ECONOMIC COMMENTARY

Sputtering through September

A part of the Q4 2021 Market & Economic Insights series

Equity markets across the board experienced declines during the month of September as concerns about bond tapering, the Delta variant, corporate tax increases and the impact of inflation combined to create a difficult environment for equity investors.

In short

  • As the global economic recovery moves into its next stage, euphoria will moderate and investors and economists alike need to look to data to stay grounded and focused on the future
  • Equities struggled as inflation and higher Treasury yields created concerns about valuations, particularly for technology stocks
  • A long-awaited rotation from growth to value could finally be here, however it is important for investors to remain exposed to companies that can grow their earnings over time, as higher earnings are the primary long term driver of higher prices

One of the most difficult aspects of investing during a recovery is determining the path and persistence of the recovery, and navigating the inflection points along the way are critical in order to position portfolios accordingly. September represented one such inflection point, as the euphoria of the early recovery wanes and the consequences of the actions taken to restart a stalled global economy are realized.

Liquidity is ample due to massive monetary infusion from central banks globally, but capital market asset prices are elevated as a result. Supply chains remain disrupted, however a lack of clarity regarding what goods will be in demand in a post-pandemic world is forcing companies to make assumptions around the products to be prioritized. Yields remain at historically low levels, disadvantaging savers and setting the stage for a challenging period for bond investors as interest rates rise. And inflation is hitting producers and consumers seemingly from all sides, as wages struggle to keep pace.

Yet, economic growth and earnings are still moving higher, albeit at a slower pace than experienced in the first half of the year, and there are still bright spots that should help keep investors grounded in terms of where the recovery is headed. For example, manufacturing PMI, which has been moderating somewhat, moved higher in the month of December, as the ISM Manufacturing survey came in at 61.1 in September; the increase was led by strength in employment and higher prices, as well as inventories. While companies continue to cite supply chain disruptions and pandemic related absenteeism as hurdles, it is likely that these pressures will ease in the coming months, and will create the opportunity for companies to operate at higher capacity and should mitigate pricing pressures for inputs and labor. In the interim, however, inflation in producer prices, as represented in PPI, is still running hot, up +8.6% year-over-year for the month of September.

As for the consumer, confidence has waned over the last several months, and this trend continued into September. The Conference Board’s measure declined from 115.2 to 109.3 during the month, as consumers became less optimistic regarding current and future conditions. Specifically, consumers expressed concerns around the purchase of big ticket items such as homes and autos and seemed less optimistic about the availability of jobs compared to previous reports. With that said, the University of Michigan consumer confidence survey, which is tied more closely with spending patterns than employment outlook, was steady in September after a sharp drop in August, and is consistent with the September retail sales report, which exhibited an increase of +0.7% for the month, well above expectations given the lackluster confidence readings and the fact that inflation, as measured by CPI, is running hot at +5.4% year-over-year.

The final piece of the puzzle is, of course, the labor market. And once again, non-farm payrolls managed to disappoint for the month of September. Following August’s report, which showed an increase of only +235k versus expectations for a +720k bump, September came in light, up by only +194k for the month, although peeling back the layers of the report yields a more nuanced assessment. Private payrolls rose by +317k, led by hiring in leisure & hospitality, which had underwhelmed expectations for August. Professional services and retail trade industries also posted strong gains, which were offset by a sharp drop in government jobs of -123k. The unemployment rate fell below 5%, to 4.8%, for the first time since the pandemic began, while the participation rate was steady at 61.6%, still below its pre-pandemic level. Wages, however, continue to reflect the inflationary pressures we are experiencing across the global economy, with average hourly wages rising 19 cents during the month to $30.85.

The one tailwind that has been consistent through the crisis has been the Fed, but it would appear that even the Fed winds are shifting. Following the September meeting, the tone was modestly more hawkish than perhaps anticipated. While Chairman Powell and his fellow Governors did not explicitly announce the beginning of the taper, it appears that the taper in the Fed’s monthly $120B in asset purchases will begin in November and conclude by the middle of 2022. In addition, there was a marked shift in the Fed’s dot plot, which reflects the individual FOMC members’ views on interest rate hikes; the dot plot now indicates that half of the members believe the first interest rate hike will occur in late 2022, versus 2023, and that there will be three hikes each in 2023 and 2024. All of this hawkishness follows downgraded expectations for U.S. growth for 2021, as the Fed now believes the economy will grow by +5.9% this year, down from +7% in July, likely a result of the Delta variant’s impact on consumers and suppliers alike.

So where does that leave investors? While equity markets were stronger than initially expected in the month of August, September was an entirely different story. Whether the narrative of the day was higher interest rates, increasing taxes, debt ceiling challenges, China, inflation pressures or just plain old valuation concerns, investors were hit from all sides during the month of September, and the declines in the month were enough to hamper quarterly returns. Leading the way lower were growth stocks, particularly technology, which from a market cap perspective still account for the largest sector in the S&P 500; it lost -4.65% in September. Domestic small caps fared slightly better in the month, but were down over -4% in the quarter, while international developed equities held their own, losing only -2.9% in September and -0.45% in the quarter. The worst performing equities were emerging markets, namely China, which were down over -8% in the quarter. Bonds closed the quarter essentially flat, after a sharp rise in yields in September left diversified investors with no place to hide. High yield bonds continue to outperform high quality issues, as they have for most of the year. The biggest winners have been in the commodity space, as inflation and supply chain disruptions have pressured input prices continuously higher throughout much of 2021.

In focus: Growth, value & the impact of inflation

There is no arguing that growth stocks, and in particular technology stocks, have taken it on the chin over the last several weeks, and it is fair to say that the beatings could continue until morale improves – particularly if one contemplates that the economic and market conditions we are facing will likely continue. It is clear at this point that the economy, particularly in the U.S., has entered a new phase. While saying we are now in a post-pandemic world seems overly optimistic, many have accepted that the challenges presented by COVID-19 will be present for the foreseeable future, and we must now deal with the aftermath.

The most pressing concern in this new environment is inflation. There is no denying that prices for producers and consumers are rising at a faster pace than the global economy has experienced in over a decade. Initial analysis pointed to massive supply disruptions as production ground to a halt last year, laying bare the susceptibility of producing goods that require intricate planning and almost perfect execution - from factory to port to arrival on our doorstep. In addition, fiscal and monetary stimulus against the backdrop of a rapid downshift in consumer spending yielded an increase in wealth that is now being plowed back into goods, services, and of course, stocks.

And whether it is transitory, semi-transitory, or truly persistent, the Fed and other central banks are feeling the heat. The days of bond buying will come to end at some point next year, and rate hikes will follow. As a result, the assets that performed so well in days of low growth and low rates are ceding their leadership to companies that are positively correlated to higher input costs, such as energy and materials, and those that stand to benefit from higher rates, such as financials. The caveat is that in an environment where the economy moderates back to its pre-pandemic rate of growth, inflation is likely to ease as well. And companies in sectors such as technology and health care will continue to innovate, delivering earnings growth that will likely outpace the global economy, offsetting the short term benefit enjoyed by cyclical names in this environment.

Identifying companies that are growing their earnings through higher revenues based on delivering products and services that expand share or spend should be the assignment, regardless of what sector or style those companies fall into. Attempting to time rotations such as the one we are experiencing is incredibly challenging, and require a longer term horizon – which is exactly what growth companies focus on.

What we’re watching

From concerns that the U.S. was entering a deflationary spiral to overblown fears of hyperinflation in just two years, the real story lies somewhere in the middle.

Central banks globally spent decades fretting about hyperinflation, and then spent the last decade worried that prices would be stagnant or decline during the foreseeable future. Prices for goods and services are higher, but the increase is likely to moderate, creating a foundation for a more normal inflationary environment.

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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