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October 7, 2021
Global equities had sloppy, uneven performance in the quarter as several restraining factors developed over the summer. To be fair, with the incredibly strong performance coming off the March 2020 pandemic-induced lows, we were probably due for some stock flattening, if not a 5% pullback or outright 10% correction in prices.
When the numbers are reported at the end of October, the U.S. economy, which registered over 6% annualized growth in both the first and second quarters of the year, is expected to have slowed in 3Q to roughly 2-3%. The primary culprit for the slowdown to what are still reasonably strong growth rates was the spread of the highly contagious delta variant of Covid-19 and the impact it had on both restraining consumer spending on services and prolonging global supply chain dysfunction. An example of how supply shortages are impacting the slowdown is currently taking place in the auto industry where Toyota recently announced a 40% reduction in production. The company cited the inability to procure enough semiconductor chips needed to manufacture the increasingly sophisticated cars.
The concept of “stagflation,” a term coined in the 1970s to describe an economy with high inflation rates and little to no economic growth, has resurrected this year, even though it is difficult to characterize the current growth environment as stagnant. Inflation is the greater long-term risk to the markets as price increases in certain sectors have been surprisingly persistent with strong aggregate demand and constrained production due to supply chain and virus issues. Price surges were particularly acute in the energy sector as the OPEC+Russia cartel showed surprising production discipline and a rather severe Atlantic hurricane season shut down Gulf Coast production a few times in the U.S.
The lumber price undulation experienced this year is an example of the economic response to commodity price spikes. Lumber prices surged earlier this year as the industry could not hire enough loggers to meet the demand from home builders. The increase in prices naturally elicited more labor supply to take advantage of sharply higher wages being offered by producers. At the same time, the end buyer demand softened as new homes became somewhat less affordable. The combined effect rather quickly moved lumber prices down to a market clearing level where supply met demand. This natural behavioral reaction may next take place in the automotive industry as it is poised to ramp up production in anticipation of some loosening in semiconductor chip supply.
In addition to the profit impact that higher input prices can have if manufacturers cannot fully pass along the increase to consumers, higher inflation rates usually provoke some reaction from the various global monetary authorities that are all subject to certain price stability mandates. The U.S. Federal Reserve consistently characterizes this year’s inflation as transitory. Moreover, it says the inflation is a function of base effects from very low Covid-induced prices of last year and what they believe to be temporary supply chain issues that should dissipate over the coming months. Other central banks in the demographically challenged developed market countries are suppressing the urge to tighten into this inflationary environment unless, and until, the price increases become truly persistent.
We are likely moving into a new monetary policy regime where the central banks view deflation as riskier than inflation and more difficult to eradicate. They are likely willing to tolerate more inflation before acting to initiate tightening programs.
With inflation currently rising faster in the U.S. than in most other developed market economies, the Fed will be the first global central bank to begin removing the extraordinary purchase of short to intermediate maturity government bonds. The Fed has been very careful in its messaging to avoid market disruption, but as indicated in its quarter end meeting, the “tapering” process should begin in December.
However, there will be no Fed funds rate increases until late next year or early 2023 as employment has yet to fully recover. An additional perceived central bank mandate around ensuring greater income equality could further bias the Fed towards protracted ease which would keep rates low and bode well for further appreciation of risk assets.
Fiscal policy concerns and dissonance within the Democratic Party contributed to September market skittishness. While dominating the headlines at the end of the quarter, debt ceiling debates and government shutdowns have historically been viewed by markets as political sideshows with minimal long-term impact. But fiscal policy will be less supportive of the economy as the government passes the baton of consumer support to the private sector with taxes increased for both individuals and corporations. Senators Manchin and Sinema have become leaders of the moderate faction of the Democrats and their influence on the political process should lead to a notable tamping down of the magnitude and scope of spending increases including the tax increases needed to finance the spending.
Political developments in China helped drive outright declines in many Asian and emerging equity markets in the quarter. The Communist government announced a Common Prosperity initiative to promote greater participation in the growth of wealth and to rein in excesses that have developed in certain sectors of the economy. These excesses were overtly demonstrated in the property sector where Evergrande, the second largest real estate developer in the country, could not fully pay end of quarter interest payments. The global surge in energy prices will likely have an inordinate impact on a Chinese economy that still relies heavily on manufacturing for GDP growth.
These recent developments, in addition to the already established demographic headwinds and ongoing trade conflicts with the U.S., will further slow longer term economic growth to the 3-4% annualized range from the previously forecast 5%. Expect pressure on the Peoples Bank of China to offset this growth slowdown with more aggressive monetary ease through the remainder of this year into 2023.
Given the above trend economic growth the U.S. experienced in the third quarter, and little risk of recession on the horizon, it was somewhat perplexing that bond yields declined in July before moving back up for the rest of the summer. Meaningful foreign buying of what are effectively higher-yielding securities provided some support. Any remaining bond bears who would be prone to short treasury securities may be hibernating until the Fed leaves the intermediate maturity area of the market. Looking ahead, bond yields should continue to increase towards 1.75% on the 10-year treasury by year end and the treasury yield curve should continue to steepen. Continued careful messaging by the Fed and a gradual implementation of the tapering process should prevent any disruptive spike in yields.
Also of note in the fixed income markets was the stability of credit spreads in both the investment grade and high yield areas of the corporate bond market. While credit continues to be historically expensive from a portfolio construction perspective, these narrow spreads confirm both the strength of the economy and the low likelihood of any increase in debt defaults.
In assessing the global equity markets, it appears the U.S. large cap sector, as reflected by the S&P 500 index, is vulnerable to a correction given the strong year to date performance on top of last year’s impressive returns. Investors should be aware that the average stock in this index has already corrected over 10% and the small and midcap sectors have underperformed large cap year to date. With the current infection rate decline from the delta variant of Covid-19 and the anticipation of greater certainty around both fiscal and monetary policy, we may again see increased breadth of participation in the U.S. equity market. This is likely to be reflected in a “re-recovery” trade which favors the classic cyclical sectors of Financials, Energy, and Industrials over the less cyclical sectors such as Technology and Communication Services that have outperformed year to date. Any recovery in the cyclical sectors should also help the performance of the more manufacturing-oriented European and Japanese markets.
Earnings growth will slow somewhat due to tougher year-over-year comparisons and input cost pressures. However, earnings per share is expected to be up on average 25-30% for both the third and fourth quarters. This kind of earnings backdrop, with only slightly higher interest rates, remain a favorable environment for equity price appreciation.
Low inventories, the need for supply to catch up with demand, strong jobs and wage growth, and very healthy corporate and consumer balance sheets all provide a favorable economic backdrop and imply a low probability of recession going into 2022.
Persistent, more permanent inflation in commodity prices, particularly energy, could hamper growth. However, it appears inflation is peaking and pandemic-related effects such as port congestion will begin to be rectified. Wage pressure may take much longer to dissipate. Continued productivity enhancing technology investments by corporations will be key to maintaining profit margins, preventing the development of a truly inflationary cycle, and growing real wealth in the economy.
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Partner & Chief Investment Officer
Ben is the Chief Investment Officer and a Partner in the New York office. He leads the firm’s Investment Committee and is a member of...
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