Market Commentary - August 2021

Monthly Update

In August, the world’s stock markets continued to power higher as the news flow was not much different than we saw in July. What particularly continues is a current of easy money which has elevated valuation multiples. Also reflected in markets is in the continued tug of war between the contagious Delta Covid variant, with different countries taking different approaches, and the desire by many to power through and learn to live with the virus. Higher inflation continues to course through the global economy which leaves central bankers in quite a quandary between fighting it and not wanting to upset markets or the economy.

The S&P 500 was up for the 7^th straight month in August and up for the 9^th month out of the past 10[1]. The Euro STOXX 600 was up as well. The story in Asia was a bit more mixed as the Shanghai composite rallied by 4.3% in August after a 5.4% decline in July in response to the more aggressive regulatory approach that the Chinese government took against its large and successful internet companies like Alibaba and Tencent[2]. The Nikkei rallied 3% after a 5.2% selloff in July, while the South Korean Kospi was flat to name a few other markets[3].

When looking at the Asian region, we have seen a contrast in approaches to dealing with Covid. Many countries were very successful at containing the spread in 2020 via strict restrictions and diligent mask wearing. But, in a world of effective vaccines, some countries in Asia have been much slower to roll them out and China has taken a ‘no tolerance’ policy towards its spread. This results in very harsh responses to even modest outbreaks. On the flip side, Singapore has a highly vaccinated population and is acknowledging that Covid will not go away anytime soon. They are committed to learn to live with it and are doing their best to fully reopen. These influences have been key in determining the direction of stock markets in the region, on top of the China regulatory moves. I mention this all because Asia is a main source of supplies like semiconductors and many key auto components. Any issues there can easily have global repercussions.

Inflation

While I do not want to downplay the influence of the more contagious Delta variant of Covid and its impact on consumer mobility and global supply chains, I still believe the main factor impacting the economy both in the US and elsewhere is the stagflationary environment we now find ourselves in. I define this is as a slowing in growth but with persistent inflationary trends that are a key factor in that slower growth.

Let’s look at a few examples. We just saw the S&P CoreLogic home price index for June and it showed a year over year increase of 19% nationally[4]. This pace even exceeds the sharp home price gains we saw in the mid 2000’s during that housing bubble. A dearth of inventory of existing homes, along with not enough new homes being built, combined with strong demand this past year are the main catalysts. The problem now is that we are pricing out first time home buyers while many other buyers are calling a time out on these aggressive price increases. Many have resorted to renting instead. Further on the supply side, builders are having more difficulty in delivering homes priced below $300,000 (where much of the demand resides) because of higher raw material and labor costs[5].

Another example of what is going on is the auto sector. The lack of semiconductor chips has resulted in widespread disruptions to production lines and a resulting lack of inventory on dealer lots. In turn, buyers are shifting to used cars where prices are up 42% year over[6]. The level of new car sales in particular has fallen to recessionary levels.

With respect to material costs, the CRB commodity index was little changed in August but was still higher for the 9^th month in the past 10[7]. The Baltic Dry Index, which measures the cost of freight for dry bulk items like iron ore and different grains, rose to an 11 year high[8]. The cost of a containers shipped from Hong Kong to LA is up 400% over the past year.[9]

On the labor side, the National Federation of Independent Businesses (NFIB) said in its August survey that there are a record number of companies planning to hire but a record number of ‘Positions Not Able to Fill’ and the end result is a record high in ‘Compensation’. This survey dates back 48 years. It is why I argue that the August slowdown in hiring was more to do with a lack of labor supply rather than a moderation in demand for workers.

Federal Reserve

As stated earlier, this economic situation puts the Fed in quite the quandary as they debate whether their focus should be on containing inflation or should they continue to hope and pray the spike is just ‘transitory.’ For now it seems Jay Powell is betting on ‘transitory’ but a shift in monetary policy still seems inevitable in coming months. Their next meeting is on September 22^nd and I would not be surprised to see an announcement that the tapering of asset purchases will begin in October.

Pressure is also building on the European Central Bank where they are still conducting a program called the Pandemic Emergency Purchase Program (PEPP) even though the ‘Emergency’ is clearly over. We have seen some comments recently from ECB officials that want to start scaling back this program which has a stated end date of March 2022.

The importance of how both banks may pivot in the coming months cannot be overstated as the markets, both stocks and credit, have developed an incredible level of addiction to the easy money that flows from the current programs. Thus, the direction of policy from here could single handedly determine where markets go over the coming 12+ months.

Interest Rates

After an incredibly volatile first 7 months of the year, August saw some quiet in global interest rates. The 10 year yield, which finished July back at 1.22%, had a pickup of 9 basis points to 1.31%[10]. The 5 year yield had a sharper move up, also rising by 9 bps, but off .69% to finish at .78%[11]. The rise in nominal rates was followed by an increase in REAL rates as inflation expectations in the TIPS market gave back the July jump and remain well above where they started the year. The 5 year implied inflation rate in the TIPS market finished August at 2.51% (vs 1.97% at year-end 2020)[12]. The 10 year implied inflation rate at month end was 2.34% (vs 1.99% at year-end 2020)[13].

In Europe, it is still a sea of negative yielding securities. The German 10 year yield ended August at -.38%, up 8 bps and compared with -.57% at the beginning of 2021[14]. Rising inflation expectations this year are not just a US phenomenon. The ECB’s preferred inflation expectations gauge is the 5 yr Euro inflation swap and it finished August at 1.69%, up just 1.5 bps in the month but well higher than the 1.26% where it started the year[15]. The ECB has quite the needle to thread if the rising inflation pressures do not subside.

The Economy

As stated earlier with housing and autos, the two most interest rate sensitive sectors of the economy, a shortage of supplies and labor are throwing a lot of mud in the gears of business. This is a global phenomenon as all countries are facing similar challenges. The only question is how much of these pressures can be passed on to consumers via higher prices. Also, rising inflation relative to wage growth is resulting in falling real wages which negatively impacts consumer spending.

To quantify the changing GDP expectations in response to these factors, the Atlanta Fed’s GDPNow (a measure of real inflation-adjusted GDP) started August predicting Q3 growth of 6.1%. That estimate is now down to 3.7%[16]. With respect to the services sector of the US economy, which is its largest component, I am sure the Delta variant is having an impact but I will argue again that the moderation is more likely due to supply problems, particularly of labor. How many of you have passed ‘Help Wanted’ signs in front of restaurants and bars?

Conclusion 

While the stock market continues to power higher in an unrestrained melt up, it seems the economic environment is more challenging because of the growing influence of inflation. The biggest key for markets going forward will be the central bank responses and whether they decide to scale back the epic accommodation that has been going on for 18 months now.

Either way – I say this in just about every monthly letter, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.

Disclaimer