Showdown at Jackson Hole

The past quarter saw strong perfor­mance in almost every asset class. Real estate investment trusts (REITs) posted the strongest gains in the second quarter and year-to-date, rising 6.96% and 16.48%, respectively. Emerging market stocks (+5.64%) and large cap U.S. stocks (+5.23%) also did well. Even invest­ment grade bonds produced decent returns, rising 2.04% in the quarter—a remarkable feat given the Fed’s tapering activities and souring attitudes toward fixed income generally.


As you know, we have been worried for some time about rising inflation risks. Though price pressures still appear well-contained, recent data indicate that we may have passed an inflection point. So far, Fed Chair Janet Yellen is unperturbed. When asked at her last press confer­ence if the Fed was behind the curve on inflation, Yellen replied:

“I think recent readings on CPI index have been a bit on the high side but I think the data we're seeing is noisy. Broadly speaking, inflation is evolving in line with the committee's expectations.”

“Noisy” or not, the market is starting to sit up and take notice of rising core inflation data. One measure of how sanguine (or not) the market is about inflation can be found by comparing the yield on 10 year Treasury Inflation-Protected Securities (TIPS) with the yield on nominal coupon 10 year Treasuries. The difference between the two is the market’s expectation about long-term inflation, since it represents the breakeven adjustment investors expect to receive as compensation for inflation. As the chart shows, inflation expectations have clearly been trending higher for the past few months.

Yellen’s showdown

The debate about inflation will take center stage at the Fed’s annual confab in Jackson Hole, Wyoming next month. The conference, officially called The Economic Symposium, is hosted every year by the Federal Reserve Bank of Kansas City and draws the economic elite from around the world: central bankers, finance ministers, academicians and government policy wonks. They will discuss some of the most pressing issues in global economics and you can bet they will be very interested in dissecting recent price and GDP growth trends in light of the past five years of quantitative easing.

Their debates matter to normal folks like us because they provide a hint of what to expect from policy makers going forward.  So far, economic strategists around the world have been willing to embrace unorthodox measures to try to stave off economic malaise, but as price pressures increase, patience with such measures will quickly wear thin. Don’t expect fellow central bankers and academicians to blithely yawn if Yellen tries to brush away inflation concerns with her “noisy data” argument. She and her fellow doves could be in for a real showdown at Jackson Hole.

An update on the recovery

The recovery from the 2008/2009 financial crisis continues to impress with both its strength and longevity. The chart on the right shows the gains in the S&P 500 in the aftermath of every major financial crisis since the Black Friday market crash in October 1987.  

It is said that market rallies and economic recoveries rarely die of natural causes—they are usually killed by exogenous shocks. We can see this in our recent economic history by remembering the sequence of these financial crises. The Dot-com bust was only 17 months old when the 9/11 attack occurred. The 9/11 attack was followed within months by a rash of corporate accounting scandals (Enron, Tyco, Arthur Andersen, etc.) in 2002.  These events constituted a triple-whammy that put the market in intensive care for 79 months. The S&P 500 was just breaking back into positive territory when the 2008 financial crisis hit, delaying the S&P 500’s full recovery another 50 months.

I highlight this history to make a point: While recent market performance is encouraging, we need to remember that recoveries are always vulnerable to unforeseeable shocks.   That is why we structure portfolios to fit each investor’s particular situation, portfolios that are designed to weather the inevitable storms. We have no way of knowing if Yellen’s showdown at Jackson Hole will result in a market shock.