Fed May Look To Tapering To Help Solve Inflation And Supply Chain Problems

Key Takeaways:

• The Fed Looks to Taper Its Bond Buying Program Which Could Change the Housing Market
• Inflation, Supply Chain, and Worker Shortages Emerge as Consistent Earnings Themes
• Preparing for 2022: Sector Rotation, Inflation, and Taxes  

According to the Stock Trader’s Almanac, the final quarter of the year tends to be the strongest seasonal cycle for the bulls. After the September slump, stocks commonly find a bottom in October, and then they tend to close the year out higher. Of course, this isn’t always the case. In fact, during the 2000 dot-com bubble, November saw the S&P 500 (SPX) drop more than 11% and the Nasdaq Composite (COMP:GIDS) drop almost 23%.

Because every year is different, investors need to be aware of what factors can influence stock prices. This year, there are many influences including the Fed’s tapering plans, earnings, rising inflation, rising interest rates, broken supply chains, rising oil prices, and potential energy crises. Let’s break down these issues and discuss some red flags that could derail November.

Tapering Down 2021

The Federal Reserve is expected to start tapering in November, which means it plans to reduce the amount of stimulus it has been putting into the economy. The Fed started stimulating in March 2020 because of fear related to the economic impacts of the COVD-19 pandemic. Economic growth and rising inflation have the Fed feeling confident that it’s time to reduce the amount of stimulus.

One risk with reduction of stimulus is that it could increase mortgage rates. In March 2020, the Federal Reserve cut interest rates by a full percentage point, lowering the federal funds rate to a range of 0% to 0.25%. Typically, when the Fed cuts its rate, longer-term interest rates and yields fall too. However, this time, mortgage rates didn’t fall—they rallied. This is because investors in the money markets didn’t want to take on the risk of loaning money for such a small rate of return. The idea of money markets may be new to some people, so let’s break it down.

First, the Fed only controls the federal funds rate, which is a very short-term interest rate that helps determine borrowing costs for banks. However, there are rates that go along with various maturities up through 30-year mortgages. These rates are set by the money markets. The money markets are where borrowing and lending take place between large banks, investment banks, government entities like Fannie Mae and Freddie Mac, and others.

The Fed is also a player in these money markets. It’ll lend and borrow along the various maturities using a monetary policy tool called open market operations. The Fed uses its open market operations activities to promote liquidity in various parts of the economy—these actions are called quantitative easing, or QE.

In 2020, when mortgage rates started rising despite the cut in interest rates, the Fed had to jump in and start buying mortgage-backed securities (MBSs). This helped stimulate home refinancing loans and home loans.

So, why does all this matter? Well, the Fed has been buying $80 billion in government debt and $40 billion in MBSs. According to the September FOMC Minutes, the Fed hopes to slow buying by $15 billion per month including $10 billion in Treasuries and $5 billion in MBSs. That means money markets will have to pick up the slack. If lenders aren’t willing take the loans at the current rate, then mortgage rates will likely rise in order to entice investors to lend money.

On the bright side, higher mortgage rates could slow down the hot housing market, which could help rein in some of the rising raw material and construction prices. A slowdown in homebuilding could also provide some much needed help for the supply chain because demand for materials could ease up.  

Q3 Earnings Themes

Speaking of higher costs and supply chain issues, the third-quarter earnings season has seen these two themes throughout many reports. Let’s look closer at these themes and other issues that earnings season has brought to our attention.  

As usual, earnings season kicked off with a lot of Financial stocks and the third quarter has been a pretty good start. Rising interest rates have really helped banks increase their margin in the spread between borrowing and lending. Additionally, the latest FOMC Meeting Minutes revealed a dot plot that had the majority of FOMC participants projecting at least one rate hike in 2022. These types of conditions should continue to favor the Financials sector.  

 One reason for rising rates is rising inflation. Many companies have reported higher input costs from raw materials. Many raw materials have seen prices rise substantially. However, some of these, like lumber, have also come back down to pre-COVID-19 levels. But costs are still high because of transporting costs, especially shipping costs. Additionally, high demand for shipping products has caused supply chain bottlenecks. One of these bottlenecks has been the Port of Los Angeles. It has had to move to 24-hour unloading and loading because ships are backed up and just sitting in the ocean.

In other areas, many bottlenecks are caused by labor shortages. The Fed’s Beige Book reported that many workers have chosen early retirement or decided to quit because of burnout, lack of childcare, or vaccine mandates. In order to entice workers to return, companies are offering higher wages, which cut into profits. While this is terrific for workers, it can be hard on companies and their stock prices.

Larger companies are more able to absorb higher costs. This is one reason why large- and mega-cap stocks have performed well. The S&P 500 (SPX) and Dow Jones Industrial Average ($DJI), which are made up of large- and mega-cap stocks, have outperformed the more capitalization-diverse and tech-heavy Nasdaq Composite (COMP: GIDS) and small-cap Russell 2000 Index (RUT) in recent months.

Technology stocks have joined the laggards because rising interest rates are hurting the way many investors value them. Additionally, work stoppages and supply chain issues have backed up semiconductor production and caused shortages that are reaching across technology and electronics and into cars, industrial machinery, and pretty much anything that needs a computer chip.

In fact, Apple (AAPL) has had to reduce its sales projections for its iPhone 13 because it’s unable to get all the parts it needs to make the phones. To make matters worse, energy problems in China are also hurting manufacturers because factories are experiencing stoppages due to the lack of electricity.

The difficulties with inflation, supply chains, labor costs, and semiconductors may result in technology stocks disappointing investors as the earnings season moves forward. However, many investors may be willing to cut technology stocks some slack, because it’s not the lack of demand that is hurting their sales; it’s the lack of supplies to meet the demand. Technology stocks also have some of the largest profit margins of any sector, which means they can better absorb higher costs. So, in the end, it may be that technology stocks continue to perform along with the overall market as they have done most of the year (see Figure 1).

On the other hand, retailers don’t usually enjoy large margins and are much more susceptible to rising costs. Additionally, retailer stocks came out strong at the beginning of the year as consumers were still focused on buying products and had less need for buying services because COVID-19 kept them home (see Figure 1). Now, that an increasing number of consumers are getting out and about, services may cut into the sales of retailers. Rising costs and lower sales would be a bad combination for any business, but in the short term, many retailers may welcome the reprieve so they could try to get caught up on demand.

The Consumer Discretionary sector that includes retailers has shown great resilience so far, and the sector has been one of the strongest through October. But, if you compare the Producer Price Index (PPI) to the Consumer Price Index (CPI), you’ll see that producers are trying to absorb the higher costs and not pass them on to consumers. It’s unclear how long producers can do this, so eventually, something’s got to give.

Through the first few weeks of earnings, many companies have demonstrated an ability to pass on these costs to consumers without seeing it negatively impact sales. Others have not. This means companies need to find ways to cut costs or hope that they don’t lose customers when they raise prices. A normal supply chain could go a long way to helping reduce these costs.

Inflation Fears

So, is there an end in sight for rising costs? That’s the question for 2022. Inflation is complex and has several aspects to it. This is because inflation can be more than just the rising cost of goods and services; it’s also about the value of a currency. Many economists say that inflation starts with the money supply, but there’s more to it than that. Let’s break down some of the influences of inflation and how these influences may be a factor going forward.

I already talked about how the Fed worked to provide liquidity and stimulate the economy in response to COVID-19. However, Congress also increased the money supply by issuing Treasuries and sending out stimulus checks under the American Rescue Plan. The direct payments included $411 billion to individuals, $362 billion to state, local, and tribal governments, and $203 billion in unemployment benefits. When you consider the Fed’s action and Congressional actions, there’s a lot of money floating out in the economy right now.

Unfortunately, a high supply of any product or service makes the value of it lower. Dollars aren’t immune to this. When there’s a high supply of dollars that means the dollar is worth less. Therefore, you’ll have to use more dollars to buy certain goods.

For example, many commodities have increased in value with the large supply of dollars. One such commodity is crude oil (/CL). Lower demand for oil due to the pandemic was compounded by a production war between Russia and Saudi Arabia. Oil prices dropped to $13 per barrel. Today, oil prices are testing 2013 prices around $85. Analysts from Bank or America are projecting oil prices will return to $100 per barrel in the second half of 2022.

It’s not just oil but all petroleum products including gas, natural gas, and heating oil. Similar trends can be seen in agriculture like corn, cows, and hogs, as well as base materials like metals and lumber. The S&P GSCI Commodity Index ($SPGSCI) has risen more than 174% from its April 2020 low.

Energy and materials companies have performed particularly well with rising commodity prices. In Figure 1, the S&P Energy Select Sector Index ($IXE) returned more than 54% over the previous year. If commodity and oil prices continue to rise, then these sectors will likely continue to perform well.

With that said, the fact that a lot of money is out there doesn’t mean that it’s being spent or invested. Money velocity measures how often the same dollar is used over and over. Right now, the Fed’s measure of money velocity is quite low. This suggests that there’s a lot of money still sitting on the sidelines. Therefore, the problems could actually be much worse than they are. Many businesses and consumers are likely saving money to protect against bad economic times. However, as COVID-19 cases diminish and life continues to return to normal, more of this money could be spent or invested.

The high supply of dollars also contributes to price inflation. Price inflation occurs when there are too many dollars chasing too few goods. Of course, the other side of this equation is the supply of goods. Supply chain issues, work stoppages, labor problems, and lockdowns have diminished the number of goods available for consumers. As we move into the holiday season, the demand for goods is increasing and putting more strain on the supply chain.  

But a quick glance at the calendar shows much of this pressure could be gone soon. The holidays will come to an end in just two months and regular economic cycles should emerge and reduce some of these pressures. Also, as consumers get out of the house and start moving around, they’re likely to spend more on services and less on products. The slowdown in demand can give companies a chance to get back on top of their production and inventories, which could result in lower costs. Shipping lanes could also have a chance to catch up.

In looking at the supply side of the inflation equation, some of the inflation may be as the Fed has labeled it, transitory and has a good chance of subsiding. This was the Fed’s projection for some time. However, more and more economists and even more and more Fed members are projecting longer-term inflation issues, but there could be some relief in certain areas.

Planning for 2022

One of the Fed’s primary functions is to keep inflation low. In order to do this, it will likely try to address the money supply issue by tapering in November as projected. Next, the Fed may also be willing to raise interest rates sooner rather than later. According to Bloomberg, the bond market is pricing in two rate hikes for 2022, but a lot of economists and analysts doubt that the two hikes will happen. Whether there’s one hike or two, interest rates and yields will likely continue to rise in the near future.

Investors creating a portfolio strategy may want to consider how they want to approach the Financials sector of their portfolio. And, because rising rates are often a drag on tech stocks, investors may want to consider adjustments in this sector as well.  

A lot of stock performance in 2022 will likely depend on inflation. If the money that’s sitting on the sidelines gets put to work and velocity increases, inflation could continue to rise even if supply chains get back to normal. Rising inflation has benefitted the Energy and Materials sectors. Prolonged inflation could be a benefit for Industrials that create the heavy machinery used to drill, mine, harvest, and haul raw materials. Therefore, investors should also consider how they weight their portfolios in these sectors.

So, what happens if the Fed is successful at curbing the money supply and supply chains get back to normal? Well, if inflation does subside, then Technology, Communications Services, and Consumer Discretionary sectors will likely be bigger beneficiaries in this scenario.

Tax Consideration for 2021

As the year wraps up, many investors start considering their tax obligations. This is a good idea. While I’m certainly not a tax expert, there are a few things that investors should be aware of.

The congressional spending bill is getting closer to passing. As of this writing, nothing has been decided, however, many published reports have bought up a concern about the potential tax implications particularly around capital gains taxes. This is because an increase could have a negative effect on the markets if investors feel the need to adjust their portfolios before the end of the year. 

Also, income tax brackets have changed, so make sure you check out the new ranges. Second, 401(k) limits have increased, so it may be time to increase your contributions. Finally, there are changes in the alternative minimum tax (AMT) and estate tax exemptions. For more information on these topics, check out the article 2021 Taxes: 8 Things to Know Now and talk to your tax advisor.

While November tends to be a positive month for the stock market, investors who allocate their portfolios based on their goals and risk tolerances have a greater likelihood of weathering any autumn winds. If the Fed does taper, then that is a vote of confidence in the strength of the overall economy and another reason for the seasonal cycle to stay intact.

TD Ameritrade® commentary for educational purposes only. Member SIPC.