Understand the Environment to Stay One Step Ahead
What is implied if the economy still increased employment by 467,000 jobs in January when millions were home sick and firms deferred reopening due to Omicron? It seems clear that people and business leaders desperately want to get back to living their lives, we think. Moreover, the sheer size of the job gain implies that the economy may surge forward, as Omicron recedes, as it has already begun to do. Therefore, we believe economic activity is likely to pick up steam in the next few months, which will add to inflation pressures in the near term and place increased pressure on the Fed to retreat from its highly accommodative monetary policy. While the large rise in interest rates over the past week was striking, there’s a lot more to go.
Several European countries and numerous U.S. states are already pulling back restrictions imposed due to the pandemic, as Omicron cases plunge. Consumers are responding, with bookings for cruise ships and air travel already picking up. Hotel occupancy is already back to pre-pandemic levels. An economy that has been growing quite strongly is about to get a turbocharged boost.
Interest rates have surged over the past few weeks, as it has become clear that Omicron is receding and economic growth and inflation remain hot. The Fed had been hoping that inflation would moderate considerably, as some of the temporary surging components reversed course. But it has become clear that some other key components are unlikely to recede, so inflation will not moderate adequately based only on the temporary factors that boosted inflation in the first place. Specifically, auto production is rising and the shortage will likely disappear over the course of two to three quarters. The chip shortage might last a little longer, but supplies should gradually improve. And port bottlenecks should also lessen gradually. But keep in mind that the recovery in auto production will stress labor markets even further.
Most critically, the labor market is likely to get tighter over time and that will have a broad and sustained impact on costs. There may be some continued rise in labor force participation, but it is likely to be very gradual, driven in part by rising compensation. Moreover, it is the lack of labor supply that will serve to constrain economic growth. Demand may be turbocharged, but that will add only minimally to the supply side of the economy. Housing costs are another key item that is unlikely to moderate much over the near term. The housing shortage could take a few years to unwind, which implies ongoing increases in rents.
The Fed and investors increasingly recognize these conditions, which is why interest rates are likely to remain under upward pressure whether the Fed acts slowly or aggressively. But it is likely that the Fed will decide to act more quickly so that it doesn’t lose credibility in the marketplace and Powell doesn’t tarnish his legacy. In fact, the slower the Fed’s response, the higher rates are ultimately likely to go.
This environment is positive for stocks relative to bonds. Within the stock market, these conditions are more positive for companies that own real assets, or benefit from higher inflation or higher interest rates, including real estate, energy, financials—particularly banks and insurance companies—and companies that benefit from the reopening of the economy, most notably service companies, especially those in leisure industries. High multiple stocks, utilities, and consumer staples will be at some disadvantage over the near term as interest rates increase. On the fixed income side, we emphasize shorter maturity issues, particularly floating rate bonds, and also higher yield securities.
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