Fed Gives Bulls a Shot in the Arm
August 28, 2020
The record-setting run continued on Wall Street with the S&P 500 recording an all-time high each day this week. A number of key developments helped fuel the index’s move higher. At the Kansas City Fed’s Annual Economic Symposium, Federal Reserve Chairman Jerome Powell took the virtual stage to announce a seismic shift in the Fed’s approach to managing inflation and inflation expectations. The move not only makes it more likely that the central bank will keep its interest rates low for an extended period but is also willing to tolerate a higher level of inflation in order to further fuel the economic recovery from COVID-19. Another crop of strong Q2 reports from the stay-at-home stock segment, led by Salesforce.com (cloud computing) and Dick’s Sporting Goods (at-home fitness) also encouraged bulls by showing how companies have successfully pivoted operations during the pandemic. In economic news, the economy continued to show improving results with healthy reports on personal income, consumer spending, and durable goods orders. For the week, the S&P 500 rose 3.26% to end at an all-time high of 3508.01.
Higher Wages Boost Consumer Spending
The Commerce Department reported personal income rose 0.40% in July, reversing June’s 1.00% slide. The increase was driven by more businesses reopening and employees returning to work as well as a rise in rental income which more than offset a decrease in government benefits and income on assets. The rise in personal income helped lift consumer spending 1.90% in July, its third straight monthly increase – albeit growth at a decelerating rate. The rise in consumer spending comes amid high unemployment and the expiration of a $600 a week federal unemployment benefit. That benefit has since been replaced by a $300 a week federal unemployment benefit which should help provide some support to consumer spending, but the open question is to what degree consumer spending will further weaken without a more substantive fiscal response. COVID has widened the chasm between those who have flexible, largely white-collar jobs, who have sailed through the pandemic remarkably unscathed, and those who have seen their incomes decimated. In aggregate, personal income is still 5% higher than it was prior to the pandemic which is astounding when you think about it, but it will start to drift lower due to a higher burn rate now that the first round of stimulus has ended.
Autos Rev Up Durable Goods Orders
Durable goods orders rose 11.2% in July, up from a 7.60% rise in June. Robust demand for autos drove the increase in durable goods orders as consumers continued to make the shift from mass transit to personal transit amid the pandemic. During the month, auto sales rose a healthy 21.90%. Demand for durable goods orders was broad-based with rising demand for machinery, fabricated metals, computers, electronic products and electrical equipment, and appliances. Overall, durable goods orders continued to rebound off their COVID lows as factory floors were back to work.
Bullish sentiment remained high on Wall Street amid a healthy dose of economic news and corporate earnings reports. Yet, it was the Federal Reserve which took center stage this week and captured the market’s attention. In comments to the Kansas City Fed’s Annual Economic Symposium, Chairman Powell signaled a major shift in the central bank’s mandate. The Fed’s previous mandate dates back to 1977 when, having been scalded by stagflation, the Fed determined that its mission should be to ensure full employment but to do so while proactively controlling inflation (which has generally been interpreted as an annual inflation target of 2.00%). For context on this position, it should be noted that inflation has historically been strongly correlated with labor shortages (or unemployment below 5.00%). Over the last decade, however, the Fed has observed that despite increased government borrowing and periods of very tight employment, inflation has remained stubbornly low. The old mandate placed more onus on the Fed to mechanically react when it felt the economy was at full employment, thus raising rates, cooling marginal demand for borrowing, and slowing the economy. That resulted in the Fed having trouble accomplishing its second goal — 2.00% inflation. Furthermore, it placed the Fed in a position where its actions more directly affected asset prices (equities, bonds, real estate, etc.) by allowing the market to read the Fed’s preferred metric and then bid asset prices up or down knowing that the Fed had to follow a fairly prescribed path with respect to setting the Fed Funds rate. This put the Fed in the uncomfortable position of having to be the source of potentially pricking asset bubbles. The new Fed mandate still seeks full employment but allows inflation to rise such that the economy achieves a 2.00% inflation target on average over the long term. The mandate is considerably more ambiguous by design. How much will they be willing to allow inflation to rise? What is their definition of “long term”? In the short term, it likely means that rates will stay low for the foreseeable future, but it will be completely uncharted territory if, and when, inflation does pick up. Everyone knows the math behind averages. You can quickly change the mean average if you mix in a high number with a low number, and how will the Fed react to a hypothetical spike in inflation that may otherwise be perceived as being transient? The scenarios are too numerous to count but suffice to say is that if we have been averaging below 2.00% then we will need to average greater than 2.00% to meet their long term target. The thing about inflation is that it has a nasty way of accelerating, and under the new mandate, the Fed is switching from offense to defense. Ultimately, the major shift is that it is now the market’s job to contend with pricing risk and inflation more proactively, flipping the script and allowing more leeway to the Fed to trail both the inflation data and market prices rather than being the price setter. It’s a desirable shift, but not without its own set of future risks.
The Week Ahead
The dog days of summer are coming to an end as the Labor Day holiday approaches. In observance, Week in Review will not be published on Friday, September 4th. Our next edition will arrive on September 11th with the latest on U.S. consumer and producer prices as well as China trade.
Out with the Old and In with the New
Since its inception in the 1800s, the Dow Jones Industrial Average (DJIA or simply the Dow) has served as a barometer for the stock market. The index includes 30 public companies trading on the New York Stock Exchange and the Nasdaq that are intended to represent the overall health of the U.S. economy. The component companies have strong financials, a history of sustained growth, and a demonstrated ability to weather economic downturns. All except two companies pay a dividend. It was announced earlier this week that three companies will lose their spot on the index at the start of trading on Monday, making it the biggest shake-up of the Dow in seven years.
The Dow was created by journalist Charles Dow and his business partner, Edward Jones, two of the three founders of the Wall Street Journal. Their early index, which was a precursor to the DJIA, included 12 large, profitable, and well-respected companies that served as a reference for industrial activity in the U.S. at the time: American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal and Iron, U.S. Leather, and U.S. Rubber, which were among the titans of industry. Charles Dow hoped to open the world of investing to the everyday public by providing analysis of companies and stocks in an understandable way. He used his skills in journalism and interviewed company executives and scrutinized financial information to provide highly informed coverage of business and the economy. Charles Dow is credited with paving the way for publicly traded companies to provide full financial disclosures to the public. To calculate his index, Dow simply added up the price of one share of stock of each company on the index and divided by 12. The composite number served as a bellwether for the market advancing or retreating and is thought to have been the first reliable source for evaluating the market’s direction.
The Dow grew to 20 companies in 1916 and expanded to 30 stocks in the 1920s. The index encompasses blue chip firms that broadly represent the U.S. economy across all sectors, so as the economy evolves and changes, so does the index. (Incidentally, the term “blue chip” derives from the game of poker whereby the blue chips have the highest value.) Over the years, many iconic American companies have been removed from the index, such as General Electric, Sears, AT&T, and General Motors. The formula used to calculate the DJIA changed over time as well to account for stock splits and market and share price fluctuations. It now uses what is called the Dow Divisor in order to help balance the average.
On Monday, August 31st, three changes to the component companies on the Dow will take effect before the market opens. Salesforce.com will replace Exxon Mobil (which has been a Dow component for nearly 100 years), Amgen will replace Pfizer, and Honeywell International will replace Raytheon Technologies. The changes were prompted by Apple’s stock split which would have reduced the benchmark’s exposure to the information technology sector. Apple’s stock split means that the stock which was trading north of $500 will trade at about $126.50 per share when the split occurs, taking the technology weighting within the Dow down considerably.
Cloud computing company Salesforce.com has been one of the best performing tech stocks over the past decade. Amgen is one of the world’s largest biotechnology companies, and Honeywell is a highly diversified conglomerate, described by its CEO as an industrial technology company. Below is the list of the new components of the Dow after this week’s announcement.
- American Express Co
- Apple Inc
- Boeing Co
- Caterpillar Inc
- Cisco Systems Inc
- Chevron Corp
- Salesforce.com
- Goldman Sachs Group Inc
- Home Depot Inc
- International Business Machines Corp
- Intel Corp
- Johnson & Johnson
- Coca-Cola Co
- JPMorgan Chase & Co
- McDonald’s Corp
- 3M Co
- Merck & Co Inc
- Microsoft Corp
- Nike Inc
- Amgen
- Procter & Gamble Co
- Travelers Companies Inc
- UnitedHealth Group Inc
- Honeywell International
- Verizon Communications Inc
- Visa Inc
- Walgreens Boots Alliance Inc
- Walmart Inc
- Walt Disney Co
- Dow Inc