Economic Monitor: There's Somethin' Happenin' Here
BY: Mark Drachenberg
One of the most well-known protest songs of the 1960s, “For What It's Worth,” was written by Stephen Stills after he watched Los Angeles police officers, in full riot gear, intimidate a large gathering of young people who had organized to protest the enforcement of a curfew in West Hollywood. According to Stills, there was no reason for the police to respond how they did, as no looting or violence were taking place.
While the lyrics of the song speak to a different time and environment, some resonate today – “There's somethin’ happenin' here, and what it is, ain’t exactly clear” – in terms of how the pandemic has altered, and continues to alter, our economy. Inflation is on the rise, the economy slowed dramatically in the third quarter, and yet, the markets staged a strong rally in October.
Like the song says, “We got to beware,” and “Everybody [needs to] look [at] what’s going down,” if we want to be able to navigate through the uncertainty. Let’s look at the markets, the economy, and the Fed in a bit more detail to see if we can find our way.
What a change a month makes…. again! In September, the markets gave back most, if not all, of July and August's gains; October righted the ship, essentially recovering everything and more.
The fourth quarter started with a bang, as equity markets surged on strong earnings growth and reasonably stable economic data. The Dow gained 5.93% in October, while the S&P 500 and NASDAQ logged respective gains of 7.01% and 7.29%. The S&P 400 (mid-cap stocks) added 5.89%, and the S&P 600 (small-cap stocks) tacked on 3.43%. 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), made up ground, albeit in less spectacular fashion, increasing 5.32% and 2.38%, respectively.
The effect of the spike in interest rates during September carried over into October and caused the U.S. Aggregate Bond index to fall, though just 0.03%. Any fears of an imminent correction seem to be laid to rest for now. Market valuations have come down a bit, and earnings have remained strong, both of which should lessen the blow of another eventual selloff.
Where to begin? How about with third-quarter GDP? The preliminary number came in at just 2% annualized, which was a far cry from estimates earlier this year of 6% or more. On the other hand, the number was above what some pessimists thought (1% or below for the quarter). The economy slowed primarily because of the Delta variant, which kept people from traveling, spending, and working. Ongoing supply-chain issues also served to drag things down.
Unemployment continued a downward trend; however, the focus there should not so much be on the actual rate, but on the number of individuals that have stopped looking for work. The labor participation rate, which measures the percentage of all people of working age who are employed or are actively seeking work, fell to just 61.7% in September. Everywhere you look – not just at fast-food places or discount stores – there are "help wanted" signs. Ultimately, this will lead to higher wages, which should lure people back to work, but that could also impact the inflation rate. The low participation rate is being affected largely by older adults who have decided to either retire earlier than planned, or have simply given up looking for work. In either case, Covid is a prime contributor to those decisions.
Inflation continues to run hot and has reached multi-year highs. Yes, some is transitory, but the length of that transitory period is now in question. So far, the consumer has proven resilient to price increases, due to historically high savings rates, but that won’t persist indefinitely. Fourth-quarter GDP estimates are in the 5% to 6% range, and are being supported by higher factory output data, consumer confidence numbers, and rising leading economic indicators.
The Fed’s actions in coming months will be both reactive to current economic data and reflective of their forecasts. This seems elementary, but can be confusing, because sometimes those things appear to conflict. For example, the Fed may be looking at higher inflation rates for longer than originally anticipated, which, in theory at least, would support the argument to raise interest rates. However, the Fed will continue with its bond buying (continuing to pump money into the economy), albeit at a slower, and slowing, rate.
The Fed announced it will begin the tapering process in November by reducing its bond buying by $15 billion per month until June 2022. It also said that it could begin raising rates as early as the third quarter next year, but there are two things standing in the way that happening. First, changes to the Board will likely move it into a more dovish direction even if Chairman Powell is reappointed. And second, the Fed will likely not want to start raising rates until after the mid-term elections next November. So, don’t expect any rate hikes until after the mid-terms, and perhaps not until 2023, barring economic data that forces its hand.
What’s going on here is, the economy is strong enough to withstand the Fed cutting back on its bond purchases, and with money still pouring in (not to mention added stimulus from Washington in the infrastructure and spending bills), the markets should continue to climb higher.
Inflation, employment (or lack thereof), and stimulus measures are among the threats that could derail ongoing recovery. Investors need to take time (stop) to assess the economy (look what’s going down) and the risks facing it. But keeping a careful eye on the economy and markets is always a good thing, and can lead to some great opportunities. With rates and energy prices going the way they are, financial-, energy-, and industrial-related stocks should do well, and there continues to be opportunity in the technology sector, too.
It sounds like a broken record, but the TINA principle continues to hold. While the markets may climb higher, September was a good reminder to be diversified, somewhat defensive-minded, and ready to act, should things head in a direction different from the one expected. Getting rid of the froth through a normal correction could be what the market needs to move substantially higher, although September’s pullback may be all we get for now.
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. Like the song says, “There’s somethin' happenin' here, and what it is, ain’t exactly clear,” so be vigilant and on top of your strategy. To discuss your portfolio, or any other issue you may have, please call the Wealth Management department of State Bank of Cross Plains at (608) 826-3570. We look forward to speaking with you.