Economic Monitor: Just What We Thought...?
BY: Mark Drachenberg
In October 2006, then-Arizona Cardinals head football coach Dennis Green went on an epic tirade after watching his team blow a commanding lead over the Chicago Bears and, ultimately, lose the game. That rant gave us one of the most memorable lines in the history of sports press conferences: “They are who we thought they were!” That same line seems to apply to the current state of the economy and markets – or so we might think.
The pandemic-related economic shutdown and subsequent reopening has played out exactly as we thought, right? Well, maybe not. While Dennis Green and the Arizona Cardinals knew their opponent and should have been prepared for the game, we didn’t, and don’t, have that luxury. So, as things continue to play out in ways both expected and unexpected, we can’t really say that this is just what we thought would happen.
What we’re finding, and indeed did expect, is that the recovery has been uneven at best and problematic at worst. Data, expectations, results, and outlooks are changing daily, which creates an environment of uncertainty and fear, while the reality is perhaps more positive than it appears. Let’s take a look in a bit more detail.
What a change a month makes! September saw the markets make a giant U-turn and give back most, if not all, of the gains made in July and August. Third-quarter returns were flat to negative, as fears over inflation, rising interest rates, Evergrande, political fighting, and more threatened to derail the markets and push them toward the first correction since the spring of 2020.
A spike in interest rates sent tech-heavy indices into a freefall, while less tech-dependent indices fell to a lesser degree. The Dow dropped by 4.20%, and the NASDAQ and S&P 500 fared even worse, falling 5.27% and 4.65%, respectively. The S&P 400 (mid-cap stocks) shed 3.97% and the S&P 600 (small-cap stocks) 2.43%. Also, the equal-weighted S&P 500 index (less reliant on the performance of a few of the largest stocks) and international stocks (generally more value-oriented) performed better, but still shed 3.79% and 3.19%, respectively.
The spike in rates also hit bonds and caused the U.S. Aggregate Bond index to fall 0.87% on the month. At this point, we’ve not entered correction territory but there is a heightened sense of uncertainty, even in the face of stronger earnings. Market valuations have come down, which could soften the blow from further selloff.
There are so many things going on right now that may have an impact on our economy that it’s hard to choose what’s most important. The ongoing threat from the virus is certainly a concern, and is really the source of virtually every economic issue. There’s good news, though, in that the number of cases is dropping, and we seem to have turned a corner in the fight. Whether that is temporary or not remains to be seen.
While the economy is strong, third-quarter GDP estimates fell, and fourth-quarter estimates are under some pressure, as well. While estimates are falling, the rate of growth is still above the trendline since the Great Recession, and revisions to estimates for 2022 are generally higher.
Let’s dive into some of the threats that exist at the moment:
- Energy prices, including natural gas, are soaring due to lower rig counts and rising demand, although the U.S. is better positioned than Europe.
- China’s Evergrande situation threatens credit markets across the world, but likely will be contained to China.
- Political fighting over various fiscal measures will impact the U.S. to a greater degree. Excessive further stimulus is not necessarily needed at this time, and could fuel additional inflation if approved (more on this in a moment). Paying for the additional stimulus with tax hikes threatens corporate profits and will be a drag on the markets in the short run. (It’s interesting to note that the debt-to-net-worth ratio in the U.S. has fallen over the past decade, and the cost to service the national debt is well below 1980s levels, largely due to lower interest rates. Rising interest rates would affect our ability to service our debt, threatening future growth.
- The ongoing chip shortage is expected to last somewhat longer than previous estimates and will continue to hurt auto sales, especially.
- The employment picture is improving, albeit ever so slowly. With extra unemployment and other benefits expiring in September, there has been an uptick in job applications in certain industries, including fast food. Interestingly, it is largely older adults applying for these jobs, not teenagers.
- Inflation poses perhaps the biggest threat right now. While the rate of inflation has been increasing, the biggest question regards how transitory it will be. Concerns are growing that the stickiness of some price increases may be greater than originally thought, threatening demand for certain goods and services. The good news for investors is that, so far, the higher rates have not hit corporate earnings, as companies have figured out how to absorb the added costs.
Some of this is what we thought it would be, and some is not. While longer-term growth will likely slow, for the balance of this year and next, economic growth should remain strong.
While “all eyes on the Fed” has become a normal way of life for investors and economists, perhaps more attention is being paid to politicians right now, as the fiscal debates in Washington continue. That doesn’t mean that the Fed has been quiet, though. Chairman Powell indicated that the tapering process will likely begin in November and end sometime in mid-2022. That’s good news for an economy strong enough to allow the Fed to take its foot off the gas somewhat. The concern the Fed faces is what to do if inflation remains higher than expected and we have not reached full employment, as there is little historical precedent for the Fed to fall back on, should that happen.
Inflation is the biggest concern, and the Fed must fight through the noise to determine how much is permanent. Supply-chain issues are helping cause higher rates, as demand remains strong. Rising inflation could cause demand to fall back over time (in fact, we may be seeing that start to happen), easing the pressure to raise rates; supply chains could improve to meet demand; or the Fed could raise rates to force demand to ease. Certainly, we’d prefer that supply chains improve, and they should, but it’s a matter of when. Also on the minds of investors is whether Chairman Powell will be reappointed to another term. As of now, odds are that he will be.
Certainly, there’s a lot going on, some of which we expected and some we did not. While we anticipate, and would welcome, a short-term market correction, we’re not there yet and may not be for some time. Yes, we’ve given back some gains, and September was a rough month, but the economic outlook is still quite strong for the remainder of this year and next. The TINA principle still holds, and therefore, the markets should climb higher unless something we don’t expect happens, like a rate increase by the Fed, or the Evergrande situation overflowing to the rest of the world.
While the markets may continue to climb higher, September was a good reminder to be diversified, somewhat defensive-minded, and ready to act if it appears that the economy and markets are heading in a direction different than expected. Getting rid of the froth through a normal correction could be what the market needs to move substantially higher. In the meantime, look for areas where valuations may improve, such as value and international stocks, or that may provide some protection, such as floating-rate bond funds. Just be prepared for the hangover, whenever it may occur.
To discuss your portfolio, or any other issue you may have, please contact me directly at (608) 826-3508, or reach out to anyone in the Wealth Management team at (608) 826-3570. We look forward to speaking with you.