Market Commentary - September 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 7 month winning streak for the S&P 500 was halted in September as the index fell -4.8%. The selling was broad based domestically and Europe was also down across the board. There was some green seen in Asia, particularly the Shanghai composite, the Nikkei and the South Korea Kospi to name a few. Interest rates were higher with the US 10 yr yield up by 18 bps to just under 1.50% while the German 10 yr bund yield was up by 18 bps to -.20%, its least negative since June. The 10 yr UK gilt yield jumped by 31 bps to 1.02%, the highest since May 2019[1].

The catalysts for the market action in September were multi-fold. The Federal Reserve told us that a trimming of asset purchases is most likely to begin in December. The European Central Bank also announced a modest trimming of its Pandemic Emergency Purchase Program. The Bank of England hinted at a possible interest rate hike in the first quarter of 2022. At the end of August the Bank of Korea hiked interest rates and Norway did the same in September. These moves are in response to the rising inflation situation we find ourselves in, which in turn is limiting economic growth because of the major supply side challenges.

FedEx and Nike were two high profile companies which cited higher costs, labor shortages and supply disruptions as reason for hits to their earnings reports[2]. We expect to hear very similar stories when Q3 earnings releases role out in October and into November.

China also made a lot of headlines in September, with property developer Evergrande the main culprit. The 2^nd largest home builder, and largest private debtor company in the country with $300b of debt and liabilities, said that the tighter lending restrictions put in place last year finally caught up to them[3]. Their model of relying on short term financing to fund longer lived projects became its own Ponzi scheme and that short term money has run out. The question now is to what extent this infects other parts of both the Chinese economy and, possibly, the global one.

Politics were certainly in the news in September with Democrats trying to muster support for a large social spending bill. The progressive wing has made clear that bill needs to pass in order for them to support the smaller physical infrastructure bill. What comes of all of this will most likely dictate where taxes go, but keep in mind that whatever spending does take place will be spread out over 5-10 years.

Central Banks

It does finally seem that we are approaching taper time with respect to monthly asset purchases of Treasuries and mortgage backed securities. The Federal Open Market Committee, and Jay Powell in his follow up press conference, laid the groundwork by saying they have seen ‘substantial progress’ toward achieving the goal of maximum employment. With core inflation running at an annualized pace of 4.5% year to date, as measured by the Fed’s favorite gauge, they have certainly far exceeded their self-imposed 2% target[4].

With inflation expectations in the Eurozone rising to the highest level since June 2015 as measured by the 5 yr euro inflation swap, the ECB has begun trimming the pace at which they are buying bonds monthly in their emergency program[5]. Of course the Covid emergency is over but the ECB is still being very aggressive. This particular program does expire in March 2022 and we expect a further tapering in the months to come.

In the UK, inflation expectations have risen to the highest level (3.87%) since July 2008 as of this writing[6]. If you recall back then, crude oil was approaching $150 per barrel. The Bank of England is already scheduled to end QE at year end but now there is a possibility of a rate hike in the first quarter of 2022.

While these moves have also coincided with rate hikes in some emerging markets, and a trim in quantitative easing from the Reserve Bank of Australia and the Bank of Canada, they also mean the massive tide of liquidity is now beginning to ebb. Since QE started in late 2008/early 2009, stock market movements all around the world have followed the direction of monetary policy. When QE was on and when rates were low and/or being cut, stocks did well. When QE was off or trimmed and rates rose, stocks struggled. The Fed thus helped to create its own market cycles. I have said before that we no longer have standard economic cycles. We have credit cycles instead. These ebb and flow with the direction of interest rates and QE.

Inflation and its Economic and Earnings Impact

I have been talking about rising inflation pressures for more than a year now but it is becoming more obvious that it is not so temporary and rather something more persistent and sustainable. On the demand side, over the past year consumers shifted their spending to goods from services as big ticket items became more affordable due to cheap financing options. Unfortunately the world’s supply chains were wholly unprepared for this jump in demand at the same time Covid resulted in labor shortages, a sharp increase in commodity prices, and increased transportation costs. Put them all together and voila, we now have the most intense inflation pressures since the 1970’s. We also had a very sharp increases in the rate of home prices with the July S&P CoreLogic figure showing a gain of 20% y/o/y, a pace never before seen. And Apartment List.com in its October National Report said rental prices have risen by “a staggering 16.4%” from January to September.

Inflation is thus not just a Wall Street debate, it is now a Main Street, real world challenge, especially for those households whose wages are rising at a slower rate and for those businesses who are trying to absorb ever rising costs. These in turn are leading to slower economic activity.

On the FedEx quarterly earnings conference call on September 21^st (access can be found on its website), company executives said they physically couldn’t get enough people to man its warehouses. They quantified the impact by saying “We estimate that the impact of labor shortages on our quarterly results was approximately $450 million. Labor shortages had two distinct impacts on our business. The competition for talent, particularly for our frontline workers, have driven wage rates higher and pay premiums higher. While wage rates are higher, the more significant impact is the widespread inefficiencies in our operation from constrained labor markets.” While it’s great to see higher pay for employees, if it is not offset by faster productivity growth, profit margins get squeezed which leads to higher prices for customers and lower earnings and cash flow.

Nike on its earnings conference call heard two days later (access can be found on its website) attributed its challenge to factories in Vietnam where they source about 50% of its products. Vietnam over the past few months closed most of its facilities in order to attack Covid and this rather harsh approach has completely disrupted production and with the widespread backups in transportation has also dramatically lengthened delivery times. In a normal environment, Nike said it could get product from factory floor to customer within 40 days. Now it takes 80 days.

Expect to hear a lot about the challenges with the supply of goods and the delays and costs of delivering products once fully produced. For example, the lack of semiconductors has been a high profile problem for the auto sector. There has been a sharp decline in the production of new cars and trucks which in turn has led to a big increase in the price of used cars. CEO’s of some semiconductor companies believe this supply problem could last into late 2022 or even into 2023.

Finally on inflation, September has seen another increase in the price of oil and gas, particularly in Europe. Low inventories, the lack of new investment because of the mandated shift to renewable energy, less wind this year and a phasing out of coal have been the main reasons. In the US, natural gas was up 33% in September and is close to $6 per million BTU, a level last seen in 2013[7]. WTI crude oil was up 10% for the month[8].

China

China’s economy over the past 30+ years has seen an impressive performance taking hundreds of millions out of poverty and into the middle class. In fact today, almost 90% of employment in urban China is with privately owned companies according to Matthews Asia. However, some of this growth has come along with a growing dependence on residential real estate, both the construction of and the home for household savings. A lot of debt accumulation has been a big part of this. Chinese authorities for years have been trying to cool down the rate of home price gains but to no avail. Finally in August 2020 they created the criteria of three red lines at which banks had to adhere to when deciding to lend to developers. Evergrande, the most over indebted developer, has been the first victim of this lending crackdown as it was very dependent on short term financing that has now dried up. They have a huge amount of debt and liabilities owed to suppliers, contractors, and wealth management holders that total $300b.

Home buyers that have put down deposits will likely get their apartments finished and other vendors will likely get paid back though. The big question then is what the spillover effect will be. I do believe China is headed for a slowdown in its economy as it transitions away from its large dependence on residential real estate and households that own a lot real estate have to deal with a likely drop in prices. With China the 2^nd largest economy, it’s hard to think it won’t influence global growth too.

This said, it is estimated that China will see a doubling of its middle class over the next five years from 300 million to 600 million. It will be this growth driver which hopefully mitigates any challenges with the transition away from the over dependence on real estate[9].

Conclusion

The market’s momentum was broken in September but it still has been a good year in terms of performance, and all on top of the strong gains last year. Covid has certainly been a human tragedy both in terms of lives lost and also lives and businesses hugely disrupted. However, the stock market, with the help of monetary policy, has powered right through it. This said, and with the factors stated in this piece, I believe we are entering a different macro environment where I see the word ‘stagflation’ being rightly used.

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

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The market and economic data is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The information in this report has been prepared from data believed to be reliable, but no representation is being made as to its accuracy and completeness.

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