Highlights:
- Despite downward revisions to 2021 estimates, real GDP has recovered to pre-pandemic output levels and appears on track to return to the 20-year growth trend that preceded the pandemic
- Corporate earnings are expected to reach all-time highs in 2021, although service sector industries still struggling to reopen fully.
- Consumer spending continues to drive GDP growth, though we have seen personal savings rate decline by 35% year over year.
- Unemployment continued to decline in 3Q21, finishing the quarter at 4.8%, though jobs gains are continuing to decelerate.
- Inflation continues to run hot, with the Consumer Price Index (CPI) growing 5.2% year-over-year in August. While many still view the current spike as a “transitory”, it’s becoming increasingly apparent that inflationary pressure is likely to persist for longer than previously anticipated.
- The Federal Reserve downgraded its previous 2021 GDP estimates from 7.0% to 5.9%. However, with continued growth and high inflation, they still indicated that tapering may begin in 4Q21.
- Tensions over infrastructure packages currently being negotiated in Senate have resulted in a stand-off over debt ceiling issue.
- Despite modest declines in 3Q21, equity markets are expected to remain elevated throughout the remainder of the year. Optimistic recovery prospects and the expectations of rising interest rates are likely to favor Value stocks vs. Growth in the short to mid-term.
- Fixed income markets remained sluggish in 3Q21, though high-yield and credit-sensitive sectors finished the quarter relatively strong. Low yields and rising rates make a difficult backdrop for public bonds.
- Private equity and real estate have delivered strong returns in 2021. With an improving economy, and high public equity valuations, private markets may provide a good opportunity for growth, lower volatility, and inflation hedging.
GDP Analysis
Economic growth rebounded sharply in the 2nd half of 2020 and continued to gain momentum through the first half of 2021. A third round of estimates released by the Bureau of Economic Analysis seems to confirm this trend, as annualized real GDP growth in 2Q21 was 6.7%, slightly higher than the 6.3% increase in 1Q21. i Although the economic environment is expected to remain favorable throughout the remainder of the year, a number of factors have contributed to a deceleration trend that is causing analysts to dial back growth estimates for 2021.
After an upward revision at the of the 2nd quarter, the Fed has since revised downward its year-end 2021 estimates for real GDP growth from 7.0% to 5.9%. ii These revisions primarily reflect the impact that the Delta variant, supply chain disruptions, and continued mandated COVID restrictions, have had on recovery prospects. The combination of these have resulted in a slower labor market recovery rate and a longer than anticipated period of inflationary pressure on consumer prices and production inputs. Similarly, in August, Goldman Sachs indicated it was also reducing its year-end GDP estimates, due primarily to the weaker-than-expected recovery within consumer service sectors, which has been stunted by the COVID resurgence and related restrictions. iii That being said, the economy is still moving forward. As we enter the fourth quarter we have seen real GDP recover to levels comparable to Q4 2019 (pre-pandemic), and we remain on track to regain the 20-year growth trend that preceded the pandemic. iv
Consumer Spending
As is typically the case, consumer spending continues to be the driving force behind domestic GDP growth. Through the first of 2021, consumers have been buoyed by record high personal savings levels, unprecedented fiscal stimulus, and pent-up demand, following various levels of economic restrictions for the past year. At the end of 3Q21, the personal savings rate among domestic consumers remained a healthy 9.4%, albeit significantly lower than the 15% mark it hit last year at this time. v The drawdown in savings is no doubt a result of a reopening economy providing more outlets to unleash pent-up demand, and in our opinion is expected to continue now that enhanced fiscal benefits have largely expired.
Labor Markets
Total nonfarm payroll employment rose by 194,000 in September (lagging expectations of 500,000), bringing the unemployment rate down from 5.2% to 4.8% heading into 4Q21 (7.7 million). vi Though significantly reduced year over year, unemployment still remains meaningfully above its pre-COVID level of 3.5% (5.7 million). vi Furthermore, the rapid pace of job recapture that occurred at the recovery’s outset appears to have slowed over the past few quarters. Many have pointed to the extension of enhanced unemployment benefits as a key disincentivizing factor preventing people from returning to the workforce. While there is certainly merit to this argument, there also appears to be a supply-demand mismatch within the labor market that is causing a deceleration in job growth that could very well persist for a while, even though benefits have expired. Geographic migration, shifting preferences towards remote work, rising retirement rates, and workforce exits related to childcare, all seem to be contributing to a slower, more uneven labor market recovery. The Delta variant also seems to have further exacerbated employment gains, particularly in service-related industries (restaurants, leisure, hospitality, etc.), where a combination of public hesitancy and government mandates and restrictions have reduced the number of eligible workers who are able and/or willing to return to these types of roles.
Digging deeper into these factors, we notice that the labor participation rate has only slightly recovered from pandemic lows, currently sitting at 61.6%, reflecting 3.5 million people who have left the workforce altogether. vi Some are unlikely to ever return, as Baby Boomer’s saw the pandemic as an opportunity to pursue their retirement aspirations a little earlier than anticipated. As a result, the retirement percentage jumped to 19.5% in April 2021, up from 18.6% pre-COVID. vii
The pandemic exposed many individuals to the benefits of a remote work environment including the ability to work from anywhere in the world. As such, geographic migration that occurred during the pandemic has resulted in a certain degree of frictional unemployment, particularly in the service industries, which could take longer to shake itself out, further delaying a full labor market recovery at the regional level. School shutdowns also forced many families to recalibrate their childcare needs, causing some to drop out of the workforce to care for their young children. While this factor appears to be reversing, now that schools have reopened across the country, a resurgence in the Delta variant could further delay workforce reentry for many parents, particularly in geographic regions with stricter regulations surrounding quarantines following exposure.
Many factors have converged to create one of the tightest labor markets in recent memory. In general, job growth is expected to remain positive in the foreseeable future, and the pace of job gains is expected to pick up a bit now that enhanced unemployment benefits have expired. However, as we see it, the pandemic appears to have created some structural and cultural changes to our domestic labor market that will need to be dealt with before a return to “full employment” is attained.
Corporate Earnings
Corporate earnings have recovered spectacularly and are expected to reach new all-time highs in 2021. This partly reflects the fact that some of the most important sectors of the U.S. equity market, including Technology, Communications Services, Health Care, and Consumer Staples, have experienced few negative impacts from the pandemic and, in many cases, actually achieved stronger revenues. More generally, earnings have been bolstered by powerful consumer demand and higher productivity as businesses have thus far been able to reduce costs in a more virtual environment. To be clear, the recovery has not been felt evenly across the entire economy, with service sector industries like restaurants, hospitality, and leisure all experiencing fallout from the resurgence of COVID over the summer and bearing the brunt of the pandemic woes. Additionally, these industries are among the hardest hit by labor shortages and wage inflation. iv
While the snapback in earnings is encouraging, 2022 and beyond may prove more challenging in our opinion, as slowing economic growth, elevated inflation, higher wages, and the potential for corporate tax increases all conspire to tighten margins. In particular, we believe supply chain disruption due to economic shutdowns will likely continue cultivating supply crunches in 4Q21 and into 2022, especially for industries that had consciously reduced their output levels in anticipation of a more gradual recovery. This is particularly true in the semiconductor space, which has led to productivity shortfalls in a wide variety of sectors including automobiles, electronics, and industrial equipment.
Inflation
Inflation continued its ascent in 3Q21 with headline CPI reaching 5.5% YoY in September and looking less and less “transitory” with each passing month. viii From our perspective, this is no longer merely a rebound from the steep price declines in early 2020 when COVID first hit. Inflationary pressure has been exacerbated by pent-up consumer demand colliding with sustained supply shortages across major sectors of the economy. It’s becoming increasingly apparent that these disruptions are unlikely to subside in the near-term, as even those in the “transitory” camp now recognize that the conditions feeding inflation are likely to persist longer than previously anticipated. The Fed’s rhetoric continues to imply that inflationary pressure will eventually subside once supply-chain disruptions work themselves out. However, the PCE deflator, the Fed’s primary measure of inflation, is up 4% year-over-year, well above its stated long-term target of 2%. iv Furthermore, some members are now calling for rate increases to occur in 2022, implying that even the Fed is unsure about how long “temporary” will last.
It is now clear that the cost of the lockdowns is immense, and the clear damage to small businesses and supply chains has been more than apparent. The US economy cannot be switched off and on like a light bulb. Lockdowns threw complicated supply chains into chaos, and restarting them has proven more difficult than many assumed. Every day, countless decisions are made in order to get the simplest of products on store shelves. Each part of the process depends on those before, and if just one part is thrown out of whack, the ramifications echo down the line. When you lock down the supply-side of the economy, while simultaneously stimulating the demand-side, inflation is inevitable. A massive spike in consumer spending by people who weren’t producing is a recipe for unbalanced markets. viii
Some industries have been hit harder by inflationary pressure than others. In particular, the global semiconductor shortage has significantly increased prices across a broad range of goods, most notably automobiles. iv Ramping up natural resource production following economic shutdowns last year has also proven to be a more timely and sluggish process than simply flipping a switch. We saw evidence of this last year when lumber prices spiked in December, and we’re experiencing it now as the 25% year-over-year increase in energy costs has been felt by consumers for goods like fuel, air travel and electricity. ix
It remains to be seen how much longer we can expect the currently elevated inflationary environment to continue. That being said, it’s apparent that inflation will play a critical role in determining the pace and potential of our domestic recovery prospects and will be monitored closely by industry professionals. Moving forward, wage inflation will be of particular importance to global central banks, as this has historically been one of the primary drivers of long-term sustained inflation. Though many would argue that wage growth of this kind has been long overdue, we believe steep and persistent wage increases could potentially turn an otherwise “transitory” inflationary event into something that requires a more aggressive monetary policy response to control.
Monetary Policy
Despite largely maintaining its dovish monetary posture, the Fed’s rhetoric coming out of their September meeting continued to reflect the more hawkish tone it had adopted in June. While still generally viewing inflation as a “temporary” phenomenon, the Fed has acknowledged that economic conditions continue to strengthen at a relatively rapid clip. That being said, they did downgrade their year-end estimate for 2021 GDP from 7.0% to 5.9%, which it claims is due to the unexpected resurgence of COVID variants, a slowdown in the labor market recovery, and higher than anticipated inflation rates. iv Despite this revision, there continues to be strong indications that the Fed will begin tapering its quantitative easing this year, perhaps even as early as November. This would entail reducing the $120 billion/month purchases of open market treasury and mortgaged-backed securities. While it still remains unclear as to when the Fed intends to begin implementing rate hikes, it’s noteworthy that half its members now anticipate rate hikes beginning in 2022, while virtually all of its members expect multiple rate increases in 2023 (half expect increase of at least 1% by year-end 2023). ii This change in expectations seems to reflect some members’ belief that inflation will persist longer than previously anticipated and longer than the current rhetoric implies.
Despite September’s more hawkish forecast, it’s important to note that the dot plot (projections for the federal funds rate) reflects a range of estimates that can and do frequently change. Given the unprecedented nature of this recession, coupled with elevated equity markets, any change in tone regarding monetary policy is enough to inject volatility into markets that are already somewhat difficult to interpret. As it relates to a long-term strategy, Chairman Powell reiterated the Fed’s focus on unemployment and wages in determining the next phase of monetary policy actions, as well as a willingness to allow inflation to run well over the target 2% level for an extended period of time if necessary. ii While the workforce participation rate remains sluggish, it seems unlikely in our opinion that a dramatic shift towards more contractionary measures (rate hikes) will happen in the near-term. However, substantial acceleration in wages could ultimately force the Fed’s hand to act earlier than anticipated, as wage pressure has historically been one of the most important drivers of inflation and therefore monetary policy.
Fiscal Policy
Unprecedented fiscal stimulus over the last 18 months has proven to be a powerful accelerant for the economic recovery, though the long-term effects of such large stimulus are yet to be fully realized. The most recent $1.9 trillion package, passed in March, is still working itself through the system and will likely continue supporting the economy through the end of 2022. However, the loose spending practices we saw in 2020 may finally be coming to an end now that economies have generally re-opened, and labor shortages have begun to induce wage inflation.
The highly anticipated $1 trillion bi-partisan infrastructure package is still alive, although seemingly on life support, as it has been tied to a larger $3.5 trillion infrastructure package that may not even have enough support to pass on a party-line basis. The debate over infrastructure is a familiar one, with one side stressing fiscal conservatism while the other is pushing for government investment. However, this time stakes seem higher in the context of a historic recession and national debt levels expected to equal GDP by year-end (99.7%). iv Further exacerbating tensions is that these bills are directly tied to a more serious fiscal matter, debt limitations related to government spending. The federal government is currently on pace to run out of the assets necessary to fund its operations and continue making good on its debt payments to creditors in the next couple of months.
Technically, the U.S. hit its debt limit at the end of July, however the Treasury Department has been utilizing “extraordinary measures,” to delay default. These resources are expected to be fully depleted by the end of October, which means Congress will have to vote to raise the debt ceiling in order for the U.S. to avoid defaulting on its debt. The consequences of failing to reach an agreement on the debt ceiling cannot be overstated. A recent extension of the debt ceiling to December provides some hope that a compromise can be made. Historically, debt ceiling votes have passed on a bi-partisan basis, as neither party wants to be held responsible for the fallout from a default scenario. However, due to the polarized political climate we find ourselves in today, coupled by heated debate over the infrastructure bills, it appears bi-partisan support for debt relief is off the table this time around. While Democrats still have the ability to pass this measure on their own through a process known as reconciliation, there is still intraparty dissent regarding the prudence of the proposed spending bills. Given their razor thin majority in the Senate (50-50), Democrats would need the support of every single member of their caucus in order to raise the debt ceiling, which they don’t currently have. While the risk of a government default/shutdown scenario is somewhat elevated, it is still less likely to occur than Congress coming to agreement and passing the necessary legislation to maintain our nation’s strong economic standing. The situation will continue to be monitored closely as the December deadline approaches.
Equity Markets
After a roaring first half of 2021 equity markets finally encountered some headwinds in Q3 and pulled back a bit during the quarter. The S&P 500 declined -4.6% in September and ended the quarter up only 0.6%. Concerns about inflation, resurgence of COVID cases, and looming debt ceiling negotiations, led to heightened volatility during the quarter. Performance of 8 out of 11 primary economic sectors was positive during the quarter. Financials, Utilities, and Communications Services were the strongest relative performers, generating returns of 2.7%, 1.8%, and 1.6%, respectively. Conversely Industrials, Materials, and Energy sectors were the poorest performers, down -4.2%, -3.5%, and -1.7%, respectively.
International stocks also underperformed in 3Q21, with the MSCI All Country World Index (ex-US) finishing down -3.0% for the quarter. Emerging markets suffered from growth and regulatory fears in China, posting a sizeable loss in Q3 of -8.1% and wiping out all gains from the year, with YTD losses of -1.2%. On a relative basis, international equities continue to appear cheaper than domestic equities, with YTD returns on the S&P 500 and MSCI ACWI at 15.9% and 5.90%, respectively. iv / i
As is typical coming out of recessions, value and small cap stocks outperformed growth and large cap stocks through the first half of 2021. This trend slightly reversed in 3Q21, as declining interest rates, fears surrounding the Delta variant, and relatively disappointing labor market data sparked a resurgence in growth stocks. Value stocks remain attractive relative to Growth stocks when comparing their long-term valuations. Given that Value tends to outperform Growth during periods of above-trend economic activity and rising interest rates, we think it’s reasonable to assume that value stocks will have more room to run in 2021 and into 2022
As we continue emerging from the pandemic and mandated shutdowns, favorable recovery prospects and a persistently low interest rate environment are likely to support equities for the remainder of the year. That being said, against the backdrop of political tensions surrounding the debt ceiling and infrastructure packages, we believe the risk of a correction and continued volatility remains higher than usual for this stage of market cycle.
Fixed Income Markets
Fixed income investing has been challenging this year as easy monetary policy has kept 10-year Treasury yields low, finishing the quarter at 1.52%. Liquidity facilities established by the Fed to protect parts of the bond market have compressed spreads, while low foreign yields and a temporary lull in Treasuries all appear to be suppressing long-term rates. iv
As such, fixed income has struggled thus far in 2021. Most categories saw little movement over the quarter and are still showing negative returns YTD. The Barclays U.S. Aggregate Bond Index was essentially flat in Q3, up 0.1%, but is still down -1.6% for the year. Intermediate-term Treasuries were flat for the quarter and are down -2.8% YTD. Conversely, TIPS and more credit sensitive sectors, like high-yield and leveraged loans, have fared much better. High Yield securities were up 0.9% for the quarter and have returned 4.7% YTD.
With income low and yields likely to rise (putting pressure on bond prices) public fixed income looks less and less attractive from our vantage point. In the current environment we prefer private, floating-rate, credit or private real estate for the income potential and inflation hedge. Moving forward, the Federal Reserve will be a key driver for fixed income markets, as we await its decisions related to tapering and eventually rate increases. While it is likely the bond market’s initial response to these actions could be somewhat disruptive in the short-term, a “normalization” of monetary policy will generally be perceived as a bullish indicator to investors and will ultimately provide more income potential in the long run.
Outlook
After a spectacular start to the year, markets around the world appear to be slowing down a bit, as the reality begins to set in that supply-chain disruptions and inflation may be with us for longer than previously anticipated. Year-end economic growth numbers are still expected to remain strong across the board, however decelerating employment and GDP growth estimates indicate that the though the recovery is still incomplete, the peak of growth is likely behind us. We believe 2022 will likely be defined by central bank policies, particularly as it relates to inflation, with the potential for rate increases providing headwinds and possibly bouts of volatility over the next year.
In this context, we encourage individuals to view markets from the perspective of investors rather than traders. That is to say, avoid market timing approaches, as high inflation rates essentially guarantee meaningful value deterioration for holding large cash positions. Instead, we strongly encourage you to connect with a fiduciary advisor to revisit asset allocations, liquidity needs, and risk tolerance to ensure your current investment strategy is in line with your overall financial goals and objectives.
| Andrew Mescon, MBA
VP of Strategy |
|
Sarah Archer
Chief Investment Officer |
Sources:
i. Envestnet PMC: Economic and Market Overview (3Q 2021)
ii. Federal Reserve: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210922.pdf
iii. https://fortune.com/2021/08/18/goldman-sachs-us-growth-forecast-cut-delta/
iv. P. Morgan: Economic and Market Update 4Q 2021 (as of 9/30/21) & Guide to the Markets 4Q 2021
v. https://fred.stlouisfed.org/series/PSAVERT
vi. Bureau of Labor Statistics: https://www.bls.gov/news.release/pdf/empsit.pdf
vii. FS Investments: Q3 Outlook – Zooming in on Inflation
viii. First Trust Economics Blog: https://www.ftportfolios.com/retail/blogs/economics/index.aspx
ix. Charles Schwab: Q4 2021 Quarterly Chartbook
x. Vanguard: https://personal.vanguard.com/us/funds/tools/benchmarkreturns
xi. FS Investments – Providing Little Income, Barclay’s Agg Still Underwater
xii. FS Investments – Q4 2021 Corporate Credit Outlook
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