Dear Lucy, We Really Thought We Could Trust You This Time
We all remember the comic strip Peanuts where Lucy Van Pelt convinces Charlie Brown to trust that she would not pull the football away if he kicked it. Through repeated pleas, he reluctantly agreed to kick the ball. As he began his approach, he was able to focus solely on kicking the ball, because this time he knew Lucy would do what she said. With all of his strength, he planted his anchor foot and swung his kicking foot towards the ball and just like previously, Lucy pulled the ball back and watched him fly into the air until he was horizontal with the ground and gravity took over from there, as he landed on his back with a loud thud. As Lucy walked away, she again lectured him for trusting her. Dr. David Kelly, CFA, chief global strategist at J.P. Morgan calls Lucy’s trick, “moving the goalpost”.
In today’s economy, the Fed plays the role of Lucy, whose dual mandate is the unwavering commitment to promote maximum sustainable employment and price stability and to use all available tools to achieve the mandate even if it meant raising rates. The role of Charlie Brown is played by the financial markets who really believe the Fed will raise rates.
The Fed’s Mandate
The two primary indicators of the Fed are unemployment under 5.1% (full employment) and a controlled inflation rate of 2%. The US economy is within striking distance of full employment inflation, currently standing at .20% as of August, remains well below the target.
An indirect component of inflation is wages which have only risen 1.8% over the last year. In other times when unemployment breached the 5.3% threshold, wage increases were much stronger achieving gains on a year-over-year basis of: 3.3% (Nov ’88) , 3.4% (Jun ‘96), and 2.6% (Jan ’05). One contributor to slow wage growth is the increase in the retirement of the baby boomers, who are generally higher paid and more experienced, being replaced by lower paid and less skilled younger workers.
Another drag on inflation is the lack of pressure on commodity prices. China’s focus on infrastructure build-out topped out at consuming over half of the world’s concrete, aluminum and nickel; and nearly half of the world’s steel, copper and coal. As China moves away from an infrastructure-based economy towards a consumer-based economy it has reduced its demand for commodities, subsequently causing prices to collapse. This confirms our stance that now is not the time to invest in commodities.
Where Do We Go From Here?
With current inflation at 0.2% and so far under its 2.0% target, the Fed couldn’t afford to shock the economy and potentially drive it into a deflation spiral that would produce far worse results. It’s hard to believe inflation will move upward in the next couple months and allow the Fed room to raise rates in December at their next meeting.
Joe Davis, Global Chief Economist at Vanguard articulates it well, “Regardless of when the Fed decides to act, the more important question has to do with the velocity of the ascent and the cruising altitude that interest rates reach after liftoff . . . or should I say takeoff. In other words, more important than when the Fed starts is where it stops! …. We shouldn’t expect a vertical liftoff but rather a much more gradual ascent (perhaps as low as 1% in the first two years), as well as a much lower cruising altitude (a terminal rate of 3% or lower) than some are anticipating, including the Fed.”
In conclusion, we expect inflation to stay low as opposed to hyperinflation and for rates to rise to the 2.5% to 3 % range within the next 3 to 5 years. Our bond portfolio continues to be positioned for this environment and we continue to monitor the markets closely for opportunities.