Most people tend to believe that if you want to take on low risk investments, you invest in bonds. Although this is true for the most part, lately the fixed income markets have been more volatile than even some equity markets.
Daily Global Perspectives
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The regional manufacturing indices for November so far are blockbusters.
The biggest headline in most news outlets continues to be inflation reaching all-time highs. As an investor, I always try to remind myself that if the headline is in the newspaper, that means the market has already likely discounted it.
Last week’s Federal Open Market Committee (FOMC) meeting went as expected, as we can see reflected in market gains these past few days. Tapering will start sometime this month and continue at a pace of $15 billion per month until June of 2022, unless any major changes occur. Federal Reserve Chairman Jerome Powell said he believes that raising rates now would be inappropriate because inflation is expected to be transitory. He also mentioned that it is possible maximum employment may be reached at the end of next year. This implies that the FOMC sees a rate hike late next year as possible but not probable, going against market expectations. The market is expecting two rate hikes next year and four in 2023; expectations did not change after the meeting, as investors will want to see inflation decrease rather than trust Powell’s words alone. It’s important to note that market considerations have much less influence on the Fed when it expects to raise rates than when it expects to lower them — this means that with the Fed poised to raise rates, policy actions will be driven by FOMC members rather than market participants.
In recent weeks, many market participants have started fearing that a period of stagflation may be on the horizon. Stagflation occurs when inflation increases – i.e., buying power decreases - and economic growth remains subdued or declines. While growth rates may be slowing down due to base levels shifting and most of the COVID-19 lockdown re-openings complete, we believe inflation will begin to subside, and that we may even see disinflationary pressures in some core goods in the not-too-distant future.
During the COVID-19 pandemic, demand for goods was pulled forward as the U.S. central bank printed billions of dollars, and the Federal government distributed cash to households. That sudden rise in demand was subsequently met with a decrease in supply caused by the pandemic shutdowns. And it is this dynamic that is the primary source of the temporary imbalances we’re seeing today, as evidenced by the back-up at southern California shipping ports. Fortunately, while still at tight levels, we are starting to see some relaxation in a lot of these pressures. For example, although core-good prices in both PCE and CPI continue to increase, their rate of increase is now lower. Additionally, we anticipate that the now 50-plus interest rate hikes by central banks around the world will begin to take their toll on global growth, which in turn should also impede inflationary pressures.
“Petrol,” “Texas tea” and “black gold” are nicknames for U.S. oil. Oil used to come mostly from Texas, now it increasingly comes from North Dakota to Pennsylvania and other states; at the same time, prices are rising, which is good for America. That makes sense: while rising oil prices help Saudi Arabia, they help America more because we are the number one producer in the world of oil, natural gas and coal. High energy prices are coincident with the economic boom in the United States. One only has to look at the manufacturing indexes ― where energy is a big contributor of capex ― and at third-quarter S&P 500 energy sector profits, which are reporting a whopping 1572% increase compared to a year ago ― with about half of all companies reporting so far. Meanwhile, Wall Street analysts are once again underestimating corporate profit growth for the quarter: on October 1 they predicted 29%, but as of October 28 earnings are expected to grow by 38.6%. As my latest article “The Tug of War Between the Current Economic Boom and Potential Stagflation” provocatively asked, “Do you believe in Santa Claus rallies?”
This week will be a very eventful earnings week. Among the companies reporting are big tech names such as Microsoft, Facebook, Apple and Google. So far, about 25% of the S&P 500 companies have reported third quarter earnings; Q3 earnings have exceeded expectations by about 13%. Although this is lower than Q1’s 22.5% and Q2’s 16.5%, it is still more than 8% higher than the five-year average. As earnings reporting progresses, we expect to see supply chain constraints continue to be the main issue companies worry about. It’s important to note that companies across a broad range of industries have reported strong demand from consumers, allowing for margins to be little affected by increasing supply side pressures. We believe that, even as labor costs increase, the pricing power of S&P 500 companies will continue to keep earnings strong for the foreseeable future.
Over the past few years, energy companies have decreased the rate of reinvestment into their companies. High yield issuance for energy companies has essentially flattened since 2015. Rig counts have doubled since the trough in 2020 but are still about 50% below their 2018 peak and about 75% below the 2015 peak. It’s clear that energy companies have held back from significantly increasing capital expenditures, due to both short- and long-term issues. In the short term, although demand remains high right now and supply is tight, energy companies expect demand to decrease to normal levels next year. We can see this reflected in Wall Street analyst expectations for oil production in 2022, which have been decreasing for the past three months. In the long term, environmental, social and governance (ESG) initiatives are leading energy companies to return more capital to shareholders rather than reinvest. Additionally, management compensation and many bonds have been tied to reducing emissions, creating another deterrent to capital expenditures. If energy companies do not reinvest in themselves, they will not be able to increase supply and keep up with demand. In the short term, this could lead to higher commodity prices and better margins for energy companies; in the long term it could make alternative energy sources more competitive.
The third quarter earnings season kicks off this week with JP Morgan reporting on Wednesday, Citi, Bank of America and Morgan Stanley going on Thursday and Goldman Sachs on Friday. Corporate earnings have helped the S&P 500 gain over 18% YTD as of October 11, but earnings growth has shown signs that it will start slowing down as earnings revisions ratios have been coming down since June. Another reason for the slowdown in earnings growth has been supply-side input costs. Goods prices have been increasing for a few months now, while commodity prices are also starting to put pressure on margins. Although I believe that the rate of earnings will decrease, I still believe it will continue to be positive. As I mentioned in a previous post, the economy will start to slow, which is quite normal as we shift the base year over from rapid growth in 2020 to moderate growth in 2021.