March 19, 2021
Despite setting another record high mid-week, the S&P 500 ended the week lower as bond markets continued to sound the alarm over rising rates. Stocks hit all-time highs Wednesday as Federal Reserve Chairman Jerome Powell struck the right tone at this week’s FOMC meeting. He once again reiterated the central bank’s commitment to keeping interest rates low for an extended period of time in order to maintain the economy’s momentum. The FOMC meeting came during a light week of economic data. Retail sales and industrial production both took a hit in February due to icy weather that left businesses without power and disrupted supply chains nationwide. Still, the setbacks look to be only temporary as businesses have been quick to resume operations. The spring thaw should also release newly vaccinated consumers, whose pockets will be stuffed with stimulus dollars. After a slow initial Covid vaccine roll out, the U.S. hit its 100 million “shots in arms” goal on Friday, which equates to 12.30% of the population being fully vaccinated against Covid-19. With the rate of vaccinations accelerating, consumers should be more mobile and eager to spend their recently issued $1400 stimulus checks. However, things have turned too positive for markets recently, who are growing more wary of the potential inflationary forces gathering. The U.S. Treasury yield hit a one-year high of 1.75% this week, up 0.30% from the beginning of the month. This took its toll on growth stocks, pushing the S&P 500 index down -0.77% for the week.
Bond Bears Keep Up the Pressure on the Fed
At its FOMC meeting, the Federal Reserve once again reiterated its pledge to hold interest rates near zero until the economy reaches maximum employment and sustained 2.00% inflation. The central has been on a media blitz lately, making the case it will maintain its easy monetary policy for an extended period of time in order to achieve those goals. According to the Fed’s latest projections released this week, most of the Fed’s 18 officials expect to hold short-term rates near zero through 2023. Given the amount of liquidity that has been injected in the economy over the last year, bond investors have, ironically, hoped to hear the Fed hint that it is prepared to fight inflation, but the central bank’s continued commitment to low interest rates, and its more laissez-faire policy approach, has instead caused investors to fear that the Fed will not act quickly enough should inflation begin to accelerate. Adding to this, bond bears worried over the central bank’s upgraded 2021 GDP forecast of 6.50%, which is significantly higher than its December projection of 4.20%. To make matters “worse” (in the eyes of inflation hawks), the Fed now forecasts that unemployment will decline to 4.50% from the current 6.20% level by year end. The projections and commitments by the Fed read like a wish list for economic growth but had bond investors and subsequently equity markets wondering if all this greatness will all be too much and happen too fast.
Winter Weather Freezes Spending
Retail sales were off to a strong start in 2021 by jumping 7.60% in January, correlating with the last round of stimulus checks hitting consumers’ bank accounts. However, the gains proved short-lived as consumers followed up with a -3.00% slump in February. The month’s brutal winter weather took a toll on businesses as many were forced to close their doors due to widespread power outages. Restaurants and bars, which had been attempting a comeback following the pandemic restrictions, saw receipts drop -2.50%. Motor vehicles also slumped during the month, down -4.20% as tough road conditions made it difficult to get to the lot for a test drive. Winter weather was a major contributor to the poor reading, and the next several months should see consumer spending up significantly.
Industrial Production Slips, Breaking Four Month Win Streak
Consistent with the retail spending report, icy weather and supply chain bottlenecks pushed industrial production down -2.20% in February, breaking its four-month win streak. Here again, the bulk of the decline was due to the harsh winter storms that hit the south-central region in mid-February. The deep freeze took a particularly tough toll on petroleum refineries, petrochemical facilities, and plastic resin plants, forcing them offline through month-end. Manufacturing output also slipped during the month, down -3.10%. The decline was driven by a -8.30% drop in motor vehicle and parts, which reflected both a global chip shortage and brutal winter weather. Utilities, not surprisingly, were big winners in February as output surged 7.40%.
It was another rocky week for markets even as the Fed stuck largely to its script. One thing that really did stand out from the FOMC meeting, however, was their forecast for 4.50% unemployment by year end. Just as interesting was the fact that they also expect the unemployment rate will fall to 3.90% in 2022 and 3.50% in 2023. By most standards, that is a very tight labor market, yet despite this, the Fed still maintains that inflationary pressure will remain transitory. It expects a temporary increase in prices this year – with inflation expected to rise 2.40% – before settling back to 2.00% next year and for the long run.
This all presents an interesting conundrum for markets. The economy has thus far been infused with close to $4.5 trillion in stimulus aid directed primarily to those with the highest propensity to spend. This is good news for corporate earnings. The ink is barely dry on the latest stimulus bill and talks are revving up on a new infrastructure package, which could add another $2 trillion to the economy. All this is to say, you’ll have plenty of money floating around. You then have the Fed that is going to be more hands off and let markets set rates for themselves. We don’t disagree with this approach at all, but in many respects the training wheels have come off for the markets and you don’t know if or when the Fed will interject a rate hike if inflation does appear. You then have a specific event – vaccinations and the global reemergence of consumers. They are flush with cash and they are ready to experience all the things they have been missing for the last twelve months. And finally, you have a projection that labor markets are going to be much, much tighter – which if the other three conditions hold – should mean that wages should rise. Historically, rising wages have had a very positive correlation with inflation.
Some of these factors have been in and out of play over the last decade and yet inflation has been nowhere to be seen. Those forces have either been transitory; producers have become more efficient and prevented supply/demand imbalances; or there has been just enough excess labor to prevent sustainably higher wage pressures. The economy has responded, in some cases with the help of the Fed, to avoid inflationary spirals despite conditions at times being conducive for inflation. Today, however, we’re playing at a different scale. In 2008, the bank bailout was highly controversial, constituting roughly $2.7 trillion. Just like today, there were concerns over the unprecedented liquidity that was being injected into the economy, but this was largely in the form of growing the Fed’s balance sheet in order to provide liquidity to institutions. Due to the slow global recovery and its diffused dispersion, the liquidity never materially caused a spike in economic growth or inflation. Today, we’re talking about a $4-6 trillion (depending on the size of any future infrastructure deal) Keynesian program, that is oriented to direct, immediate spending at a time when all the stars are aligning for a tight labor market and incredible boom in consumer demand. The Fed might be right. This could all be a transitory condition once all the money is spent but the market is certainly starting to take notice of its risks as this week’s trading reflected.
The Week Ahead
The real estate market has been hot throughout the pandemic. We’ll see if the streak can continue with next week’s existing and new home sales data. Also on tap, February personal income and spending figures. In overseas action, the Eurozone releases March composite PMI figures.
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The Shape of Social Security
Social Security is a major source of income for many retirees, ahead of IRAs, 401(k)s, and other work-sponsored retirement savings plans. In 2020 alone, $1 trillion in Social Security benefits will be disbursed to about 65 million people — that’s more than one in every six U.S. residents. The funds used to cover Social Security benefits are financed through a dedicated payroll tax. American workers pay 6.2% of their wages to the government on earnings up to $142,800. Employers match that amount, and those who are self-employed pay 12.4% into the Social Security trust fund. The fund is invested in interest-bearing Treasury securities, earning an average interest rate of 2.5% so far this year. Over the last decade, the money collected through the dedicated payroll tax hasn’t been enough to cover what is being paid out in benefits. In years past, interest earned on the fund has been used to cover the deficit. In 2021, the interest won’t be enough to cover the shortfall, and beginning this year, Social Security will begin to draw down trust fund reserves to help pay beneficiaries.
Social Security retirement benefits can be claimed as early as age 62. However, the full retirement age (FRA) for those who turn 62 in 2021 is 66 and 10 months. FRA is set to increase by two months each year until it hits 67. Individuals who claim before their FRA will see their benefits reduced by up to 30%. Those who delay claiming until their FRA can increase their benefits by up to 32%. The benefit amount is based on an individual’s lifetime earnings. The structure of lower monthly benefits for those who claim early and higher monthly benefits for those who defer is designed to keep lifetime benefits equal for an individual with average life expectancy, regardless of when benefits are claimed.
A new study from the Boston College Center for Retirement Research examines the results of different claiming decisions, the impact of interest rates, and the role of life expectancy and other factors on Social Security benefits and its future solvency. Interest rates are an important component of the Social Security program: they determine the amount the government must put aside to pay future benefits. A decline in the interest rate increases the amount that the government needs to reserve, affects interest on larger balances in the case of later claiming, and increases the cost of benefits paid at older ages. Another challenge to Social Security is that individuals are living longer – and receiving benefits for a longer period of time. In 1935 when the Social Security program originated, life expectancy was 60.7 years, and it has risen to 78.81 years in 2020. The Boston College study’s authors shared the following insights from their research:
- Low income workers tend to claim Social Security benefits early at age 62. Given that lower income individuals have shorter life expectancies, claiming early may be a reasonable idea but the research shows they tend to claim too early.
- Higher income earners also claim early. Of all workers in the highest quintile of earnings, 37% take Social Security at age 62.
- Early claiming of benefits is a boon to the Social Security program. Workers at all income levels left about $1.9 billion in the program’s coffers in 2018 by claiming benefits early.
The study’s authors argue that a low interest rate environment suggests that early claiming shouldn’t be penalized as much as it is, and delayed claiming shouldn’t be rewarded as much as it is. In other words, benefits should be higher at 62 and lower than scheduled for those who wait to claim Social Security benefits until age 70. Specifically, they suggest a 10.7% increase in benefits for those claiming at 62 and a 3.3% decrease in benefits for those who wait to claim until they reach age 70.
The latest official estimate from the Social Security Administration shows that just 79% of promised benefits will be payable in 2035 due to depletion of funds, but that estimate does not factor in the effects of the pandemic which could accelerate that timetable. In the majority of cases, financial advisors will continue to advise individuals to defer claiming Social Security benefits until at least FRA. Situations where that may not be encouraged would be if an individual has a financial need or if they are in poor health with a shortened life expectancy. Social Security reform is expected to be in the crosshairs of legislators soon, and we will be watching to see how Congress addresses the solvency issue and what that may mean for American workers and for our clients.
Source: Andrew G. Biggs, Anqi Chen, and Alicia H. Munnell, ‘The Consequences of Current Benefit Adjustments for Early and Delayed Claiming’, Center for Retirement Research at Boston College, January 2021, https://crr.bc.edu/wp-content/uploads/2021/01/wp_2021-3_.pdf (accessed March 19, 2021)