Cutting the Cord
“In the very desire for help, one is apt to forget that the objective should be to enable the individual to stand on his own feet.”
— Eleanor Roosevelt
Eighteen months after the onset of the global pandemic, the answers to many key questions are coming into focus: 1) the coronavirus, while dangerous, can be contained with strategies including vaccines, new clinical treatments, and community awareness; 2) the virus is not going to be eradicated and will be part of our landscape in the future; and 3) society is rapidly dialing back restrictions put in place early in the pandemic.
We will leave the healthcare battles to the medical professionals and scientists and, instead, examine the harsh reality that much of the pandemic-driven economic stimulus will be rapidly withdrawn over the next few quarters. In our last letter, we spoke about mixed signals in the markets and economy. We feel those signals are largely being driven by concerns regarding how the economy will perform when extraordinary fiscal and monetary support is withdrawn. The persistence of these signals underscores the importance of understanding the nature and scale of the support that will be withdrawn in 2022. Our economy will be forced to stand on its own as the Federal Reserve (Fed) and the Federal Government cut the cord on pandemic support.
Most commentators have been focused on the actions of the Fed, which will start reducing bond purchases this month, but the lack of stimulus payments from Washington in 2022 will have a much greater impact on growth. Even if infrastructure and social spending bills are passed by this Congress, the government will be sending significantly less aid to consumers in 2022 than over the past two years. The spending being debated in Congress would be spread over the next decade in contrast to the massive payments that were injected directly into the economy during the height of the pandemic. These twin tapers will challenge the economy to stand on its own and could have a destabilizing impact on markets over the next few quarters.
Although many equity indices declined during the third quarter, the S&P 500 marched defiantly higher, marking its sixth consecutive positive quarter. Microsoft, Apple, Tesla, and Google were the leaders of S&P outperformance this quarter. Excluding these companies, the S&P would have had a negative return of -0.4%, which reflects the fact that slightly more than 50% of S&P constituents posted negative returns. The Russell 3000, which represents approximately 98% of the US market, declined very slightly by 0.1%. The difference between S&P and Russell 3000 performance can primarily be attributed to the relatively poor performance of smaller companies, which held the broad market down.
Profits of S&P 500 constituents have done extremely well. As of November 3rd, Q3 earnings are expected to be up more than 35% year-over-year. So far, 363 S&P companies have reported earnings with 84% beating analyst estimates and the average firm exceeding expectations by 10%. Comparing earnings from the first half of 2021 to the more normalized first half of 2019, we see S&P earnings growth of 27%, which is well in excess of GDP growth over that same period. This is one of many indications that above-average growth from here will be difficult. Of note are the widely varied earnings growth rates of the S&P sectors, outlined in the chart below.
International markets remain cheap compared to the US with the MSCI AC World ex-US index trading at a current P/E ratio of 14 (versus the S&P 500 at a ratio of 20) and offering double S&P yield. The MSCI Emerging Markets index performed especially poorly this quarter and now sports a negative YTD return, primarily due to China’s crackdown on technology companies. China accounted for 6.8% of the 7.9% decline of the iShares MSCI Emerging Markets ETF in the quarter. Alibaba and TenCent alone accounted for 2.9% of the decline. South Korea and Brazil also performed poorly, but there were many strong performers in the index, especially India, Russia, and the Czech Republic. The relative sizes of the emerging market economies mean that the poor performance of Chinese tech stocks can wipe out strong results from smaller economies. This reinforces our conviction that emerging markets are an area where active equity managers have a good opportunity to outperform passive strategies. We are currently researching active allocations in this space, but for now, we continue to favor the US over both emerging and developed equity markets.
As of September 30, 2021, the S&P was 27% above its pre-pandemic high, and international indices have also exceeded their pre-pandemic levels. Supply chain issues, input and wage pressure, and extreme commodity market events are becoming more common as demand continues to accelerate. Two anecdotal examples below further illustrate the impacts. The chart shows the current bifurcation in natural gas markets in the US versus Europe and Asia, and the bullet points are pulled from commentary published in the most recent Institute for Supply Chain Management Report. Both highlight the uncertainty and volatility facing market participants in the real economy.
It is difficult to feel good about the markets given all the headwinds, underlying disruptions, and high valuations, but we must continue to remember two key points: 1) equities are still attractive versus bonds and are reasonably priced on a relative basis; and 2) for accounts with a long-term perspective, staying invested through choppy times is ultimately rewarding. Investors can find comfort in knowing that an investment in the S&P 500 at the peak of the 2000 bubble would have resulted in an annualized return of 7.0% on September 30, 2021, and an investment at the peak of the 2007 bubble would have returned 9.8% on an annualized basis over the same time frame. We expect markets to become more volatile in the coming quarters as traders react to short-term headwinds. We will continue to position our investors to be cushioned from short-term shocks while still being able to profit from long-term growth.
U.S. Economic Update
As we close the third quarter and head into the final three months of the year, the US economy may be losing some momentum. The Bureau of Economic Analysis (BEA) has estimated third-quarter GDP growth for the US at 2%, well below the 6.7% seen in Q2. This slowdown can partially be attributed to the emergence of the Covid-19 Delta variant and supply chain issues, both of which slowed industrial production and have limited the availability of some consumer goods including automobiles and home appliances. In a separate forecast, the Atlanta Fed lowered their cumulative 2021 GDP growth to 26.5% from a previous estimate of 29.2%. Continued improvement is expected in the fourth quarter; however, it is clear that we are gliding down to lower levels of growth after the burst of activity seen in previous quarters.
Global Covid infection rates decelerated meaningfully in September. JP Morgan estimates that 85% of adult Americans have some form of immunity either by vaccination, infection, or both. Some economists have drawn analogies with the 1917 pandemic and other historical pandemics, which had 3-4 waves before fading. If we are coming to an end of the third wave, and if the current Covid-19 pandemic follows the pattern of past pandemics, this may indicate the worst is behind us.
As we adapt to life in an endemic and not pandemic Covid environment, we may find that our economy itself has mutated. Individuals will likely return to many of their pre-pandemic lifestyle choices, but some new habits will persist. We can see some evidence of this in the labor market. The unemployment rate sits at 4.8%, well below the rates seen a year ago and heading towards the historically low levels seen in 2019. This positive top-line number masks some odd details in the report.
Employers have enough open positions to hire all unemployed individuals looking for work, but the unemployment rate seems to have plateaued at its current level. It was hoped that the expiration of enhanced government benefits would draw more individuals back to the workforce, but the participation rate also remains low at 62%, 3.5% below 2019’s reading. It is unclear if this is a temporary phenomenon or if something has fundamentally changed about workers and the nature of our labor supply. If firms need to aggressively raise wages to draw in workers, this could lead to persistently higher labor costs and higher average inflation in the years ahead. Recent wage growth measures have hit 4.9%, the highest since the early 1980s.
Speaking of inflation, the headline CPI figure continues to run at its hottest pace in over 30 years with the August reading coming in at 5.2%. Most Fed officials expect the current inflation pressures to decline as the global supply chain corrects itself and demand falls back to pre-pandemic levels. Fed board members classify these issues as “transitory” without defining the time frame they are referencing. We expect supply chains to largely return to normal at some point in 2022, but they are unlikely to return to their full pre-pandemic form. Companies and countries now speak of the need for more resilient supply chains with critical manufacturing capabilities moved onshore or at least closer to home. Firms have also been operating with razor thin inventories as just-in-time delivery systems became ubiquitous, but that trend has likely run its course and companies will almost certainly hold more inventory in the future.
These more durable inventory and supply chains can be created, but they will come with higher costs. Additional supply chain expenses combined with higher wages could make for a persistent inflationary environment. This is not necessarily a recipe for a low growth, high inflation, or “stagflation” scenario, but it puts that possibility in play. After more than a decade of inflation below 2%, several years of slightly higher readings are not a disaster. The Fed has explicitly said as much by changing its inflation targeting regime to an average of 2% over a cycle instead of targeting a 2% ceiling. Expect the Federal Reserve to monitor this issue closely and act decisively to raise rates if they feel significantly higher inflation expectations are being ingrained into the fabric of our economy.
It is a positive signal that the Federal Reserve Board feels comfortable enough with the state of the markets to begin removing some monetary support. In remarks after the Board’s recent meeting in September, Chairman Powell was candid in signaling a reduction in the pace of bond purchases beginning in November. It is important to note that the Fed is currently purchasing $120 billion of Treasury and mortgage-backed securities per month, with plans to reduce purchases by $15 billion a month starting in November. The Fed will still be growing its balance sheet in 2022, just at a slower rate.
This is a very modest change in monetary policy that has been well telegraphed to the market. The consensus belief among market participants is that bond purchases will end in mid-2022 and at that point, the Fed will begin to raise interest rates from the current level of 0.25%. This would be followed by a steady tightening cycle until an equilibrium is reached between growth, employment, and inflation sometime in late 2023. The neutral rate is estimated to be a still very low 2% in the current environment, and could be the Fed’s ultimate destination.
There is some concern that the spike in inflation we have seen since the economy reopened after Covid will force the central bank to move faster than planned in raising rates. As discussed above, this is a concern, but we still expect these issues to moderate enough to take an early rate hike off the table.
The market tends to focus on the future path of interest rates because it is a significant input in valuing future cash flow streams, which has a direct impact on the multiple that investors are willing to pay for equities. While interest rates are going to rise, it does not appear that they will move far enough to fundamentally alter the current relative valuation framework for stocks in the US. However, the impact of fiscal policy may not be as fully appreciated. Consumer spending is an important input into corporate earnings, and that may be influenced by the removal of direct payments to US households from Washington, DC.
We faced a similar, but far less dramatic scenario coming out of the 2009 global financial crisis (GFC) when government spending supported consumers and firms, but much of that support was being withdrawn by 2012. The scale of our current situation is twice that seen during the GFC.
This means the economy is going to grow more slowly in 2022 and 2023 than over the past twelve months. Corporate earnings are still expected to trend higher in the next few years as companies will continue to invest in their businesses, and consumers will take advantage of the strong labor market and wage increases to maintain spending. The fundamentals remain very positive, but we will not have the large and predictable cash flows from Washington to add further strength to the market. We will have to learn to walk on our own two feet once again. Though the US has largely recovered from Covid, the first steps for the economy without extraordinary assistance may cause a stumble or two along the way.
The realization that we will face headwinds on both the fiscal and monetary fronts has already begun to set in. Markets had a volatile yet largely flat third quarter, and this uncertain market backdrop will likely continue for the next few months as investors adjust to the twin tapers. Our recommended positioning remains the same: 1) maintain a cash reserve for spending needs; 2) remain underweight fixed income; 3) favor US equities over international while staying balanced between value and growth; and 4) seek additional yield in private corporate and real estate credit opportunities in alternative holdings.
Standing on Our Own
We are moving into a post-pandemic world and financial markets reflect that reality. We need to get the economy to a point where it can function without the extraordinary levels of government and Fed support. Those institutions acted appropriately to shepherd us through the crisis, but now is the time to withdraw that support.
There will be some persistent changes to our everyday lives due to our experience with Covid-19, but for the most part we expect the fundamentals of our economy to return to their pre-pandemic rhythms in short order. We believe that by the middle of 2022, most areas of society, including the economy, will be operating on a footing more closely resembling their status prior to the coronavirus outbreak. The nearterm path for markets will likely be noisy given the amount of support being withdrawn, but we believe the economy is ready to step back into the light under its own power.
President & Chief Investment Officer
VP, Head of Private Markets
VP, Head of Public Markets
Charts & data in this report are from Bloomberg LP, FactSet, JP Morgan Asset Management & Goldman Sachs.