The Federal Reserve Bank signaled an all-clear for the financial markets this week. The tapering they promised will begin on schedule, but Fed Chairperson Jerome Powell has no plans to raise interest rates until at least some time next year.

 

The announcement was met with relief. Investors reacted by catapulting the stock market to yet another higher high. Bond traders were somewhat mollified, as well as seen by the lack of movement in interest rates. If anything, Chair Powell was a bit more dovish than investors expected.

 

He surprised markets by reducing the size of the monthly taper, which will begin later this month. At present, the U.S. Central Bank is buying $120 billion a month in assets. Investors were expecting a $20 billion monthly reduction in purchases, but the Fed decided to reduce those purchases by only $15 billion a month.

 

It appears that the rate of inflation is still not serious enough for the Federal Reserve to move forward their expectations on raising interest rates. Next summer is the earliest Powell sees a need to raise interest rates. However, he did admit that he expects the conditions that are pushing inflation higher could persist well into next year. 

 

His stance is similar to the position already taken by the European Central Bank (ECB). The ECB expects to continue its easy money policies into next year. But while most of the developed world is applying the momentary brakes ever so gradually, many emerging market countries are already raising interest rates to head off rising inflation in their economies. Chile, Russia, and Brazil, for example, have hiked interest rates recently. Of the 38 central banks followed by the Bank for International Settlements, 13 have raised a key interest rate at least once this year.

 

Investors are paying close attention to the stalled situation surrounding the two large Biden infrastructure bills after the resounding thrashing the Democrats suffered this week in various elections. Voters seem to be increasingly unhappy with what they perceive as their "do nothing." President Biden's approval ratings are dismal, and time is running out to reverse the situation before the mid-term elections.

 

It remains to be seen whether this week's election results will spur this fractured party to come together and start legislating or sink further into disarray. The House is expected to vote on at least one if not both bills on Friday, Nov. 5.

 

There is a lot riding on the outcome for the economy and the markets. And while the price tag for both bills is high, as a percentage of GDP, in reality the expenditures are a drop in the bucket when compared to what other countries are spending on their own infrastructure plans. Is it any wonder that China sees us as no more than a "paper tiger," whose politicians lack the will to compete in the areas that really matter?

 

Earnings season is winding down, but once again the results defied even the most bullish of expectations. That bodes well for stocks. More and more sectors are participating in the upturn and there doesn't seem to be many storm clouds on the horizon until we head into December, if then. This week's decline in oil may also act as a tailwind for stocks. Higher energy prices have been leading inflation higher for the last few months. If oil pulls back from here, or just remains in a trading range, equities could get a boost from that as well.

 

To me, however, the most important event of the week was drug company Pfizer's announcement that Paxlovid, a COVID-19 pill, reduced the risk of hospitalization or death by 80 percent in a clinical trial that tested the drug in adults with the disease who were also in high-risk health groups. 

 

Pfizer CEO and Chairman, Albert Bourla, said, "These data suggest that our oral antiviral candidate, if approved or authorized by regulatory authorities, has the potential to save patients' lives, reduce the severity of COVID-19 infections, and eliminate nine out of 10 hospitalizations." To me, this pill could be a game changer for the economy and for people all over the world. It is possible that we could see the coronavirus battle won by sometime next year.

 

I have been expecting a shallow pullback in the markets for the past two weeks. Instead, stocks have just climbed higher and higher. They are extended, but history says they can get even more so. As such, I am not holding my breath, nor waiting around for it. Whatever pullback does occur should be bought.

 

Third-quarter earnings have cheered investors, sending markets to new highs. The bullish wave of buying was so strong that investors ignored the disappointing third quarter read on the nation's Gross Domestic Product (GDP).

 

Economists were looking for the economy to grow by 2.6 percent, but instead, GDP gained a mere 2 percent, which was the slowest rate in over a year. Economic activity was damaged by the Delta variant as well as continuing supply-side constraints. The market's reaction indicates that investors are looking through the weak number and expecting the economy to continue to grow.

 

It seems to be a question of demand versus supply. Yes, the economy slowed, but it wasn't because demand is slowing. It was simply a matter of supply chain bottlenecks that are forcing pent-up demand further into the future.

 

As we close out this week of earnings the "beat" rate of corporations is more than 80 percent. Most of the big mega-cap technology companies (with some exceptions) have once again delivered good results, which has kept the markets buoyed. Managements continue to complain about supply constraints and higher prices, which are compressing profit margins in some sectors, but not enough to really hurt overall results.

 

As for the Fed, next week on Nov. 3, the long-awaited FOMC meeting will occur and with it the expected start date of the tapering of asset purchases. It seems to me that the Federal Reserve Bank and its Chairman Jerome Powell have done everything in their power to prepare the markets for the onset of tapering. It remains to be seen how the markets will react to the actual implementation of tapering. We could see some nervousness leading up to the meeting.

 

But the new topic of conversation — a rise in interest rates. When will the Fed start raising interest rates from the near-zero levels at present? Some traders believe that interest rates will be hiked faster than most investors are expecting. Rising inflation is the impetus behind that conviction. Persistent and accelerating inflation is the biggest risk to the market right now, in my opinion. If the inflation rate continues to gain, investors would worry that the Fed might be forced to raise interest rates by as many as two hikes next year, and three in 2023. That would most likely create severe negative repercussions for the stock market. 

 

Democrats are struggling to compromise on some version of an infrastructure bill with President Joe Biden urging House Democrats to accept a scaled-down version of his Build Back Better proposal. This week, the package would amount to $1.75 trillion versus the $3.5 trillion he originally requested. Progressive Democrats would have to agree to jettison pet projects such as paid family leave and expanded Medicare coverage of vision and dental for elders. Both of which were popular with voters and a priority for several woman lawmakers. A 15 percent minimum corporate tax, a 50 percent minimum tax on foreign profits of U.S. corporations, tax hikes on the highest income Americans, and possibly a surtax on multimillionaires and billionaires are still on the revenue raiser list.   

 

As for stocks, most markets are extended. That may mean we see some profit-taking during the next week. I am not looking for anything serious, maybe a 2-3 percent spate of selling (at most) that might take us into next Wednesday's FOMC meeting on November 3, 2021.

 

My own bet is that investors will like what Chair Powell will say, and if so, we could see another leg higher for the markets. If Congress does come through with an infrastructure compromise bill, the markets would get a lift. As such, I would use any dip to add to equities. After that, I think we have smooth sailing into the end of November.

 

This week, the Democrats unveiled a new plan to finance President Biden's "Build Back Better" legislation. That proposal, along with a 15 percent corporate minimum tax, has politicians scrambling to line up for or against the idea. Does it have a chance to pass?

 

Credit for the idea goes to the Senate's top tax expert, Finance Chair Ron Wyden, an Oregon Democrat. His plan is to target only people with $1 billion in assets, or who are earning more than $100 million over three consecutive years. This group would be required to pay capital gains taxes each year on the appreciation in the value of their assets. It won't matter whether they sell or hold those assets.

 

The plan would impose a one-time tax on all the gains accumulated before the tax was created. That could mean a huge tax bill for some entrepreneurs that still hold a sizable portion of their company in stocks, bonds, etc. These founders would have five years to pay off their one-time tax. Each year after that capital gains taxes would be levied on the annual appreciation of assets that are easily valued such as publicly traded assets (bonds and stocks). Ownership of private companies and real estate holdings might not be assessed until after they are sold with different tax rules, depending on the nature of the assets.

 

The beauty of this plan for politicians on both sides of the aisle is that if passed, the billionaire tax would only impact around 700 people. As such, there is not a lot of voter risk involved in this idea. But the upside would be that it would generate several hundred billion dollars in revenues. Capital losses on assets would be allowed, which could also be carried forward (and in some cases backwards).

 

For those who might oppose this plan, the idea of defending a bunch of billionaires is dicey at best. Most voters (and most of the media) believe this wealthy handful of people are not paying their "fair share" of taxes in the first place. And as for the corporate tax rate, most large corporations are not paying the official tax rate any way. After all the credits and other tax loopholes that have been accumulated over the decades, the effective tax rate for most corporations is well below. The tax rate for some companies is zero or below.

 

As with most new or proposed legislation nowadays, even if the tax is passed, it would likely be challenged in court. The American Constitution does not allow so-called direct taxes. The idea is that you can't levy a tax on someone that can't be imposed on others. However, thanks to the 16th Amendment, there is an exception when it comes to income taxes, which allows Congress to tax earnings. A court case would focus on whether a billionaires' tax would count as an income tax.

 

The new plan is a result of the present stumbling block between Democrats of different persuasions. Sen. Joe Manchin III, a Democrat from West Virginia, and Sen. Kyrsten Sinema, a Democrat from Arizona, have stalled any agreements, both from the size of the spending, as well the best way to pay for it. Will this tax, as well as the minimum corporate tax, ever see the light of day?

 

In the case of the corporate minimum tax there may be enough support for it within the Senate. As for a billionaire's tax, probably not.  Aside from the question of constitutionality, the current Supreme Court would also be an obstacle to interpretating the legality of the tax. The billionaire victims of the proposal, while a small group, carry enormous political weight among politicians. They would be sure to express their opposition (privately) to those that matter.

 

And finally, most Americans would probably see this kind of wealth tax as an unmistakable step toward socialism, if not Marxist. I don't think the average voter is ready to take that step quite yet.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

The S&P 500 Index and the Dow have managed to pierce overhead resistance. This week, both hit record highs. It seems only a matter of time before the NASDAQ will follow but probably not before we have a minor pullback.

 

As of Friday morning, equities have managed to string together seven days of continuous gains. Do I hear eight? That is a tall order, because stocks are now overextended by just about every measure I follow. We could do with a minor pullback, or pause, before extending this rally higher.

 

Credit for the gains can be attributed to third quarter earnings results. The results have been much better than expected. The big fear was that supply chain disruptions and rising prices would crater corporate results. Not happening.

 

Company managements are acknowledging that disruptions are hurting results, but despite them, business is still growing. And at the same time, companies have been able (for the most part) to pass on rising prices to consumers and getting little-to-no pushback from the public thus far. Guidance is good, and if this goldilocks kind of environment lasts, it's up, up and away.

 

And while fear of inflation does not seem to phase equity investors, it is another story over in the bond market. The benchmark, U.S. Ten-Year bond yield is climbing, reaching its highest level in months at 1.67 percent. The high this year so far has been about 1.76 percent and the bond vigilantes seem determined to keep selling bonds until we hit that level. The last time that occurred equities did fall by almost 5 percent. The question is what will happen this time around.

 

In the meantime, both yields and stock prices are heading in the same direction, which has been great if you own financials, but not so good if you are overweight technology. It is one reason why NASDAQ has yet to recover all their losses from the September-October declines.

 

The Democrats continue to behave like their own worst enemies, failing day after day to come to a compromise that would move President Biden's "Build Back Better" legislation forward. As it is, the proposed $3.5 trillion plan has been whittled down to somewhere between $1-2 trillion. It appears that the corporate tax hike has also fallen by the wayside, although individual taxes are still on the table. As I have counseled, readers should expect more delay and more compromise before some watered-down plan will finally be passed, hopefully this year.

 

My own explanation, however, on why investors and the markets have become more optimistic over the last two weeks is the pandemic. Every week over the last 18 months, I have been writing that the Coronavirus was the over-riding issue for the economy and the stock market. And yet, I realized over the weekend that I have not mentioned the Coronavirus once in the last two weeks. Does that mean the pandemic is over? No, not by a long shot, but I think we are over the hump barring some new and vaccine-resistant variant.

 

Thanks to the government's vaccination and booster efforts, we may be turning the corner, which could usher in a further spurt of growth in the economy. As such, I believe we could see further gains in the stock market as the year progresses. In the short, short-term, I am expecting a pullback in the markets as early as next week. On the S&P 500 Index I could see risk down to 4,450 or so, but 50 points at a minimum. That would be a dip to buy.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

Inflation is worrying investors. Every new data point seems to be heightening their anxiety. Oil and other commodities are raging higher. The rate of wage increases is also climbing, but the most important variable the Fed is watching is about to move higher.

 

Housing and/or home ownership is one of the most important components of the U.S. economy. However, housing prices per se are not included in the Consumer Price Index (CPI). Instead, the CPI measures the cost of shelter, which is broken down between actual rents paid and the Owners' Equivalent Rent or OER.

 

OER is the amount of rent that would need to be paid in order to substitute a currently owned house as a rental property. It measures (in an indirect way) the value of the present price increases in the real estate market including your home.

 

One could call it the "shelter" component of the Consumer Price Index, which is published by the Bureau of Labor Statistics. The OER represents about one third of the CPI basket and it is a number the Fed watches carefully.

 

You may wonder why rent is included in the CPI, but not food and energy. The Fed considers price fluctuations in food and energy as transitory. If, for example, OPEC decides to raise oil production next month, the price of oil would probably decline. That, in turn, would likely impact how much consumers will pay at the gas pump. Rents, on the other hand, are stickier and tend to last longer.

 

It is obvious to most readers that housing costs have skyrocketed during the last two years. Since the start of the pandemic, inflation-adjusted home prices have increased 11.8 percent annualized. To put that in perspective, real house prices have been rising 100 times faster than they did from 1955 to 1998.

 

But there has been no commensurate increase in the OER, until recently. That is because there is usually a lag time between increased housing prices and rent increases (by roughly five quarters). That lag time is now up, and right on schedule we are beginning to see OER impact the inflation rate in both the CPI and the PPI (Producer Price Index). In September 2021, the shelter index rose by 0.4 percent, accounting for nearly one third of the increase in prices across all goods and services in the CPI.

 

That is the largest increase in 20 years. OER rose by 0.4 percent, while rents of primary residences rose by 0.5 percent. Those were the biggest one month increases since the early 2000s. Economists blame the results on rapid housing price gains, more aggressive landlord pricing, low inventory and faster wage growth.

 

For the Fed, this is bad news. As the headline number of the Fed's inflation gauges, the CPI and the Producer Price Index (PPI), continue to climb higher, the pressure to raise interest rates sooner rather than later is building. The idea that broad-based inflation pressures will continue to rise thanks to supply chain issues and aided and abetted by wage growth has the financial markets nervous.  They also know that some of the long-lasting economic forces that have kept inflation low for decades have been turned on their heads. China, for example, is exporting inflation right now, after functioning as a massive deflationary force for the last thirty years.

 

Consumer expectations for inflation are continuing to surge, rising to 5.3 percent over the next year, and 4.2 percent over the next three years. Both are the highest in the history of data going back eight years, according to the New York Fed.

 

 As it stands, about half of the Fed's policy makers are expecting to start raising interest rates next year and think borrowing costs should increase to at least 1 percent by the end of 2023. That timetable may have to be pulled forward if the present trends continue. Watching the OER may give us an early warning of what the Fed will do next.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.