After a spectacular fifteen-month rally, financial-market returns for the third calendar quarter were decidedly lackluster. A September dip of 5% left large-company U.S. stocks roughly flat on the quarter; small-cap stocks fell 3% to 4%, while real-estate equities were off a bit less. Developed-market non-U.S. stocks were down less than 1%, on average, buoyed by modest gains in Japan; their emerging-market counterparts swooned nearly 9%, hurt by a 15% fall for Chinese stocks. Commodities were a bright spot: though gold declined marginally, industrial-commodity and energy prices rose around 5%, on average. Bond yields moved modestly higher, with the 10-year Treasury finishing at 1.53% compared with 1.44% at the end of June. Credit spreads narrowed slightly, allowing many short- and intermediate-term bonds to eke out positive returns.
Among U.S. large-company stocks, those in the Communications Services, Energy and Financial Services sectors outperformed the index averages, while Basic Materials, Industrials, Consumer Cyclicals and Health Care lagged. The growth investment style marginally outperformed value among both large- and small-company shares.
In early July we wrote in this space of exceptional progress combatting the COVID pandemic and the prospect of robust and accelerating economic growth. The ensuing three months were characterized by disappointment on both fronts. Meanwhile, simmering inflation fears, gyrating bond yields, and regulatory-bomb-throwing Chinese policymakers made headway difficult for financial markets.
When a stalling vaccine drive met the highly contagious delta-variant virus, the U.S. public-health situation deteriorated rapidly. From late-June/early-July lows, average daily diagnoses and deaths each increased more than ten-fold by early/mid-September before beginning to ebb. Overseas regions that had seen earlier delta-driven waves mostly improved, but others that had previously been largely spared – e.g., Japan, Vietnam – battled large increases in illness, albeit from low bases. Globally, the third, delta-dominated pandemic wave appeared to peak in late August, with average daily new cases falling nearly 30% by the end of the period.
The U.S. economy slowed noticeably as cascading supply disruptions and newly hesitant consumers combined to dampen activity. As the summer began, the robust annualized growth of +6.7% in the April-June period was expected to accelerate, reaching an 8% or even 10% clip; by the end of September, most prognosticators were calling for something closer to 4% (still a healthy pace compared to the pre-pandemic norm of around 2%). Consumer confidence fell each month, while measures of manufacturing- and service-sector activity both rolled over. The economy added an impressive 1.1 million jobs in July, but the pace collapsed to 235,000 in August (the September figure had not been reported when we went to press); the unemployment rate hovered above 5% and total employment remained more than 5 million below the pre-COVID peak.
European economies rebounded from a turn-of-year lockdown-driven slump, expanding at a torrid annualized pace above 9% in the April-June period. Amid steadily climbing vaccination rates, near-normal levels of consumer activity in September signaled third-quarter growth was likely similarly stemmy. Japan, meanwhile, struggled under an ongoing state of emergency, with second-quarter growth of just under 2% probably slowing further in the third. The Chinese economy, too, was hamstrung by draconian zero-tolerance COVID restrictions, supply-chain disruptions, a campaign to rein in the property sector and, most recently, widespread power shortages. Third-quarter growth will likely come in meaningfully below the official 2021 target ("above 6%").
A pervasive theme of the quarter was a cascade of supply-chain and labor-market disruptions, which fueled eye-grabbing price increases across a range of markets. Chip shortages continued to knee-cap the auto industry; a dearth of containers caused massive back-ups at ports; hurricanes shut down Gulf of Mexico oil and gas production; the rail and trucking industries were in disarray. Inflation remained elevated, though it stopped accelerating: the headline reading for August (+5.3%) fell slightly from earlier in the period; the prices-paid components of recent purchasing-managers indices were the lowest since late 2020; future price increases implied by the yields of inflation-protected bonds were steady despite a late-period rise in nominal yields.
Ubiquitous inflation anecdotes focused investor attention on the world's major central banks. Both the Bank of England and the U.S. Federal Reserve sent surprisingly hawkish messages at their most recent policy-setting meetings; the European Central Bank was more equivocal, but strong economic data may soon change its stance, too. For its part, the Fed indicated increasing satisfaction with the progress of the economic recovery. The central bank signaled its intent to begin winding down ('tapering') its emergency bond-buying program as early as the end of the year, while a growing number of Fed governors indicated short-term interest rates could be hiked multiple times beginning as soon as late next year or early 2023. Bond investors took note of the shift in tone, driving yields nearly 40 basis points (0.40%) higher from early-August lows.
Within equity markets, a superficial calm masked less tranquil internal dynamics. While headline market indices have so far this year experienced no dips exceeding approximately 5% from a previous high mark, more substantial downdrafts have affected small-company stocks (down 10%) and emerging-market equities (off 15%), the latter paced by a 30% plunge among Chinese stocks. Market breadth has also deteriorated markedly: since peaking above 90% in April, the proportion of S&P 500 stocks trading above their 50-day moving averages declined to under 30% by late September. Finally, a potentially salutary development: the market rotation favoring "work from home" beneficiaries at the expense of their "back to normal" counterparts dating from May showed signs of petering out; the two themes were roughly even on the quarter, and "back to normal" outperformed by more than two percentages points in September.
As we drafted this letter, the too-familiar bugbear of political dysfunction was rearing its head. Though the prospect of yet another government shutdown was a bit of a yawner, the same could not be said of the prospect of failing to raise the federal debt ceiling – which nearly all observers agree would cause immediate and widespread disruptions in financial markets and possibly severe damage to the real economy. Please call your Senators and/or Congressperson before the alleged October 18th abyss.
Earnings reported by S&P 500 constituents during the period (mostly covering the April-June quarter) were an eye-catching 102% better than the lockdown-depressed year-ago figure. Wall Street analysts expect gains of better than 35% and 50% for the third quarter and full year, respectively. Calendar 2021 and 2022 estimates continued to rise during the quarter, though at a slower pace than earlier in the year.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
- Dividend Income (for three months this is the annual yield divided by four)
- +/- Change in Earnings per Share* (average for S&P 500 companies)
- +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the +0.6% S&P 500 total return?
|Third Quarter (July-September) 2021
|+ Change in Earnings
|+ Change in Valuation
|= Total Return
Our read: Year-ahead earnings growth slowed compared with three months ago, but was still a very healthy +29% annualized. The decline in valuation was welcome, coming from an elevated level.
A waning pandemic wave and the prospect of improving immunity from widely deployed booster vaccines – at least in the rich world – are likely to buoy economic growth and corporate profitability over the next several quarters. The way forward for financial markets – barring another major public-health reversal (a vaccine-resistant virus variant?) – will likely be defined largely by perceptions of inflation and the responses of major central banks.
Given two more or less bi-modal variables – growth and inflation – we can posit four alternative futures: 1) disappointing growth and receding inflation; 2) similarly meager growth accompanied by stubbornly high inflation; 3) stronger growth paired with non-worrisome inflation; and 4) robust/too-strong growth and high and/or rising inflation. The first and third scenarios, mirroring conditions of the decade-plus following the global financial crisis and the second half of the 1990s, respectively, would likely be benign – both historical analogs featured largely calm and strongly rising markets. The second and fourth scenarios – where inflation remains a persistent or recurring problem for years – are more worrisome. Presented with either, central banks would face a dilemma. They could dust off the 1980s playbook and raise interest rates aggressively to quash inflation, but this would likely trigger major financial-market 'corrections' and risk a chain-reaction of defaults in a highly indebted real economy. Alternatively, they could opt to keep rates relatively low and let moderate inflation persist. Doing so might side-step financial-market carnage and, importantly, would allow the real burden of debts to gradually decline. But these salutary results would come at the price of eroding purchasing power and confidence, which could eventually undermine economic growth and longer-term financial-market returns.
Which path seems most likely? Although we acknowledge some risk of economic overheating during the next few quarters of 'catch-up' consumption and investment, we see few compelling reasons why future growth should be meaningfully stronger than it has been for most of the 21st century – which is to say, subdued. The list of growth-restraining forces is daunting: near-unprecedented levels of debt, sluggish productivity gains, government dysfunction/fiscal drag, aging and/or shrinking populations, a maturing and slowing Chinese economy (see below). As for inflation, many price increases seem likely to subside (or reverse) as re-opening-related bottlenecks are resolved in coming months. Emerging longer-term trends, however, seem to favor more rather than less inflation compared with past decades: slowing globalization/U.S.-China 'decoupling', re-shoring/ regionalization of supply chains, emboldened labor forces, climate-related re-engineering of the energy, industrial and transportation complexes.
The likelihood of modest growth and high(er) inflation may be heightened by developments in China – the world's second largest and arguably most dynamic economy. As noted, Chinese stocks have plunged from early-year highs; investors clearly sense something amiss. Since late 2020, the Chinese Communist Party has undertaken numerous high-profile and heavy-handed actions: scuttling much-anticipated initial public stock offerings; publicly shaming business tycoons and wealthy media celebrities; banning for-profit tutoring services; announcing draconian limits on on-line gaming; outlawing transactions in non-official cryptocurrencies; establishing strict debt-related guidelines for property developers. The Party's actions seem to have two distinct substances: first, they represent an official program to mitigate glaring inequalities within the Chinese economy and promote the Maoist ideal of "common prosperity;" second, they reflect a stepped up technocratic effort to "rebalance" the economy away from inefficient, debt-financed investment in heavy industry, low-tech manufacturing and, especially, real-estate development. While the initiatives presumably are intended to enhance longer-term performance, their near-term impact is likely to be an intentional and possibly substantial slowing of growth as well as a diminution of China's role as a provider of cheap labor and manufactured exports.
So, apart from the next year or so, we think 'stagflation' (modest growth combined with stubbornly high inflation) could be on the cards. And given the evolution of policy rhetoric in recent years – not to mention sky-high debt levels – we suspect the Fed will be inclined to let inflation run hotter for longer than it would have in the past. Such an outcome could prove problematic – even if not disastrous – for many investments as bond yields drift higher to accommodate inflation while earnings projections are downgraded to reflect lackluster growth.
The above analysis suggests several ways to prepare portfolios for anticipated developments. In the very short run, prudence dictates keeping some dry powder (that is, uninvested cash) in case the looming debt-ceiling crunch sparks volatility. Beyond the next several weeks, it will be appropriate to focus bond investments on below-average duration (which limits vulnerability to rising yields), while maintaining moderate credit exposure. If bond yields remain relatively low, tilting portfolio holdings in favor of high-quality dividend-paying stocks will enhance both income and expected return. Meanwhile, stock holdings should be balanced to avoid over-reliance on high-growth, high-price names whose appeal may persist in a slow-growth world, but whose valuations will be most at risk to rising interest rates. Finally, relatively low valuations and converging growth prospects argue for exposure to developed-market non-U.S. equities, while China-related volatility may provide attractive opportunities to selectively augment emerging-/frontier-market holdings.
Please let any member of the Oarsman team know how we can be of service to you in the weeks ahead. We hope you have a terrific fall!