According to the Sept. 8, 2021, release of the Federal Reserve’s Beige Book, the U.S. economy is facing many headwinds.
The report found that restaurants and the travel sector saw a drop in activity. Home and auto sales were low because of fewer available houses on the market and a challenging supply of computer chips for auto makers. The same report found that although more people have found work, the level of newly created employment was mixed, despite a continuing need for more workers. Due to people quitting their jobs, people retiring, and those unable to find means of suitable childcare, the employment situation remains uncertain. With continued stressors on the economy, how will the stock market fare through the rest of 2021 and into 2022?
The Beige Book, officially known as the Summary of Commentary on Current Economic Conditions, comes out eight times throughout the year. Information collection begins six weeks before, and the report is released two weeks prior to Federal Open Market Committee (FOMC) meetings, providing an overview of the economic health of each of the 12 districts of the Federal Reserve Bank.
The Sept. 8, 2021, Beige Book Report found challenges in different sectors; however, some challenges, such as the semi-conductor shortage, were faced nationally. Based on past analysis, current sentiment reported by businesses and consumers will be confirmed or dispelled by forthcoming data.
As Northwestern University’s Medill School notes, the Beige Book is devoid of formulas, statistical analysis or industry jargon. Rather, it contains observational and comparative data derived from speaking with and sampling business owners and business analysts. In contrast to statistical data, it illuminates what business executives and consumers are worrying about.
It’s often referred to as a key gauge and is especially important because when the economy takes a downturn, the data deterioration often renders business statistics obsolete. It’s also relevant because the FOMC uses it to determine monetary policy chiefly via modifying the federal funds interest rate target. Similarly, when it comes to economic figures, it’s important to keep in mind the timeliness of such statistics because they are announced after they’ve been recorded.
During the coronavirus pandemic, especially when little was known in the beginning, the Beige Book offered Fed officials the ability to speak with industry insiders in the thick of it, especially when data was scant or unknown. Others observe that the Beige Book predicted the 2008/2009 housing crisis starting in October 2006 when mortgage delinquencies began appearing.
By viewing events in real-time, it offers anecdotal evidence compared to questionable forecasts. For example, the July 18, 2018, Beige Book Report found that well before the data confirmed manufacturers’ worries over the trade war with China and Trump’s tariffs, 10 districts reported “moderate economic growth.”
According to a 2003 study performed by Occidental College and the Federal Reserve Bank of Atlanta, the more confidence-inspiring news a Beige Book Report contains, the greater the correlation with higher interest rates, especially when it comes to long-term rates. It also expresses a bullish correlation with increases in stock prices when the economy is growing, but a deceleration during an economic slowdown. When banks set their lending rates, they directly or indirectly use long-term rates as reference. Policy makers also use this as an indicator for inflation expectations in the financial markets.
While no one has a crystal ball to predict how the economy and stock markets will perform going forward, the Beige Book is an important tool the Fed and those in the government factor in when attempting to steer economic growth.
As the U.S. Census Bureau reported on Aug. 17, retail sales fell by 1.1 percent during July compared to the revised June retail sales figures. This is in contrast to an increase of 20.6 percent between May and July and a 15.8 percent increase for the year-over-year comparison to 2020 for the month of July alone.
The National Bureau of Statistics of China released retail sales figures for July on a year-over-year basis. The agency reported an increase of 8.5 percent for the month, missing the 11.5 percent growth target that many predicted, and lower than the 12.1 percent growth in June. The decrease was attributed to the resurgence of COVID-19.
According to the Centers for Disease Control and Prevention, as of Aug. 22, 73 percent of adults in America have received at least one dose of a COVID-19 vaccination (62.4 percent or 170.8 million adults are fully vaccinated). However, the distribution is uneven, portending the increase in infections, hospitalizations, and loss of life due to COVID-19, especially the Delta variant that is infecting both the unvaccinated and a low percent of the vaccinated. The Kaiser Family Foundation notes that African Americans and Hispanics who are 18 and older make up a significant portion (41 percent) of individuals who are unvaccinated but contemplating whether or not to get the vaccine.
A recent McKinsey & Company study found that if 195 million Americans age 12 and older got the COVID-19 vaccine, which would bring the vaccinated level to 70 percent, this would increase the chances for a more robust economic recovery. The study observed that a successful, broad-based COVID-19 immunization push for the public would speed the recovery by three to six months. This would bring the economy to 2019 levels and generate an additional $800 billion to $1.1 trillion in economic growth.
According to an Aug. 3 publication from The National Retail Federation, the economy’s continued recovery is contingent upon combating increasing COVID-19 infections as retail buyers are concerned about new variants. Even though the Delta variant hasn’t changed individual and retail buyer habits yet, it is negatively impacting their outlook going forward. While inflation is expected to moderate over the next 12 months, a June 2021 University of Michigan survey found that retail shoppers see inflation rising by 4.8 percent.
The Conference Board Consumer Confidence Index takes a broad measure of the economy and the generally expected course of future commercial events. It documents how retail buyers see the economy going forward, what they are likely to purchase in the future, how they will pursue leisure activities, how they see their cost-of-living impacted, the performance of equities, and how interest rates will perform going forward.
The July 2021 Consumer Confidence Survey reported an index of 129.7, slightly above June’s reading of 128.9. As the Conference Board elaborates on this reading, numbers indicate that consumers are still expecting to purchase durable consumer goods.
With mixed economic data and the rate of people opting to take the COVID-19 vaccine in flux, the more people who become fully vaccinated the more likely a full economic recovery will occur, including in the retail sector.
According to the U.S. Energy Information Administration’s Short-Term Energy Outlook, the June price of $73 per barrel for Brent Crude Oil was up by $5 per barrel over May. With more vaccinations being rolled out, uncertainty over OPEC+’s production moves, and a reduction in worldwide oil availability, the outlook for oil prices seems upward. If the price of energy – especially oil – keeps increasing, will it halt the improving economy in its tracks?
As part of the commodity boom, crude oil is not immune from the rapid rise, creating an increase in inflation that’s subject to contention of being “transitory” or longer-term. Based on the World Bank’s semi-annual Commodity Markets Outlook, the positive price of crude oil is expected to remain at present levels through 2021.
The price of energy is projected to be, according to The World Bank, about 33 percent more in 2021 compared to 2020, when oil averaged $56 per barrel. In fact, The World Bank explained that crude oil is not the only commodity expected to increase in cost, and attributed it to the recovery from the COVID-19 pandemic.
With more economies coming online, fossil fuels experiencing greater demand, and OPEC+ maintaining production cuts, The World Bank projects the price of crude oil to average $60 per barrel in 2022. One noteworthy factor is that although present levels of demand for gas and diesel are nearly at pre-pandemic levels, jet fuel demand is still lacking since air travel is not back to pre-pandemic levels.
However, The World Bank sees lower crude prices in these situations: the pandemic wears on longer than projected; there’s a major change in U.S. shale production; OPEC+ changes its production agreement; or if some combination of these three factors impacts crude oil demand.
One noteworthy statistic the International Monetary Fund (IMF) points out regarding U.S. shale production is that before the COVID-19 pandemic, shale oil output reached 2 million barrels annually, versus present-day production of approximately 500,000 barrels. While the Biden Administration has banned drilling on federal land, this shouldn’t impact shale production much. However, it signals a bigger approach with the administration’s statements on green energy.
Based on statistics from the U.S. Energy Information Administration’s (EIA) Drilling Productivity Reports, different regions show changes in oil rig production from July 2020 to July 2021. There’s been an uneven recovery over the 12-month period.
In July 2020, the following regions reported the following regarding oil rig production: Bakken at 1,385, Anadarko at 1,001, the Permian at 824, and Niobrara at 1,460. Looking one year later to July 2021, Bakken hit 2,400, with Anadarko dropping to 993, Permian increasing to 1,234, and Niobrara growing to 1,919.
Factoring in OPEC+
On July 18, OPEC+ agreed to phase out production cuts of 5.8 million barrels per day by September 2022, in response to higher prices. With Brent Crude Oil rising 43 percent between the start of 2021 and mid-July 2021, oil is forecast to hit $80 per barrel during the back half of 2021. They will therefore begin to increase oil supply at a rate of 400,000 barrels per day on a monthly basis, which will eventually reduce prices again.
Additional unknowns to the price of crude oil and the economy include projected actions by The Federal Reserve. If The Fed increases interest rates, it increases the strength of the U.S. dollar and decreases the strength of a foreign currency. This, in turn, lowers the cost of oil for U.S. dollar purchases and increases costs in foreign exchange, providing mixed demand for fossil fuel demand.
Another variable, according to the Federal Reserve Bank of Kansas City, is that 16 percent of U.S. white-collar workers are expected to work from home at least twice a week. If the Delta variant increases work from home and overall lockdowns, it could also depress oil demand.
With many unknown variables still present with the COVID-19 pandemic and the impact to commodity prices, including crude oil, the economy at-large will remain touch and go until the globe gets the Coronavirus crisis under control.
The June 16 Federal Open Market Committee (FOMC) meeting Q&A session with Chairman Jay Powell and recent comments from The Fed have signaled two potential inflation rate hikes in 2023. Two days later, James Bullard, president of the Federal Reserve Bank of St. Louis, signaled there could be a rate hike as soon as 2022. With these mixed signals and upcoming FOMC meetings, how might inflation and the markets play out in 2021?
Inflation and the Dollar
One explanation for inflation is that there are too many dollars chasing too few goods – or more simply put, things will cost more over time. Say you can purchase a pair of shoes for $100. Then, inflation is 3 percent over the course of a year, making them cost $103 after one year.
This example illustrates when the cost of things – including school, housing, clothes, food, energy, etc. – increases according to the Consumer Price Index or CPI, as the U.S. Bureau of Labor Statistics defines it.
Some Factors Impacting Inflation
One of the Federal Reserve’s dual mandates is price stability. There are three ways The Fed can steer inflation.
The first is by adjusting the Federal Funds Rate, which determines how much banks pay for overnight borrowing from a “depositary institution,” such as the Federal Reserve Bank. By raising this rate, it lowers spending and helps reduce the likelihood of inflation by tamping down costs, along with pushing up interest rates for lenders.
Another tool is the Fed increasing its Reserve Requirement. By increasing this metric, it slows down spending, and therefore inflation by how much money institutions can lend out.
The third is through open-market operations (OMO), whereby the Fed can either buy U.S. Treasury Bonds to increase the supply of money or sell U.S. Treasury Bonds to decrease the money supply.
The Fed uses the Personal Consumption Expenditures (PCE) Index from the U.S. Bureau of Economic Analysis, along with the Depart of Labor’s Consumer Price and Producer Price indexes, to gauge inflation.
Understanding Cost-Push Inflation
According to the Federal Reserve Bank of San Francisco, there are a few ways to quantify inflation. Cost-push inflation happens when inputs necessary for manufacturing cost more. This can include input resources that cost more or worker pay that rises quickly. During the energy price spike during the 1970s, the increased cost of fossil fuel increased production and commercial hauling costs.
According to the Monthly Labor Review, the Bureau of Labor Statistics, the Federal Reserve Bulletin and the American Economic Association, wage-push inflation is the “thesis” that argues employee pay has risen faster than actual good or service output and is squeezing profitability and price attractiveness to consumers.
One reason this occurs is due to a minimum wage mandate. Another reason is to attract better workers or increase their applicant pool. It’s important to know that doing so will increase the money supply in the economy, which will help them purchase more and create a higher demand for goods. This will further increase the price of goods, whereby businesses will charge more for goods to pay higher wages, which will increase the price of goods throughout the economy. It’s all about balancing the wage increases versus the cost of goods.
Demand-pull inflation happens when there’s the classic too much demand but too little supply scenario. It’s often accompanied by an increase in money supply by a loose central bank monetary policy, oftentimes leading to higher prices.
Looking to Commodities
Taking energy, specifically West Texas Intermediate Spot price, due to increasing costs of energy, this sector is projected to do well in an inflationary scenario. Looking at data from the U.S. Energy Information Administration, the price per barrel increased from nearly $45 on Jan. 1 to more than $59 on April 9, to more than $71.55 on June 18 and climbing. Be it stocks, options or futures, investors who took positions earlier in 2021 or 2020 likely benefitted from inflation.
Performance May Vary by Asset
However, it’s important to select the right assets to decrease the likelihood of losses and increase the chances of gains. For example, fixed income, in conjunction with higher interest rates, is likely to decline due to not staying competitive with inflation rates. Using the “discounted cash-flow method” to evaluate a stock, especially in periods of higher interest rates, growth stocks fare worse compared to their value counterparts. When investing in dividend paying stocks, these may provide a hedge against inflation because they oftentimes can pass on higher costs for their products, keeping their earnings in line with growth expectations, along with receiving dividends themselves.
While the future of the market can’t be predicted, paying attention to how the economy reopens and the Fed manages inflation can help determine what investments are the best going forward.
With the economy reopening and more Americans receiving COVID-19 vaccinations, the economy is expected to be operating on all cylinders. However, some economists and market analysts are afraid The Federal Reserve may create a “taper tantrum” if and when it starts to reduce its purchase of U.S. Treasury debt. The Fed’s current track of purchasing $120 billion of U.S. Treasury debt every month has kept the 10-year yield moderated. However, if The Fed signals fewer monthly purchases from current levels, recent history has already seen higher 10-year yields and increased market volatility.
As the Federal Reserve Bank of St. Louis outlines, the Federal Open Market Committee (FOMC) holds meetings eight times a year to evaluate the country’s economic conditions and determine the forward monetary policy. This includes what they will do (or not do) to the federal funds rate, which is the rate that financial institutions charge each other for overnight interbank lending.
Whatever the FOMC decides to do with the federal funds rate, it’s important to know that any changes to the federal funds rate impacts short-term interest rates, such as the three-month Treasury bill. Depending on how it’s modified (increased or decreased), the rate change impacts consumer and business loans and longer-term debt.
When the FOMC raises or lowers the federal funds rate, it sends a policy directive specifying the new target range to the trading desk of the New York Fed. Depending on the target rate of the new fed funds rate, more government securities will be bought to lower the rate, or government securities will be sold to raise the new target. This is accomplished through its open market operations (OMO).
OMO is made up of two parts. The Fed buying or selling U.S. Treasury bonds, for example, consists of the operations part of OMO. Since the Fed relies on the trading desk of the New York Fed to accomplish its goals, it uses the open market to purchase these securities through the traditional bid and offer trading method. It’s one tool in its toolbox to accomplish the dual mandate policy of maximizing employment and maintaining price stability.
Depending on which way the Fed goes – either tightening or loosening its policy – it tries to steer the level of the banking system’s reserves, creating a shift in interest rates. For example, when the Fed buys Treasury bonds, it adds capital to the purchasing bank’s reserve balance to increase lending through lower interest rates. When the Fed sells its U.S. Treasury bonds, it moves the federal funds rate upward. This lowers banks’ reserves, causing financial institutions to increase lending costs.
When it comes to the term “quantitative easing,” the Federal Reserve Bank of St. Louis defines it as “large-scale operations of the purchase of large amounts of longer-term U.S. Treasury securities and mortgage-backed securities.” One noteworthy consideration for OMO is that when the federal funds rate is near zero, which occurred during the 2008-2009 financial crisis, quantitative easing is one more tool in the Fed’s toolbox to help the economy dig itself out of a downturn and provide liquidity.
Tapering in Action
According to the Federal Reserve Bank of St. Louis, when tapering was even mentioned, it had negative effects on the markets. After continued quantitative easing was instituted to rescue the economy from the 2008-2009 financial crisis through part of 2013, the Fed made comments regarding these efforts in its FOMC meeting and during its press conference on June 19, 2013. It indicated that it would begin “tapering” (gradually lessening) its monthly bond purchases during the end of 2013, assuming economic conditions were improving. However, the market reacted badly to these comments.
U.S. 10-year bond yields spiked to 2.35 percent within hours of the FOMC meeting and press conference on June 19, 2013. On June 21, 2013, the 10-year bond yields climbed farther to 2.55 percent. Similarly, the same meeting prompted a spike in “normalized foreign exchange per USD rates,” according to the St. Louis Fed. In the two days from June 19-21, 2013, the U.S. dollar gained between 2 percent and 3 percent in value against the Euro, the British pound, the Canadian dollar, and the Japanese yen.
Looking at markets on June 19, 2013, when the Fed announced the tapering, the Dow Jones fell more than 200 points, the S&P dropped 1.4 percent and the Nasdaq finished 1.1 percent lower.
Retail and institutional investors can’t predict the future, but they can look at the past and monitor upcoming Federal Reserve events to see what it might end up doing to the stock market.
Based on data from the Federal Reserve Bank of St. Louis, the spread between the 10-year and two-year constant maturity Treasury rates increased by 66 basis points – from 0.48 percent in July 2020 to 1.14 percent by February 2021. Due to the Federal Reserve’s open market operations, two-year notes have fallen to near 0 percent, while the 10-year yield has risen higher.
Experienced investors and financial institutions such as the Federal Reserve Bank of St. Louis would see this change in the slope of the yield curve of the two U.S. Treasury rates and call it a steepening yield curve. This recent widening spread illustrates what a steepening yield curve looks like and how it impacts the economy moving forward.
The Federal Reserve Bank of St. Louis attributes the steepening yield curve to fiscal stimulus and the mass adoption of COVID-19 vaccinations. These two factors could be indicative of future economic growth, including stock market earnings and job gains.
The Yield Curve as Predictor
When it comes to the yield curve and employment, the Federal Reserve Bank of St. Louis explains how the two are related.
Employment growth mirrors the spread in the 10-year and two-year Treasury notes. When the yield curve first steepens, employment numbers might be negative. However, because the steepening yield curve projects increased economic growth, employment growth will soon follow a similar positive growth trajectory.
Historically speaking, the association between the yield curve’s increasing spread and future economic growth keeps its positive trajectory movement over time. This association, based on historical data from the Federal Reserve Bank of St. Louis, has been able to project between 18 months and 36 months of positive future economic growth and approximately 30 months of a positive yield spread and employment growth trend.
While the Federal Reserve Bank of St. Louis is uncertain about much inflation will accompany the economic expansion, it is confident that the Federal Open Market Committee (FOMC) will keep short-term interest rates low to contain borrowing costs and help boost strong financial markets through projected positive economic growth going forward.
Widening Yield Curve and Bank Earnings
As the Federal Deposit Insurance Corporation (FDIC) explains, banks benefit from a steep yield curve because they engage in maturity transformation. The New York University’s Leonard N. Stern School of Business defines maturity transformation as when banks borrow short-term and lend long-term. This lets banks profit from the mean of the short- and long-term rates, the so-called term premium. Term premium is how much premium long-term government bond holders realistically anticipate they will receive versus a string of short-term bonds that might have differing interest rates. Buyers of long-term bonds receive payment in exchange for the uncertainty of changing short-term interest rates.
A widening yield curve also can impact a bank’s net interest margin. According to the Federal Reserve Bank of San Francisco, net interest margin is what’s left over for the bank after deducting interest expenses from interest income. Donald Kohn explains that if short-term interest rates increase, interest costs accordingly increase to interest income. This would lower net interest margins as well as the bank’s holdings.
Assuming there are no further negative economic headwinds, history tells us there is a reasonable expectation of an economic resurgence from the coronavirus pandemic.