Market Commentary - October 2021

Monthly Update

After a seven month winning streak, the S&P 500 run was disrupted by a 4.8% decline in September before resuming the upward trend with a 6.9% rally in October[1]. The bellweather index was joined by the NASDAQ and small cap Russell 2000 which experienced similar increases. European stocks (as measured by the STOXX 600 index) were higher too but Asian stocks lagged with major indices like the Nikkei, Shanghai composite and the KOSPI all in the red. A continued rise in interest rates, more hawkish central banks, mounting concerns with inflation and a possible squeeze in profit margins were not enough to offset the enthusiasm for stocks that has seen a good start to the earnings season relative to expectations.

With respect to interest rates, we saw some wild moves in the bond markets of some developed countries. In Australia, the Reserve Bank of Australia decided not to defend its yield curve control which was meant to keep the 3 yr yield at just .10%[2]. The market saw a swift response and took this yield to .84% within days[3]. It was just .03% as recently as September[4]. The Bank of Canada decided to end QE cold turkey with no more taper. This immediately shifted investor attention to a possible rate hike in 2022 and the Canadian 2 yr yield in response rose to 1.09% by month end October from .53% at the end of September[5]. In turn, yields rose in Europe, particularly in the UK and in the US, with the end result being a flattening of many yield curves around the world in anticipation of monetary tightening on a global scale.

By the time you read this the Federal Reserve will have most likely announced the process by which it will trim its monthly asset purchases in the QE program. As they have stated before that they want to separate out QE from raising interest rates, a rate hike is unlikely to take place until next summer. The Bank of England will have possibly raised its short term interest rate by then and if not, will likely do so in December 2022.

The reaction function here with both rates and central banks is due to the need for them to begin the normalization process, both because it is time as we are well past the worst of Covid and because inflation is running hot everywhere. There is a growing realization that the rise in inflation we have talked about since last year is not so temporary and will instead be more sustainable and persistent.

While China made a lot of headlines in September because of the stress felt in their property market, particularly led by the largest builder Evergrande, the news flow slowed in October. The real estate developer stress has become more widespread and it is a situation we continue to watch closely as residential real estate makes up as much as 30% of the Chinese economy[6].

Central Banks & Inflation

In October, as stated above, the Bank of Canada surprisingly decided to end QE all at once instead of gradually. The RBA did not defend its yield curve control. The Brazilian central bank hiked interest rates by 150 basis points to 7.75%[7]. The Bank of Russia raised interest rates by 75 basis points to 7.5%[8]. The Bank of England sounded more concerned with inflation and even ECB President Christine Lagarde acknowledged that the inflation currently being experienced is not so transitory.

The central bank response to rising inflation is thus both global and taking place in developed as well as developing economies. With developing central banks having more experience fighting inflation, they are typically loathe to have interest rates below the rate of inflation. Right now Turkey is the outlier as they are cutting interest rates as inflation goes up, but let’s put that aside here. Developed central banks will definitely go slower in removing accommodation with the Bank of Japan likely to be the slowest.

What we see as we look to 2022 is that the very easy money put in place to fight the economic damage of Covid shutdowns will slowly be reversed in the face of inflation pressures, which are the most widespread since the 1970’s.

I believe the Institute of Supply Management did a good job of summing up the major supply/demand imbalances that are currently being felt. In its October report on manufacturing they said this: “Business Survey Committee panelists reported that their companies and suppliers continue to deal with an unprecedented number of hurdles to meet increasing demand. All segments of the manufacturing economy are impacted by record-long raw materials lead times, continued shortages of critical materials, rising commodities prices and difficulties in transporting products. Global pandemic-related issues — worker absenteeism, short-term shutdowns due to parts shortages, difficulties in filling open positions and overseas supply chain problems — continue to limit manufacturing growth potential. However, panel sentiment remains strongly optimistic, with four positive growth comments for every cautious comment. Panelists are fully focused on supply chain issues in order to respond to the ongoing high levels of demand.”

With respect to the consumer price inflation being felt by the average person, the University of Michigan did a good job of explaining its impact in its October report on consumer confidence: "Consumers' recognition of high and rising prices is near universal, so too is their desire to reestablish spending for a more traditional holiday season. People understand that the origin of inflation has been in the upheavals in supply lines and labor markets. The acceptance of higher prices was caused by swollen savings due to the record pandemic cash incentives as well as by Biden's new social support programs. The declining resistance to price hikes among buyers will be joined by less resistance among sellers to hiking prices that will be justified by higher materials and labor costs. These reactions promote an accelerating inflation rate until a tipping point is reached when consumers' incomes can no longer keep pace with escalating inflation." 

To reiterate what I’ve been saying for a while, this inflation story is a global phenomenon and that was certainly felt in Europe and China in October. A shortage of coal and natural gas led to a dramatic spike in European natural gas prices September and into October. To quantify, the Netherlands natural gas forward contract on a MWH basis rose to 155 in early October from 50 at the end of August[9]. Luckily, it has fallen back to 68 as the Russians finally increased the pace of natural gas deliveries to the region. Winter bills will still be expensive though as last year this priced ranged between 15-25. In China the lack of coal, and government attempts to cut emissions, led to a spike in coal prices and rolling power shutdowns.

This energy price inflation is reminding us that while a transition to more renewables is certainly laudable, and the future in which we are headed, it is not costless and fossil fuels will still be with us for many years to come. Unfortunately, we are seeing a dramatic reduction in the pace of investments in fossil fuels because of this transition and the timeline is being forced upon the market by many governments around the world.

Inflation is also being driven right now by higher labor costs which companies are passing on to the rest of us. Wages are rising at a quicker pace as there is a tremendous amount of demand for workers as illustrated by the more than 10mm job openings in the US according to the BLS. At the same time the supply is just not enough to meet this need, as seen in the number of people considered unemployed. In the just-reported Employment Cost Index from the Bureau of Labor Statistics, private sector compensation which includes both wages/salaries and benefits, rose 4.1% y/o/y in the third quarter of 2021, the biggest increase in 20 years.

I believe the only question left about inflation is how long it will persist. I remain of the belief that even as it likely moderates in 2022, it will remain at a pace that is higher than the pre-Covid levels and something like 3-4% might be the range for a period of time.

Equities & Credit 

Stocks continue to power higher in the face of all these crosswinds and much of the advance has been from good third quarter earnings, notwithstanding the margin squeezes we are seeing. Almost 80% of companies which have reported exceeded earnings estimates vs the average closer to 70%. With margins better than feared, many companies had success in passing on their higher costs[10]. Things do not come cheap though as the P/E ratio for the S&P 500 based on 2021 earnings is at 22x, and at 20.3x based on the estimated 2022 earnings[11].

Corporate credit though was more mixed in October with investment grade trading higher while high yield was soft. The spread in the Bloomberg CCC index to Treasuries is at 536 basis points as of this writing. It was 800 in February 2020[12]. For investment grade, it’s only at 33 basis points vs 40 pre-Covid. The yield to worst for investment grade is only 1.67% according to the Bloomberg bond index vs over 2% in February 2020[13]. As for the overall high yield index, it has a yield to worst of just 4.22% vs 5%+ before all the shutdowns last year[14].

Conclusion

The stock market’s momentum inflected higher again in October but with Federal Reserve tightening now about to begin, things could get put to the test as interest rates rise. We do not think the inflation story is going away anytime soon and as a result markets could become more bifurcated.

Either way, 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