The second quarter was mostly uneventful, as the economy continued to reopen, interest rates ground steadily lower, equity indexes gradually reached new highs, and volatility was mild. However, things changed suddenly in mid-June, following the Federal Reserve’s Open Market Committee (FOMC) meeting, where they gave us more clarity on potentially tapering their bond buying program and when they might raise short-term rates. Despite lingering questions about the sustainability of the economic recovery, particularly whether businesses can find enough employees to run at full capacity and when supply bottlenecks might be cleared up, the economic underpinnings were strong during the quarter which was constructive for the markets.
The market’s reaction following the Fed meeting was a dramatic flattening of the yield curve, driven by a rally in long-term bonds, but also an increase in short-term rates, concomitant with a selloff in the equity markets. This implies that investors were worried about inflation near term and also fear a weakening economic outlook long term. Specifically, in the days following the meeting, the 2-year Treasury yield increased from 16 basis points to near 27 basis points, while the 30-year Treasury yield plummeted from 2.21% to 2.03% in two days before settling at 2.10%. While not seemingly large moves on the surface, this equated to a four point rally in the long Treasury followed by a three point correction, all in the course of seven trading days! While a bit unsettling, things appear to have calmed down for now.
There is still a meaningful difference of opinion regarding how long elevated inflation readings will last and whether the Fed is going to be right about the temporary nature of this bout of inflation or whether they will once again need to play catch-up if they are wrong. Regardless, the FOMC meeting provided insight into when the Fed may raise rates, as shown in the infamous Dot Plot, which we have discussed in the past as being very unreliable but still widely followed for lack of anything better. Currently, the Dots point to 2023 as when we may see rate normalization. The committee also admitted that inflation is currently strong, but still feels it will subside once pent-up demand normalizes and supply bottlenecks ease. They are sticking with their Flexible Average Inflation Targeting (FAIT) for now, but have not added any clarity to their tolerance for how much average inflation needs to rise above their 2% target nor for how long it would need to stay above 2% before they act. Nothing like keeping your cards close to the vest!
Inflation is a complicated and nuanced subject. The most recent bout of inflation was driven by a sharp increase in commodity prices, especially in lumber and metals, as well as for semiconductor chips. Clearly, supply chain disruptions are partly to blame as are manufacturers’ habit of keeping minimal inventory on hand. We saw this most clearly in semiconductor chips which went on to create shortages in a number of products, most notably automobiles, which drove the price of used cars higher. It wasn’t that supply was lacking, per se, but that the industry was unprepared for the large spike in demand. In April, for example, despite shipping an all-time record volume of semiconductors, global demand was still well in excess of supply. Increasing the supply of semiconductors is not as easy as flipping a switch but over time more fabs will be built and equilibrium should return.
Similarly, a surge in home building and remodeling created a shortage in lumber that caused prices to more than double from March levels to $1,733 per 1,000 board feet, before fully reversing to $761 more recently once lumber mills increased production. Copper has also seen an increase in price since year end from $3.52 to $4.80 per pound, and has also been pulling back recently, trading at $4.28. These price movements do buttress the Fed’s argument of inflation being temporary, however commodity prices are only one factor fueling the rise in inflation.
Housing costs, primarily Rent of Shelter, accounted for about 30% of the Consumer Price Index (CPI) basket at year end 2020. This is a survey-based estimate, the interpretation of which allows the Bureau of Labor Statistics some leeway to keep reported inflation tempered. Historically, it has tended to lag increases in house prices. Anecdotal evidence points to those rental rates increasing quite a bit in parallel with rising home prices due to delays in construction because of materials shortages. According to Bianco Research, “Based on Fannie Mae’s projections, they believe Owners’ Equivalent Rent (OER) will contribute roughly 1.9% to core CPI by mid-2022. If the housing market continues to head higher, they estimate OER could contribute as much as 2.3% to core CPI by the end of 2022. This would mark housing’s strongest contribution to inflation since 1990. Simply put, OER alone has the potential to reach the Fed’s inflation target.”
Wage growth is another area that contributes to more lasting inflation. Many companies are finding it difficult to hire enough workers. This shortage is causing them to operate at lower-than-optimal capacity in many cases. Additionally, the Job Openings and Labor Turnover Survey (JOLTS) index, measuring the number of people voluntarily quitting their jobs, is at an all-time high. This is a measure of people’s confidence in their ability to find another job presumably for more pay. This has exacerbated an already very competitive hiring environment. While the unemployment rate has not yet declined to levels seen pre-pandemic, there are some measures of the workforce that may not be correctly accounted for. One implies that a large number of workers may have decided to retire (which would reduce the denominator used to calculate the unemployment rate over time) while many others enhanced their skill sets during the shutdown. It is likely that the latter may not be returning to their prior entry level jobs, especially in the restaurant, retail, and hospitality areas. This means that wages may rise and stay elevated for the foreseeable future. These two items, housing costs and labor shortages, may not correct as quickly as commodity prices have and this would have a more lasting impact on inflation. Time will tell.
What does all of this mean for investors? First, we are comfortable that the next two quarters will show robust earnings and economic growth compared to last year’s shutdown-related slowdown. Second, we do not know how successful some industries (restaurants, cruise lines, retail, some manufacturing, public venues, etc.) will be in fully re-opening to meet what we expect may be overwhelming demand. Third, once we start comparing against stronger results beginning with the 4th quarter this year, how will the markets react?
Our view is that the markets will likely be tolerant of reopening hiccups and take the longer view that at some point we will return to a more normal “steady as she goes” economic environment with relatively full employment. Equities may be stuck in a trading range because some of this economic snap-back has been discounted, but longer term should continue to do well as there are no obviously strong headwinds. Fixed income will depend on how inflation plays out beyond the next few quarters. If it is in fact stickier than expected, we may get earlier rate normalization than 2023 from the Fed. This would be healthy in our view, reflecting a view that economic growth is also more durable. We do not feel that restoring rates to pre-pandemic levels, especially if done gradually and with proper signaling to the markets, should be viewed negatively except for the very short term. It would also allow for some return of income gathering, especially in the investment grade sector.
The Fed will likely be keeping rates low for as long as is practical. This, combined with the expectation that growth will inevitably slow from the current torrid pace, will likely keep interest rates from rising excessively over the next few years. If we are correct on wages rising and staying elevated for some time, spending may remain strong for a longer period of time, thereby possibly creating an environment for a longer stretch of higher rates. Given that finding yield will likely still be challenging without sacrificing quality or taking on more duration risk, and that investment grade returns may lag during a rate normalization regime, we still prefer the non-investment grade sector because of its lower duration, higher yields, and healthy fundamental backdrop. While we have been paring some exposure to convertible bonds that have had meaningful price increases, we are still favorably disposed to opportunistically adding new names at attractive prices.
We thank you for your confidence in us and welcome any questions or comments you may have.
Sincerely,
Carl Kaufman, Bradley Kane, Craig Manchuck
________________________________
The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting www.osterweis.com/statpro. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.
Mutual fund investing involves risk. Principal loss is possible.
The Osterweis Strategic Income Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Small- and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. The Fund may invest in municipal securities which are subject to the risk of default.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
It is not possible to invest directly in an index.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
Earnings growth is the actual or expected increase in profits over two comparable periods of time.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
The job openings and labor turnover survey (JOLTS) is a survey done by the United States Bureau of Labor Statistics (BLS) within the Department of Labor to help measure job vacancies.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [ OSTE-20210702-0266]
