by Jason Norris, CFA
Executive Vice President
Is Federal Reserve chair Jerome Powell taking a shot at the Phillips curve? His announcement this week at the virtual Jackson Hole conference revealed that the focus of Fed policy is shifting to be more on maximizing employment and less on the 2 percent inflation target they have had since 2012.
In classical economics, the Phillips curve is the relationship between inflation and employment. The theory is that as the employment environment improves (i.e. unemployment declines), wages will increase which will lead to inflation. Historically, this inverse relationship has held, however, over the last decade or so the theory is no longer holding water. Pre-COVID-19, U.S. unemployment was at historic lows, but inflation stayed low and wages grew slowly.
Going forward, the Fed is aiming at the 2 percent inflation target as an average. Therefore, even if wage growth results in additional inflation, inflation may run “hot” because the Fed is remaining accommodating. Therefore, rates will be lower for longer. This is confirmed by Chair Powell’s statement, “we’re not even thinking about thinking about raising rates.”
This brings us to TINA, which stands for, “There Is No Alternative.” With rates lower longer, investors are going to be searching outside the bond market for returns. This shift might manifest in the stock market or in other options, such as Real Assets, bidding these prices up. Currently, the 10-year U.S. Treasury yields 0.7 percent and with inflation around 1.5 percent, investors are losing money in “real” terms. In April, we started trimming bond exposure as can be seen in the graphic below. We continue to believe that bonds are going to be a smaller portion of clients’ portfolios until rates increase.
With the search for real returns, valuations in equities may remain elevated, because… There Is No Alternative.
I Wanna Be Elected
Both Republican and Democratic national conventions have wrapped up and we are now heading into the home stretch of the election. Clients are increasingly asking us what effect specific outcomes will have on the stock market. As expressed in our earlier annual Investment Outlook events in January and February, our view is that elections rarely have major economic implications. To alter the U.S. economy, there needs to be major policy changes. While we may change companies or sectors in client portfolios, we do not anticipate an asset allocation shift. The chart below highlights the stock market under different party leadership. History shows that to shift the stock market, it doesn’t matter who is in charge, it’s all about what is happening in the economy.
Source: Morningstar
However, we do believe that the election will result in a financial planning event. Any changes in tax policy, big or small, may have implications with long term planning and should be reviewed.
Our Takeaways from the Week
The Fed is keeping its foot on the gas and policy will remain easy
Even at elevated valuations, investors continue to pour into the stock market resulting in a weekly gain of over 3 percent for the S&P 500