last week, the Fed implemented its previously announced plan to add investment-grade corporate bond ETFs to its QE menu.
According to economics textbooks, this hefty combination of fiscal and monetary stimulus should drive up inflation as the amount of money circulating through the economy and financial system surges. But we think inflation will stay well contained for the near to intermediate term.
Prior to the first quarter of 2020, annualized GDP growth was in line with or slightly above its long-term trend of about 2%, gradually pulling CPI inflation higher with it. Now, however, the economy is in a deep and deepening ditch, evidenced by a 4.8% contraction in first-quarter GDP, along with April’s record 20.5 million job losses and unprecedented 16.5% decline in retail sales.11
With the economy in a pandemic-driven recession, we think inflation will struggle to gain traction. History tells us that only when GDP growth returns to and/or exceeds its prior trend will inflation meaningfully accelerate. In our view, that won’t happen anytime soon. Our forecast calls for U.S. GDP growth, at best, to return to its fourth-quarter 2019 level no earlier than the second half of 2021. It may take at least another year for it to return to trend.
Markets don’t appreciate Powell’s plain talk
Last Wednesday, Fed Chair Jerome Powell triggered a decline in global equities by warning that a U.S. recovery “may take some time to gather momentum” and that the U.S. risked “an extended period of low productivity growth and stagnant incomes.” But he also signaled to markets that the Fed stands willing to use its tools to “the fullest until the crisis has passed and the economic recovery is under way.”
One tool Powell is not likely to wield, however, is negative interest rates. That would entail reducing the federal funds target rate from its current range of 0% to 0.25% to below 0%. Under such a scenario, banks would pay, rather than earn, interest on deposits left overnight at other banks. In theory, this should incentivize banks to lend rather than allow cash to remain idle.
But subzero rates are no cure-all, in our view. Here are a few potential problems:
- Since banks indirectly base their savings account rates on the fed funds rate, depositors could earn even less on their money than they do now.
- Profit margins for banks would be squeezed unless they begin to charge customers for keeping funds on deposit, which we believe is unlikely.
- Insurance companies and pension funds would struggle to meet liabilities.
- Money market funds would be at risk of “breaking the buck” (i.e., not maintaining a $1.00 net asset value) if they earned such low rates of interest.
Then there’s the issue of whether negative rates are actually effective in jump-starting economic growth. Both the European Central Bank (in 2014) and the Bank of Japan (in 2016) have taken the negative plunge, yet neither the eurozone nor Japan has generated steady, solid GDP growth since then.
Given this dubious track record, it’s not surprising Chair Powell is reluctant to embrace negative rates in the U.S. We share his skepticism and believe the Fed should stay the course in supporting the economy via:
- Traditional QE purchases. Continuing to buy U.S. Treasuries and mortgage-backed securities will help drive up their prices and their yields down. This should benefit the economy and consumers by lowering interest rates more broadly. The yield on the bellwether 10-year Treasury note, for example, is used as a benchmark for rates on a wide range of consumer financial products, including student loans, car loans and mortgages. As the 10-year yield dips, so too do the interest rates on these products, making them more affordable. This encourages higher levels of economic activity.
- Corporate “bonding.” Last week, for the first time, the Fed purchased investment-grade corporate bonds as part of QE. Boosting demand for these assets will lower their yields as well, making it more attractive for companies to borrow and deploy capital.
- Clear communication. Clarity and specificity in the Fed’s forward guidance about keeping interest rates at their record-low levels should help calm investors’ jittery nerves, especially as bad economic news keeps rolling in.
With the U.S. economy seemingly in freefall and the trajectory of its recovery uncertain, we appreciate the Fed’s grasp of the enormity of the challenges ahead. It’s heartening to see Powell and his colleagues realistically assess their abilities to meet that challenge and “up their game” accordingly.