July equity performance was narrowly mixed. There were several steep declines leading to equally steep recoveries, but overall, investors saw little net change in values despite several nominal new highs by selected broad benchmarks.
The correction in small capitalization and small value issues that has capped progress for these market sectors since late March continued last month but has not seriously eroded strong year to date gains.
International Developed markets generally followed domestic large cap benchmarks to an essentially flat month, but Emerging Markets were hit hard as fears of new Covid related shutdowns threaten to erase much of this year’s economic progress. Performance of key global equity benchmarks is shown below.
In the US markets, the Dow Jones Transportation Average was among July’s weakest performers (‐~2%), extending a tendency that began in June. Rising fuel costs, supply chain bottlenecks and new threats of increased government regulation for railroad and other shipping giants have weighed on these companies, which had been standout performers through much of 2021’s first half.1
Some of the less visible machinations on Capital Hill may be contributing to problems for concerns that move goods. Fuel costs have increased roughly 50% since January but operators are eyeing a provision in the infrastructure bill before the Senate that includes a “pilot program” to evaluate a per mile user fee for using the nation’s highways.2
This, if eventually implemented, would amount to a regressive tax impacting travelers and commuters more severely than, e. g., UPS or FedEx. The program would undermine President Biden’s oft-repeated pledge that no one with income less than $400,000 will be subject to a tax increase.
But there are direct taxes and there are taxes disguised as user fees. The mileage fee program is a three-year evaluation, but who can be confident that input about a disproportionate burden on lower income drivers would be sufficient to stop implementation by a revenue hungry Congress?
Another facet of the $1.1 trillion legislation under consideration is that only approximately 23% of roughly $550 billion in new spending funds repairs to existing roads, bridges, etc. The bulk of remaining outlays are tied to measures associated with global warming mitigation, including electric vehicle tax credits, the installation of thousands of charging stations, and mass transit upgrades and expansion.3 Mr. Biden has additionally ordered that the number of electric cars on the road rise from the current 3% to 50% within less than 10 years.4
It is difficult to cast this legislation as “pro-growth.” The bipartisan infrastructure bill is a plethora of subsidies, venture capital projects, and funding for various federal agencies with no accompanying guidance other than to combat climate change. The bill is not likely to increase employment but will increase consumers’ transportation expenses.
Democrats apparently want the federal government to reprise its role as asset allocator and arbiter of economic winners and losers, a feature of President Obama’s Administration.
History has repeatedly proven this approach to be fundamentally flawed. The government cannot spend the economy to prosperity, no matter how much money it appropriates to “innovative” companies that could not survive in the marketplace without subsidies. To coin a phrase, “We’ve seen this movie before and didn’t care for the ending.”
Congress is attempting to manipulate incentives and to redefine the structure of the economy, while the “pre-existing” economy is booming. Both employment and new claims for unemployment insurance continue to trend in positive directions, which for individuals, are likely the most relevant economic statistics.
While Congress ponders its options, the Fed is occupied with determining when it will begin to alter its policy and allow a more normal relation between interest rates and a fully functioning economy. The date at which Mr. Powell and his colleagues will begin reducing monthly bond purchases continues to shift forward with the most recent estimate now October.5
In his press conference after the Fed’s Open Market Committee July meeting, Mr. Powell expressed the sense of the Committee that inflation has been stronger than anticipated but at the same time, reiterated that the spike is “transitory.”6 The colloquial definition of transitory is, an event or effect “of brief duration; temporary.”7 In the Fed’s vocabulary, transitory apparently means, “not permanent.”
But the Fed isn’t actually sitting on its hands as prices rise. Earlier this year, many bond market observers were deeply concerned that M2, the broad measure of currency and liquid assets in the economy, was expanding at a 30% annual rate, or roughly 10X the measured inflation rate. Serious analysts began to question the Fed’s market actions, discounting Mr. Powell’s reassurance.
Away from the headlines, however, the Fed has been quietly dampening M2’s growth rate. While continuing to print the new money to fund government deficits, rather than push those dollars out into the market with abandon through bond purchases, the Open Market Committee has begun selling, then repurchasing, some of the Treasury debt it has acquired since the 2020 shutdowns.
Repurchase agreements are contracts for the Fed to sell debt to dealers/banks, thereby reducing the amount of cash in the banking system. The sales are accompanied by agreements to repurchase the assets at a specific time, whether the next day, next week or longer. These actions reduced M2’s annualized growth rate to roughly 4% in Q2.8 Monthly expansion of M2 since July 2020 is shown below.
Repurchase agreements neutralize or “sterilize” the Fed’s money creation activities. Think of the process as moving money from one pocket to another instead of continuing to fill just one side. This concept is not easily digested, but the fact the Fed is engineering a reduction in liquidity growth is an important point and confirms it is not effectively whistling past the inflation graveyard.
M2 growth at 4% is still indicative of expansionary monetary policy, but we now see the first inklings of a reversal of the Fed’s easy money stance since March 2020.
There are, of course, implications for the equity markets if interest rates begin to rise back to or beyond this year’s Q1 levels but given the gradual nature of changes to date, we suspect the economy can easily absorb nominally higher borrowing costs without losing momentum.
The level of uncertainty facing investors at this time feels inordinately high, but markets remain exceptionally effective discounters of events and so far, appear to have faith in the Fed’s ability to avoid a “hard landing” when it begins to publicly modify its policies.
A reasonable, coherent investment plan, structured to maximize the probability of achieving personal and financial goals, remains the investor’s best weapon against unexpected events.
1“Biden targets railroads and ocean shipping with executive order on competition,” www.washingtonexaminer.com, July 8, 2021.2 “Proposal in $1T infrastructure plan could cross Biden’s ‘red line’ on tax increases,” www.nypost.com, August 5, 2021.3 “The GOP’s Bad Infrastructure Deal,” www.wsj.com, Potomac Watch, August 5, 2021.4 “Biden announces new emissions standards, target that 50% of vehicles sold in US by 2030 are electric,” www.cnn.com, August 5, 2021.5 “Fed Governor Waller sees reduction in bond purchases possibly starting in October,” www.cnbc.com, August 2, 2021.6 “Fed Chair Jerome Powell Press Conference Transcript July 28: Interest Rate Updates,” www.rev.com, July 28, 2021.7 “Definition of transitory,” www.merriam-webster.com.9 “How the Fed Is Hedging Its Inflation Bet,” www.wsj.com, August 1, 2021.
This commentary is provided for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Content has been obtained from third-party sources and is believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The views expressed in this commentary are subject to change based on market and other conditions. The commentary may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.