New fans to Formula 1 (F1) international auto racing will be drawn in by the strategy, tactics and thrill inherent in the sport. Perhaps the most interesting aspect of F1, for me, is DRS (drag reduction system), which gives the appearance of legalized cheating. DRS is permitted in designated DRS zones that are set before the start of a race and used by drivers when their car gets within one second of the car in front of it. They request and are given DRS approval, which opens the rear wing of the car and slingshots it past the driver they are chasing. According to my bible for the sport – Netflix series Formula 1: Drive to Survive - DRS adds the equivalent of 10-12 km/hr to a car.
What has this got to do with the markets? Well, it appears that the U.S. economy is recovering as fast as a finely tuned race car speeding ahead at 300 km/hr. Everything is working as perfectly as it can. The healthcare response has been impressive. Vaccination rates are way ahead of anything expected in December and the U.S. may have full herd immunity by the summer. Equally impressive has been the fiscal response. The aggregate impulse from the CARES Act ($2.2T), the December COVID Relief Bill ($0.9T) and the Biden Stimulus also known as the American Rescue Plan ($1.9T) has created $5T in fiscal transfers and spending. A look at our own Chase Institute data shows that Chase card spending is nearly back to the pre-pandemic trend. Clearly, individuals are anxious to emerge from their houses and begin to spend more broadly across the economy. We have also noticed that consumer balance sheets across all levels of income have been completely refreshed with the fiscal transfers of the last year. In fact, personal income in March (reported on April 30th) jumped by an all time record of 21.1% month-over-month as the third round of stimulus payments were distributed.
This is not to say that the recovery is complete. There are still 8.4 million jobs to recover in order to reach the pre-pandemic employment levels. Also, the Federal Reserve’s (Fed) favorite measure of inflation, the core personal consumption expenditures deflator, is just slightly below the Fed’s 2% target at 1.8% year over year.
Now, onto the Fed. Chair Powell courageously supports the Fed’s current level of accommodation by highlighting the work yet to be done in both employment and inflation. He claims they cannot simply react to forecasts, but only to the actual data…and it needs to be sustained. Many of us in the markets hear this and immediately think the Fed has given us DRS permission. The trajectory and acceleration in the broad economy is unambiguous, and we now have the Fed providing the same level of accommodation they did a year ago: $120B in monthly asset purchases and a 0% Fed funds rate. We’re about to slingshot past almost every annual level of GDP growth except for maybe the 7.9% rate posted in 1983. And thanks to a vaccine led reopening, the surge in demand combined with the production bottlenecks are creating a swell in inflation that is ever-present. And all of this is underway before we have any view on how much of the American Jobs ($2.25T) and American Families ($1.8T) proposals make it through to legislation. Yet, the Fed looks away with confidence that it can begin a normalization cycle a year or so from now and not hike rates until 2024.
Our suggested path to normalization is a bit quicker: QE taper talk at the August Jackson Hole meeting; actual tapering of $10B/mo of Treasuries and $5B/mo of Agency MBS starting in January 2022; rate hikes of 25 bps at every other meeting starting in mid-2023. Frankly, given the recent run of data, this path even looks loose to me.
How does one invest in this environment? Here are a handful of possible DRS strategies:
- Short duration with a bias towards yield curve steepeners until the Fed begins to taper and talk about rate hikes
- Investment grade and high yield credit until default rates bottom
- Securitized credit to benefit from the strength in consumer balance sheets
- Local emerging market debt returns to be supported by the high real yielders
- Emerging market currencies to draught off of the broader cyclical recovery in the developed markets
In short, this is not the time to fight the Fed. Use the DRS that central banks are supplying and find a way to supercharge your portfolio returns!