The Melody is Softer

“If music be the food of love, play on”, a play script from Shakespeare, Twelfth Night best epitomises the current euphoric bull market. Indeed, investors are indulging in the musical narrative of the Fed loose monetary policy that is lifting asset prices in almost all dimensions.

The Dow had a splendid week. It closed the week at a record. There is little doubt that both the stock and bond markets have come to terms with the possibility of the Fed announcing its tapering of massive bond purchases in the coming November FOMC meeting. Although Fed officials repeatedly explain that tapering of bond purchase does not mean interest rate increase, investors are not taking the information in full faith.

We observed the Treasury market pricing in a possibility of two rate hikes in the Fed’s critical federal funds rate by the end of 2022, each increase at about 25 basis points, 0.25%. This will be a lift from the current ultra-low level of 0%-0.25%. Moreover, the move is significant as it reflects the perception of inflation running hotter despite a less robust economic growth engine as we move in 2022.

Corporations Maximimising Opportunity

Given such a conducive monetary environment, mega-money has arrived at the bond market; after all, a low-interest climate is the borrower’s haven. It is reported that more than $50 billion was raised under the corporate market of investment-grade during the past week.

The massive offering by AERcap Holdings (AER) is the highlight. Recall Pika World Update on General Electric sale of its aircraft-leasing company to AER. The week saw the enormous offering of $12 billion to help the Dublin-based financed the acquisition.

Cruise line Carnival is also tapping on the market to refinance a significant portion of its debt to ensure its business viability, especially when the pandemic continues. Investors would have to thank the Fed for the invisible hand that has been a splendid help to airlines and cruise industries as they battered the operational challenges to their cash flow.

Tax hikes appear less likely

Market participants are also delighted with the weakening prospect of a tax hike as Democrats continued to negotiate intensively on President Biden’s Build Back Better measures as a senator opposed the idea of any tax hikes on companies, any forms of increase for capital gains tax and even for high-income individual earners.

The cost of the bill is also expected to fall below $2 trillion and thus placed less pressure on a hike in rate and possibly required only some forms of changes to corporate tax law to raise sufficient money to fund the measures without the need to change the statutory rate to 26.5% from the current 21% which the House had initially worked towards.

Uncle Powell’s speech sent uneasiness

As easy money and sizeable fiscal spending continue, inflation appears to last longer than “transitory”. The reason is apparent: supply chain constraints and higher home prices become more sticky than anticipated.

Home prices had shot up by about 19.5% compared to last year. According to one economist, this measure has been somewhat missing from official price indexes due to political and statistical issues. If this is to be factored in, then the explosive run-up of inflation is more likely than ever.

In Uncle Powell’s speech this week, he shared the same sentiment, a subtle shift to acknowledge that inflation is likely to stay beyond this year and the Fed has the necessary tools to combat inflation. So naturally, this unnerves investors who see such tools in interest rate hikes down the road to alleviate the hurting impact on the economy.

A correction has yet to happen; will it arrive soon?

This is by far the most common question posed to Pika World. However, as we maintain a bright outlook on growth prospects, it is prudent to be mindful that there is always slight odds that the market could still tumble with exogenous shocks.

A key index such as S&P 500 had risen by about 5.8% since Oct 4, when the index touched its low bottom derived from a volatile declining market seen in early September. Thus, the stock market averted what is often called a correction when the index fell by 10% from its recent peak.

What has driven this insane recovery?

The healthy earnings and retail traders buying the dip has allowed the index to stay clear of any correction and infuse new oxygen into the equity market. As discussed in our daily Pika World Updates, the breadth of stocks that participated in the rally broadens, indicating optimism on earnings as the rate of future economic growth takes a back seat for the moment.

Slowing growth is the next wild card

The plain vanilla reason for slowing economic growth may pop the bubble and stop the melody of rising equity prices. For example, a look at the ISM PMI index, which measures a broad base of economic activities, had slowed down to below 25% after growing at the fastest pace since the past decades of around 50% on a year-over-year comparison.

Interestingly, according to one equity strategist, the S&P 500 movement is seen to be tightly correlated to the PMI index. So if it materialised, the chance of the S&P 500 moving south towards the 4000 psychological level is possible. After all, even when the economy is slowing, the Fed may still have its hands tied to increase the interest rate to keep a lid over inflation roaring.

The vicious cycle of materials input cost inflation is alive as companies face intense competition to capture essential supplies to meet demands. The rise in interest rate can also help avert some worry of a “bubble” to asset prices. In particular, the S&P 500 had doubled from its bear bottom during March 2020, at the height of the pandemic woes.

Earnings season take the front seat

The resounding melody often dilutes the noise of opposing force as investors indulge in the merrymaking of rosy earnings results. As the music continues to play out, the strength has to come from a rosy corporate profit outlook. 

As with every great play and musical, the ending bow will soon arrive, and till then, Pika World is preparing for the moment.

We hope you love this edition read. Have a pleasant and well-deserved rest.