ECONOMIC COMMENTARY

Risk comes roaring back

Earnings season and fourth quarter optimism buoyed equity markets this October, meanwhile higher inflation and the beginning of the Fed taper did little to dampen the enthusiasm.

In short

  • Inflation and employment remain the most critical areas of focus for the Federal Reserve as well as Washington D.C. as politicians look towards next year’s midterm elections.
  • Equities roared back after a challenging September, with earnings season fostering a new wave of positive sentiment that should continue through the end of the year.
  • Inflation is on everyone’s mind, and with it comes a renewed interest in gold as a hedge within portfolio.

During September, investors and economists were readying themselves for the next phase of the economic recovery and the jury seemed like it was still out in terms of what this next phase would bring. If October is any indication, the recovery seems ready to deliver everything we have experienced over the last several quarters, with an extra shot of espresso. Company earnings were better than anticipated, inflation was higher than forecast and economic growth is poised to outperform for the fourth quarter after the relative softness of August and September. The drumbeat of the labor market mismatch and supply chain concerns was deafening in September but has faded into the background with a new narrative citing the rationale for improvements which are just around the corner as we move towards the new year.

Congress also managed to accelerate its agenda during the month. In Washington D.C., the House finally passed, with the help of several Republicans, the bipartisan infrastructure legislation already approved in the Senate several weeks ago. The delay was based on House Democrats calling for a second bill, which included a broader scope of climate change, child care credits, early educations and family leave, to be passed concurrently to gain their support. However, after a number of centrist Democrats committed to the passage of the second bill after the costs were confirmed, Speaker Nancy Pelosi pushed forward with the vote on the Senate’s bill. While the bill will fund approximately $550 billion in new projects over the next 10 years, a large part of the bill was just continued funding for previously earmarked projects, and thus, the impact of the new spend has likely been incorporated into market expectations already.

Inflation remains the prevailing concern from an economic perspective, and what impact it may have on consumer behavior and corporate profit margins. U.S. inflation data released for October indicated that while many were hoping prices would moderate into the fourth quarter, the continued supply chain disruptions and higher wages due to elevated job openings is clearly being passed down by producers to consumers. U.S. CPI rose by +0.9% month-over-month in October versus a gain of +0.6%, and was up +6.2% year-over-year, which marked the highest print since 1990. Core CPI, which excludes energy and food prices, was also higher than expected, up +0.6% month-over-month, and up +4.6% year-over-year. The consumer price hikes are being driven by higher producer costs, not only from labor, but from inputs, as U.S. PPI was up +0.6% month-over-month and +8.6% year-over-year.

As for the other half of the Fed’s dual mandate, after disappointments in August and September, U.S. non-farm payrolls finally surprised to the upside for the month of October, as the impact of the Delta variant surge wanes and businesses attempt to fill a large number of open positions. Non-farm payrolls rose by +531k versus expectations of a +450k gain; in addition, the payrolls print for September was upwardly revised by +118k to +312k. The unemployment rate fell to 4.6% from 4.8% in September and average hourly earnings were up by +0.4% month-over-month and +4.9% year-over-year, reflecting the pressure employers are feeling to hire workers amidst a labor supply-demand mismatch. One area that’s worth watching is the labor participation rate, as there are still 3 million less people in the working population when compared with February of 2020. This is a measure that the Fed watches closely when determining the health of the employment market and could impact Fed policy.

Even the Fed could do little to upset the momentum in October. The Fed moved ahead with its well-telegraphed plan to begin tapering its monthly bond purchases beginning in November and continuing through mid-2022. The Fed plans to reduce its purchases by $15 billion a month from the current outlay of $120 billion a month. While interest rate hikes are likely to be the next step in tightening, rate hikes are not expected to commence prior to the end of the taper. Should the Fed determine that inflation is more persistent than transitory, the door is open for rate hikes to begin earlier in 2022 than previously assumed. The timing of the taper announcement from a seasonal perspective was fortuitous, as November and December tend to be positive for equity investors – and the fact that Fed Chair Jerome Powell has been talking about it for months didn’t hurt either.

As mentioned earlier, equities were on fire for the month of October, as the concerns of September – China, interest rates, Washington and even tech valuations – seemed to matter little as investors cheered an earnings season that showed deceleration, but was still better-than-expected. U.S. stocks outperformed international and emerging markets names as the S&P 500 gained +7.0% for the month, led higher by consumer discretionary, energy and technology names. Domestic small caps were also positive but did bounce back as much in October as large caps did – although they started the month of November on a strong note. As for the fixed income markets, returns continue to lag the riskier parts of the market and were further challenged as rates moved slightly higher over the course of the month. With low yields and little opportunity for capital appreciation, bonds remain a challenging arena for diversified investors for at least the next several quarters. Investors appear increasingly comfortable attempting to find other options for yield in this environment, particularly within the more cyclical areas of the market such as energy related equities and real estate.

In focus: The changing backdrop for gold

Last October, I was afforded the opportunity to share my views on the economy and the markets with a local group of CFP professionals and I dedicated several minutes of my presentation to a discussion of the merits – or lack thereof – of gold in portfolios. Inflation chatter was picking up and it seemed like the right time to address the two misconceptions that I believe are worth addressing regarding gold. With October CPI coming in at +6.2% year-over-year, I felt it was time to revisit those initial thoughts and touch on what’s happened since then.

The first misconception regarding gold is that it helps to dampen volatility as a conservative store of value. In fact, gold prices, as measured by gold spot prices, are more volatile over time and offer lower returns than U.S. stocks. Stock prices typically rise in an inflationary environment, and have some fundamental basis on which they trade. Gold does not offer the same returns, and is much more volatile.

The second misconception is that gold is positively correlated to inflation, implying that when inflation is rising, gold will rise along with it. The truth is gold is not particularly well correlated to inflation. In fact, it isn’t all that correlated at all. If one looks at a long term comparison of gold and CPI, averaging the correlation over time yields something that looks non-correlated, rather than positively correlated – which is where some of my investment colleagues may be going with the inclusion of gold in their portfolios. Perhaps the most important thing to consider is the period when gold and inflation were most correlated – this was during the hyperinflationary energy shock of the 1970s. Investors responded to the weak dollar, high energy prices and political uncertainty in the 70s by buying gold. Gold felt tangible, as it was only a few years earlier that the U.S. abandoned the gold standard.

Fast forward to now. Despite the meaningful uptick in prices that we have experienced in the U.S. this year, hyperinflation isn’t coming. Gold is not all that tangible and most investors own it through an ETF – hardly a stack of gold bars and coins hidden in a secret crawl space. Gold is impacted by economic expectations, by the dollar, by manufacturing, by seasonality in Indian holidays.– It is a speculative investment, not currency, and should be considered as such.

With that said, how has gold performed this year? Using a common ETF proxy as an equivalent for gold prices, gold declined almost -6% year-to-date through the end of October while inflation has continued to accelerate throughout the year. While other commodities such as energy and industrial metals have marched higher, gold has not participated. It is too early to tell if this is a longer term trend, and if other stores of value such as real estate and even cryptocurrencies have taken gold’s place. For those gold bugs who loaded up last year in anticipation of this year’s inflation spike, the path has been a painful one.

What we’re watching

With the infrastructure plan inked and inflation hitting home for many Americans, the narrative out of Washington D.C. will become increasingly important as we move into 2022.

Walking a fine line between touting the improved employment and growth outlook and the very real pressure consumers are experiencing will be President Biden’s biggest challenge in the new year. Even if inflation begins to moderate and prove transitory, as anticipated by many economists, the reset in wages will persist in some industries and impact overall prices and profitability on a longer term basis.

Connect with me on Twitter @ShannonSaccocia

Shannon Saccocia serves as Chief Investment Officer at SVB Private, and is responsible for setting the overall investment strategy for the firm. She oversees the asset allocation, research, portfolio management, external manager search and selection, portfolio implementation, trading, and investment risk management functions.

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