A New Quarter and the Inflation Wild Card
Another historical (hysterical) market
Unparalleled. That word might be a stretch to describe market actions this year, but given the strong follow-through earnings reports for the recent third quarter, it feels like unparalleled may not be much of an exaggeration. Although price/earnings multiples continue to be stretched at 21 times forward estimates, positive earnings reports have elevated FactSet’s blended quarterly growth rates, both actual and estimated, to an annualized 32.7%. Full year estimates are closer to 40% growth over last year and drop to 9% next year.
With one trading week left in October, the month has also tracked with historical averages (a positive month). September, on the other hand, while also tracking with historical averages, delivered negative returns across indexes. The Russell 1000 Growth Index, as an example, was one of the more negative at -5.6%.
Assuming investors stay the course and good news offsets bad, October is likely to be a strong month, and the year 2021 could chalk up more new highs along the way. To that point, as of Friday, October 22, the S&P 500 index was up 3.4% on a one-month basis and up 21% year-to-date. Even so, as we have seen throughout the year, volatility could easily change the trend because of any number of headline issues.
In the meantime, bonds have recently provided little sanctuary, stability, or yield. They booked negative returns in September, and October returns were a near-mirror picture of September. Short-term yields also spiked up (basis points) over the past few weeks in anticipation of the upcoming Federal Open Market Committee’s efforts to reduce or eliminate bond purchases and eventually reduce balance sheet inventories of trillions of dollars accumulated since the pandemic began. Investor concerns are that bond purchases cease, holdings are reduced, and rate hikes commence. This scenario is most likely correct, but answers to questions about when, where and how are unknown. Timing, however, will be based on sustainable economic and job growth, and a managed level of inflation. At this point, though, 30 Year Treasury bonds with nominal yields of 2.08%, after adjusting for inflation, are offering real returns that are still in negative territory.
A review of the broader tone of the equity markets through October shows the S&P sectors are all positive, and sectors such as financials, technology, industrials and consumer discretionary sit at or near new highs. The year has been impressive for sector rotation which, according to Bespoke Research, has witnessed seven different sectors taking the lead over a nine-month period. Energy has taken the prize as the lead performer over a three-month period.
Looking at the balance of the year and into early 2022, we see a number of reasons why equities might continue to be the investor’s asset of choice. Seasonality is certainly a near-term historical positive; November and December are typically the strongest two consecutive months for S&P performances. I would add these positives: the continuing outlook for earnings growth (albeit declining) over the next two years; expectations for still improving jobs, travel, consumption and construction; and an unclogged supply chain to help restock inventories and fulfill manufacturer orders. These factors are all in addition to corporate earnings reports and investor confidence. Finally, the possibility that a longer-term outlook for equity appreciation and sustainable dividend yields could help equities continue to attract investor cash.
Consumers in for the long haul
A few consumer headwinds swept through the past month after the University of Michigan’s Sentiment Index fell to its second lowest level since 2011. Adding to consumer and investor angst were ongoing Delta variant concerns, continuing supply-chain shortages and increasing prices at the checkout register. One particular data point that caught market watchers’ attention was survey expectations for inflation levels to potentially hit a 13-year high of 4.8%, at least over the near term.
Coupled with inflationary fears and inventory shortages (autos still being one of the more extreme cases), rising prices also became a self-fulfilling risk as headline prices rose 0.4% on a monthly comparison basis. Gasoline and natural gas prices spiked in September by a respective 1.2% and 2.7%. The real headline story concerning gasoline, however, was that as of last week, the average gallon of gasoline was priced at $3.38, according to AAA. Also noteworthy was the fact that gasoline demand increased 4.4% to 9.63 million barrels/day versus the same period last year. A reminder that once again commuters are facing longer and more congested drive times.
One bit of good news in the data was that travelers saw a 6.4% decline in airfares and a slight decline of 0.6% in hotel prices. Also positive was a data point from the New York Fed that reported survey respondents were quite optimistic about future wage growth and job opportunities.
The latter outlook comes into better focus with the latest Bureau of Labor Statistics report that highlights the number of people quitting their jobs in numbers that break two decades’ old records. According to the data, 2.9% of those employed turned in their two-week notice, and more specific to the private sector, the rate was 3.3%. Interestingly, those employed in the service-related industries were more likely to quit, the highest number being in the leisure & hospitality sector (6.4%), closely followed by the retail sector with a quit rate of 4.7%. What has likely reassured those newly unemployed was the job openings rate that now sits at near historic rates of 10.4 million job opportunities.
Not surprising, with job openings now exceeding quits, the labor markets continue to improve, though candidly by fits and starts. The unemployment rate has continued to fall to a new pandemic low of 4.8%, with September’s newly employed count rising by 194,000 and weekly jobless claims through October 16th hitting a new pandemic low. The detractor: Despite the rise in new jobs filled and posted, and lower unemployment rates, a large segment of the employable population is still sitting on the sidelines. Whether because of COVID concerns, vaccine fears or temporarily living on savings, this segment is not actively looking for jobs, and that helps explain the rising number of “help wanted” signs on storefronts. The unfilled demand for labor was also evident in the recent NFIB small business survey that reported record numbers of companies are planning to increase wages in the near future, given the number of openings and potential workers still missing in action.
With jobs and openings obviously more plentiful and average households still in sound financial shape, consumers continue to shop. September’s sales growth of 0.7% was rather subdued, however, given consumer concerns about lingering impacts of the Delta variant. Sales categories that did well included sporting goods (+3.68%), general merchandise (+1.96%), and not surprising given oil prices, gasoline stations (+1.76%). Auto sales were positive but contributed only a nominal increase of +0.54%, in contrast to negative sales trends in electronics (-0.86%) and healthcare (-1.40%). The bars & restaurants sector experienced the most consistent growth over the past seven months, most likely reflecting the vaccine availability and reopened businesses.
Another interesting category included building materials. Although it was positive (+0.07%) in September, the category has been on the cusp of flattening or perhaps stalling growth rates. More than likely, the earlier pandemic sales surge in this category resulted from stay-at-home remodeling projects, now either finished or put on hold as the economy reopened. This factor may have also contributed to the zigzag in housing market trends, which over the prior few months have sent mixed signals about sustainable traction, especially given the unknown future housing demand, availability of inventory and, most certainly, pricing. This past month, for example, housing permits dropped by 7.7% as housing starts fell by 1.6%.
An offset was the September’s NAHB Housing Index report which rose to a three-month high fueled by foot traffic and sales expectations. Over the same period, existing home sales jumped by 7% over August 2021, while existing home inventories fell to a supply low of 2.4 months. And even with median national sales prices up 13.3% over this time last year, the year-to-date pace of sales is higher over the past year than the prior two years. These mixed industry signals are also symptomatic of and compounded by those trends impacting both manufacturers and retailers—labor and inventory shortages. In the case of the housing, the impact is delayed move-in dates, falling inventories and declining affordability for new homebuyers.
Obviously, consumer demand is not an issue today. It is supplying parts and labor that have created the bottleneck for consumers and, frankly, the economy. Retail sales, despite slowing growth, are still above longer term trends. What has become evident, according to Fed data, are delays in supply chains and delivery times. The New York Fed reported that while factories are still receiving strong order flows, supply chains are worse now than previously, for the past three months in a row. The Philly Fed Business Index reported similar issues with strengthening new order logs but slippage again in delivery times. Other culprits beyond labor and supply chain hiccups included the weather, specifically hurricanes.
Despite bottleneck issues, the services and manufacturing data continues to paint a fairly upbeat picture beyond the shortages we’ve mentioned. A recent report from Renaissance Macro Research noted that the ISM Composite Index (a blend of manufacturing and services managers) reported an average index reading of 62.3 for September. These general levels of growth expectations usually foretell a strengthening economy, not the downturn that many keep expecting to occur. I find it interesting that estimates today are predicting a rather dramatic decline in this coming week’s third quarter GDP report. One estimate from the Atlanta GDP model projects a growth rate of 0.5%, given the general backlog in deliveries and job shortages already mentioned. These models are counter to the ISM data reports, usually more consistent with an annualized GDP level closer to 6%.
Looking forward to the next few months, other potential positives exist. One, in particular, is an expected upturn in productivity and innovation in light of solid growth in R&D outlays. Over the past five quarters, research and development expenses have grown by an annualized 5% versus the average 30-year R&D growth rate of about 3%. An apparent increase in hiring, especially in the service industries, reflects more businesses reopening and more consumers getting out. Another positive is a pickup in chip manufacturing that has curtailed auto production and a multitude of other industries relying on the semiconductor industry. Taiwan, a large exporter of chips, increased its production by 2.4% in August, up 8% from the April 2021 low, and up almost 120% from January 2020. The negative, of course, is getting product to the market.
In that vein, the transportation network into the U.S. is still challenged. The most recent data points to 100 freighters anchored off the Ports of Los Angeles and Long Island, coupled with 57 ships berthed in their respective ports. Before the pandemic, the number of freighters anchored offshore awaiting off-loading was closer to 20 ships. Compounding this issue was the rush of pre-orders for raw materials, components and finished goods earlier this year, a phenomenon usually associated with panic buying (much like the long lines at the gas station before the storm).
These two ports have a significant capacity, representing about 40% of container imports and 30% of container exports to and from the U.S. And yet in June, the Los Angeles port was the first port in the Western Hemisphere to offload 100 million containers over a 12-month period. Record port activity represents considerable post-pandemic demand. Although we don’t expect normalcy by year-end, there is hope for some relief of demand/supply-chain pricing by the first half of 2021. Most recently, President Biden has ordered the ports to begin operating on a 24/7 basis to help unclog the bottlenecks. And in terms of costs, containers arriving from China have been falling in price rapidly. Container costs (transitory inflation) have fallen this past week by 50% for shipments between China and the West Coast to about $8,000. By contrast, for shipments to the East Coast, container costs are down about 25% to $15,000. Before the pandemic, container costs were a nominal $1,500.
Setting the Stage
The market today is an investor conundrum, fueled by a laundry list of all the things that might go wrong. COVID has yet to disappear from daily news. Inflation worries abound. Washington is mired in debt ceiling discussions, government shutdowns and stimulus packages. The potential risk of a China contagion related to its $5 trillion real estate markets exists. And, of course, the notion that the Fed will begin tapering away from its market liquidity support over the next few weeks is a source of concern. Overall, that adds up to quite a bit for investors to digest and process over a brief period of time.
Of course, positives such as earnings growth, resolution of supply-chain logjams and a still relatively robust economy exist. COVID is still the concern, but vaccinations continue. Last week’s data indicates roughly 50% of the U.S. population has been fully vaccinated and 85% of the adult population has had at least one shot. And 44% of the global population has been fully vaccinated. With increasing vaccination rates, travel and businesses will continue opening with fewer restrictions and potentially more positive economic impacts. These changes are already reality as the U.S. opens borders a bit more to fully vaccinated foreign nationals beginning next month. This loosening of restrictions should, in turn, provide an economic tailwind to the service and travel industries.
So, what are we to make of Washington’s debates about debt, a government shutdown and stimulus packages? No doubt, a resolution will occur, but I am uncertain about how or when it will happen, or the magnitude of any package. Most recent leaked conversations suggest Congress won’t let the government shut down and will indeed raise the debt ceiling once again. Stimulus packages are coming down in size, and the higher tax rates on corporations and individuals will likely be a little less onerous than some feared.
The markets were rattled a few weeks ago by a number of regulatory changes taking place in China with newly imposed restrictions and rules throughout the market economy. The Chinese government’s push for the country’s industries to “reform” their businesses (and get in line with government expectations) was interpreted by investors as a market warning signal. With the apparent collapse of the Chinese-based real estate firm, Evergrande, and the likely debt payment defaults, investor angst accelerated. Although a number of these issues have yet to be resolved, investors have apparently moved on because of the recent recovery in select sectors of the Chinese markets.
Ultimately, investor concern is more likely centered on upcoming Fed actions and the potential impact of inflation, permanent or transitory. In terms of the Fed’s activities, the message has been relatively clear about its first stage. Stepping away from supporting market liquidity through continued bond purchases will possibly begin phasing out sometime in November. The phase out of around $120 billion in monthly purchases will probably take several months. At that point, the Fed balance sheet of Treasury securities and mortgage-backed securities will remain initially stable at +/-$8.5 trillion, double the post-pandemic balance. In the meantime, investors have been rather relentless in pulling forward the timing of rate hikes and expectations for two hikes in 2022 and three in 2023. Questions about when and how much will ultimately depend on the economic traction and the inflationary environment.
From the inflation perspective, prices are on the rise; some are probably temporary, but some more likely permanent. Recent wage growth is likely to be sticky as companies get people back to work. Inflation and worries about inflation, though, won’t settle down until supply chains begin working again and economies are fully open.
Certainly, COVID took a toll on the markets as manufacturers shut down, inventories disappeared, and consumers stopped driving or leaving their homes. The results were a lack of inventory now plaguing supply channels and distribution ports, more expensive appliances and vehicles missing crucial computer chips imported from overseas, and oil and gas wells shut-in or shutdown as the demand for energy and energy prices fell.
Today, that situation has changed across the industry spectrum, and businesses are trying to jump-start their operations and distribution channels again. Add in a few severe cold snaps, hurricanes, West Coast fires, port congestion and transitional labor shortages, and it will take a few more months to understand which cost increases are here to stay and which are transitory. You can be sure that the markets will be watching for resolution of these issues.
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