The recovery from last year’s Corona Crash was dramatic to say the least. Fundamental economic conditions that created the growing economy and greatest labor market in two generations prior to the pandemic, also laid the groundwork for a recovery that was unprecedented in recent history. But now the markets are signaling some warnings we had better pay attention to. While some equity market indexes reached new highs just a week or so ago, others peaked three months ago. And during this time, the fixed-income markets have come under stress. The main driver of this is inflation and tax concerns.
We have enjoyed quite benign inflation for a few decades, but this is showing signs of being interrupted. Recent inflation figures have come in at an annualized rate of over 4%. This is more than double the Federal Reserve’s target rate. The bond markets have been reacting to this. The Federal Reserve has made it clear over their last few statements that they see no conflict with continuing to buy federal government debt at a pace of at least $120 billion per month (known as quantitative easing), holding interest rates to zero for a couple more years, and somehow containing inflation. They view the recent uptick in these inflation figures as “transitory”. The markets aren’t buying that. As a result, in order to defend the dollar, interest rates are rising. Interest rates move in inverse relationship to bond prices. Hence, the bond market has been selling off.
Stocks are also sensitive to these conditions. In particular, technology companies are quite interest-rate sensitive as they are not capital-intensive, but more intellectual-property oriented, and as such rely on strong forward earnings growth projections. Future profits are put at risk when inflation erodes the value of the dollar. As a result, large-cap tech stocks have declined over the last couple months in recognition of this risk. These are the very companies that led the pack in the stock market’s recovery over the last year.
Coupled with this is a divergence in the labor markets. The recovery of many industries is being hampered by a lack of workers to take jobs that employers are offering. The most recent Bureau of Labor Statistics’ Jolts Survey reveals that a record 8.1 million job openings in March are going unfilled. This exceeds the number of unemployed. In other words, there are more jobs available than people who need jobs, but these positions are not being filled. Many governors and business leaders are making the case that the enhanced unemployment benefits in place until September are creating a perverse incentive not to work. The average benefit now exceeds the income a worker can make at a $16-per-hour job. If someone can make more money for not working, it shouldn’t surprise anyone when people decide not to work. The Biden Administration sees no correlation with this, but this Jolts survey from their own executive branch suggests otherwise. Flooding the economy with even more “stimulus” checks is also distorting economic equilibrium. There are some disruptions with the supply chain, predominantly in the chip and micro-processer areas, but these labor market distortions are not mainly happening in those affected industries, so it can be concluded that is not the cause.
The other situation that is alarming to the markets is the administration’s proposals to raise top-tier income tax rates, the corporate tax rate (and eliminate other currently-favorable corporate tax provisions), and most damaging – nearly double capital-gains tax rate on high earners. These would, if enacted, place severe downward pressure on investment assets, which are priced for after-cost and after- tax returns. Our competitiveness in the global economy will be greatly compromised. These taxes would do significant damage to the labor markets, distort efficient allocation of capital, and they don’t even bring in much in the way of revenues. Combined, they cannot come anywhere close to paying for the massive spending proposals presented. In fact, history shows that raising the capital gains tax rate reduces revenue as investors decide not to sell and realize those gains. So, either we continue to run unsustainable deficits and debt levels, or the middle class will get hit with major tax increases. The market is realizing this as well.
All this is to say that we have a strong recovery going that is not in need of continued emergency-level intervention, but the very provision of this intervention is now causing structural economic problems that the market is sending warning signals about. As of now, some technical indicators are showing some mitigation. Since the tax increase proposals have not resulted in legislation, and many politicians are against them, this threat is being watched but not yet acted on. Inflation figures can be volatile and a few more months of data will help in clarifying the extent of this problem. The governors of several states are foregoing the federal government’s enhanced employment benefits in order to prevent the damage to their workforce. And, many measures of market volatility indicate increased fear, which is a contrarian indicator and is actually good for market health. As the market technical indicators are not yet in correction mode, the best course of action at this point is patience and a bias toward market participation. But we’re watching this closely, and are concerned. Defending the great gains of recent years will be our priority.