U.S. large cap stocks, as measured by the S&P 500 index, returned 0.6% during Q3-2021. Global equities, as measured by the MSCI All Country World index, retreated a modest 1.1%. Domestic large cap stocks outperformed small and mid cap, and developed international stocks outperformed emerging markets. Below is a table of global equity components, historical returns and valuations for reference.
U.S. equities have been the clear leader over the last decade, and now represent 60% of global market capitalization, compared to just 43% in 2017, and includes four of the world’s five largest companies with valuations exceeding $1 trillion (Apple, Microsoft, Google & Amazon). These large cap growth companies and a very accommodative Fed are to thank for much of the domestic equity outperformance over the last decade. As a result of this outperformance, domestic stock valuations are considerably higher than their historical averages and more expensive than foreign equities.
In last quarter’s letter (read here) we described a number of factors supporting both optimism and pessimism for the domestic equity market. Our conclusion was these factors were somewhat balanced in the aggregate, and our views have not changed.
We also wrote about what could go wrong, with our primary concern the consequences of a monetary policy error by the Federal Reserve Bank. If monetary policy is overly accommodative, labor shortages and strong demand for goods and services will cause higher inflation, and if too restrictive, higher unemployment and weak demand for goods and services increase the risks of an economic recession.
So what happened during the third quarter? The combination of supply chain bottlenecks, labor shortages and higher energy prices contributed to the highest inflation in over 30 years, with the Consumer Price Index (CPI) rising 5.4% for the twelve months ending September 30. Excluding food (+4.0%) and energy (+24.8%) components, the CPI was up 4.0%.
The Federal Reserve Bank of Atlanta sorts CPI components into either “flexible” or “sticky” categories based on the frequency of their price adjustment. As noted in the chart below, the Sticky-Price CPI (orange line), increased 2.7% on a year over year basis and the flexible CPI (gray line) is up 13.5% on a year over year basis.
The more flexible components of CPI are 8 times more volatile than those defined as sticky. It appears the spike in these components may have peaked and are poised to moderate. Further, with prices rising faster than wages, disposable personal income after inflation is down, and may eventually impact consumer spending. Finally, the government is winding down its stimulus payments which have contributed to the high demand for goods and services.
The Fed has stated repeatedly it considers the rise in inflation as transitory, but it is becoming more apparent that supply disruptions and labor shortages are lasting longer than expected and having a larger and more persistent effect on prices and wages. As a result, it may take longer than expected for inflation to reach the Fed’s long run target of 2%, and some portion of the recent inflation could become more permanent and structural in nature.
To address these inflation risks, the Federal Reserve officials have agreed it is time to reduce emergency pandemic support for the economy. In mid-November or mid-December, the Fed will begin tapering monthly bond purchases, with completion planned by mid-year 2022, and potentially increase its target interest rate later in the year. The interest rate futures market reflects two quarter point increases in the Fed’s target interest rate in the second half of 2022.
So what is our take on this? We do not expect the supply chain issues and labor shortages to suddenly disappear or inflation to return to the 2% Fed target any time soon. We are experiencing an unprecedented set of supply side disruptions, tight labor markets, trillions of government stimulus and easy monetary policy. We should not be surprised by the current conditions.
There are many complex and inter-related issues contributing to the supply chain issues and related shortages of products.
- $2 trillion of debt financed government transfer payments to low and moderate income households (who have a higher propensity to spend) during a period when you could not spend money on services or experiences. Flush with cash from government stimulus, spending that normally would have been allocated to experiences – vacations, concerts, dining out – was spent on durable goods, with a large portion dependent on imports from East Asia. As demand was peaking, the Delta variant caused many shutdowns at semi-conductor factories, ports, and other key links in the supply chain.
- Container ships carry over 90% of the world’s traded goods and we are the world’s largest consumer. In search of the lowest costs, maximum efficiency and highest profits, domestic businesses for decades have off-shored most manufacturing, reduced inventories and relied on a finely tuned supply chain to enhance shareholder value. We are learning that “just in time” manufacturing, with minimal inventories, is vulnerable to disruption and only as strong and dependable as the weakest link in the chain. In addition, every disruption in the supply chain cascades into the subsequent links, compounding these issues.
- Container ship imports are up about 20% from the pre-pandemic level. The ports are overwhelmed with many ships waiting in queue off the coast of California to be unloaded. There is no where to place additional containers and a shortage of dock workers, trucks and truck drivers to transfer what has already been stacked on the docks. Trucking companies and truck drivers make money based on the miles driven, and they will not wait in line at the port for cargo when there is other freight they can transport more efficiently. Further port congestion is caused by containers waiting for export on a ship that is in queue to be unloaded. It will take a long time to clear the congestion.
- Because ships are not being unloaded, there are not enough empty containers to import all of the stuff we want to buy, delivery times are unpredictable, and shipping costs from Asia to the U.S. have skyrocketed. Meanwhile, shipping costs from the U.S. to Asia have plummeted. Given these shortages and pricing disparities, it is profitable to ship empty containers to Asia if you have them.
Regarding the labor market, there are more jobs available than people looking for a job. Unemployment insurance and multiple rounds of stimulus have allowed many people to quit their jobs without any sense of urgency to find another one.
- The most recent data on job openings and turnover is from August, when the number of people quitting their jobs increased to 4.3 million. At the end of the month, there were 10.4 million job openings.
- The most recent data for employment is for the month of September. Nonfarm Payrolls rose by 194,000 and the unemployment rate declined to 4.8%. The number of unemployed persons fell by 710,000 to 7.7 million. There were 6.0 million unemployed persons who “currently want a job” but were not counted as unemployed because they were not actively looking for work. You may need to read this more than once to fully comprehend its meaning.
- The labor force participation rate was 61.6%, 1.7% lower than February 2020. There are 153.7 million persons employed.
- Private sector wages increased 4.6% in September, the highest in more than a decade.
The trillions in stimulus payments, higher wages and partial shutdown of our economy earlier this year had a silver lining – the household savings rate increased to 16.3% of disposable personal income through August, well above pre-pandemic levels, according to the Commerce Department. Retail sales rose 13.9% in September and will likely remain elevated in the near term due to the high savings rate and pent up demand for goods and services. In addition, the shipping bottlenecks and labor issues may become even more severe in November and December due to the expected spike in holiday-related sales.
So what’s next? As stated previously, one of our biggest concerns is a Fed monetary policy mistake. The Fed’s dual mandate of maximum employment and stable prices is a significant challenge and fraught with risks. While we have no idea what might occur near term, we are optimistic long term for the following reasons.
- As stated in the minutes from its recent meeting, the Fed will probably remove its monetary policy accommodation, first by ending its bond purchases next year followed by a very deliberate and gradual increase in its target interest rate.
- As the economic impact from the government stimulus programs and easy monetary policy fades, consumer spending will decline, the supply chain issues will eventually dissipate and economic growth and inflation will drift towards pre-pandemic levels.
- Short term interest rates are likely to rise more than long term rates as inflation expectations decline and the economy slows.
- Although most asset category prices are elevated, a gradual return to historical inflation and interest rates would be constructive for the markets and contribute to a stronger and more stable economy.
- U.S. COVID infections are decreasing steadily and are at 34% of the January 7 peak, with over 400 million vaccines administered so far. Globally, 3.7 billion vaccine doses have been given.
- To address labor shortages and inflation issues, we expect continued high levels of investment in technology, automation and innovation.
- As COVID risks decline, we will see more consumer spending habits shift back to experiences and bring some relief to the supply chain of goods.
We are grateful for your trust and confidence. If you would like to review your financial plan or investment portfolio please do not hesitate to reach out to us. We welcome your questions and will be responsive.
The JRM Investment Counsel Team
Jack, Phil and Lauren