Stocks finished October on a strong note, as the passage of the U.S. infrastructure bill helped to support risk sentiment. Central Banks continue to remain accommodative, even though the Federal Reserve recently began to taper its asset purchase program by $15 billion earlier this month. Recall that in 2020 the Fed began a quantitative easing program where they bought Treasury bonds and Mortgage-Backed Securities (MBS) to help support the economy. By buying bonds and MBS the Fed lowers the cost of capital for corporations and lowers mortgage rates for consumers. With lower mortgage rates we have seen housing prices move higher in response to increased demand, and the lower cost of capital for corporations has allowed them to fortify balance sheets by raising cash. As the Fed tapers its purchase program, it is reasonable to expect higher yields and interest rates over time, particularly in an inflationary environment, as we are now.
With inflation in the domestic economy now passing 6% on a CPI basis, inflation-protected assets like commodities are beginning to respond strongly. Precious metals, energy, and agriculture all had a strong October, and while there will be many stops and starts along the way, we continue to think that commodities will play an important role in portfolio diversification over the next several years. One point we would highlight is that a portion of the inflationary pressure is largely out of the Central Bank’s control, as it is being driven by supply chain and labor market issues, which are not easily solved through interest rates. If there is a shortage of shipping containers, tractors, or computer chips (as there is now), these issues are likely to persist until the respective industries can increase production to a point where the output gap closes, and in our view, this is unlikely to happen before the end of the year. For this reason, among many others, we favor value over growth (chart below), diversification over concentration, quality over junk, and short duration over a long duration.
Overall, the symmetry of risks at this juncture is somewhat balanced in our view. We are entering a period of strong seasonality for equity markets, but at the same stock equities are richly priced, and geopolitical risk, particularly with Russia and China, remains high.