“I must use beautiful words. I never know when I might have to eat them.” — Everett McKinley Dirksen (U.S. Senator, Illinois, 1950-1969)
Third Quarter Recap
Most global indices slipped this past quarter after a dismal September wiped out gains from summer. Bonds led the way lower, with U.S. 10- year Treasury yields making a round trip and ending up at just under 1.50% for the period. Commodities were also mostly lower, with oil and natural gas the exception. Sector rotation grew more frequent, with rallies in the reopening plays (restaurant and travel stocks) giving way to growth stocks (especially technology) in August, then moving to cyclical and value companies late in the quarter.
Economic growth and corporate earnings continued to advance at an amazing pace until a COVID-19 spike of the highly contagious Delta variant caused a marked slowdown. Sales were also held back by supply chain issues, including bottlenecks at major ports and shortages of semiconductor chips used in computers, smartphones and autos. Also contributing to the slowdown: Labor shortages due to a mismatch of skills and the unemployed hesitant to return to work because of the pandemic resurgence.
Inflation – Transitory or Trend?
Supply chain issues and labor shortages together with the after effects of massive fiscal and monetary stimulus have produced the highest inflation readings in nearly three decades.
Prices of items from food and clothing to gasoline have increased, influencing consumer sentiment. Although supply shortages are being addressed, responses will take time. Farmers can plant more crops, but this won’t largely happen until next spring. Semiconductor companies can build more chip foundries, but it may take from 18 to 36 months, with many of them starting late last year. Eventually, there may be a surplus of numerous goods.
A key question is whether the increase is transitory or the beginning of a longer-term trend higher. Two things that cause inflation to be “sticky” are housing and wage inflation. Housing prices have boomed since the pandemic began, although this has not been fully reflected yet in the Owners’ Equivalent Rent (OER) component of the Personal Consumption Expenditure (PCE) report, the Fed’s preferred inflation gauge. Wage inflation has been elevated, but it remains to be seen if unemployed workers will reenter the labor force after the expiration of unemployment benefits, vaccination mandates and the recent cresting of the Delta variant.
The Fed’s Response
The Federal Reserve expected an increase in inflation this year, but not to this extent. Although Chair Jerome Powell has reiterated that the increase in inflation is temporary, the Fed is likely to begin the tapering process of monetary stimulus before year’s end. The withdrawal process should be complete around midyear 2022, with an eventual increase in the Federal Funds rate (the main benchmark for short rates, currently at 0.25%) occurring late next year.
Note that the entire timeline of the taper and rate increases has been moved forward several months from the Fed’s earlier projections. Future adjustments will depend on further changes and the pace of change of the inflation rate, along with any setbacks from the improvement in employment.
COVID-19 Developments and Possible Congressional Legislation
It appears that the Delta variant has peaked in most countries, including the U.S. Vaccination rates are rising again due to employer mandates and other actions by the government and private sector. Moreover, additional measures such as booster shots, pending FDA approval for children 5 to 11 years old and a promising new antiviral drug all have the potential to eventually make the disease manageable and lead to a more normal life for all.
The $1.2 trillion bipartisan infrastructure bill recently passed by the Senate, is being linked now to a $3.5 trillion reconciliation package in the House of Representatives. Negotiations between the Administration and more liberal and centrist factions of the Democratic party are continuing. We believe a smaller bill with fewer tax increases is possible, although the timeline of an eventual agreement is uncertain. It is also our belief that the Federal debt limit will be raised, though some amount of political brinkmanship by one or both parties may occur before an agreement is reached.
The Outlook for Yearend 2021
- Although real GDP growth has slowed considerably, it should bounce back well above its 2.2% pre-pandemic trend in the upcoming quarters due to the fading of the Delta variant.
- The duration of elevated inflation still won’t be known for at least a few months.
- Fed tapering of monetary stimulus will probably start by yearend, with a liftoff in short rates by late 2022.
- Equities are still more attractive than fixed income, with bond yields expected to rise well into next year.
- After a stellar 18 months, stock prices could be choppy. Returns should still be positive, however, though much more moderate.
- Quality in stock selection is crucial, with consistent earnings, positive cash flow and good balance sheets as important as ever.