APW Investment Committee Q4 2021 Commentary
Q3 2021 Review
Global equity market appreciation slowed dramatically in the third quarter, including a sharp reversal in emerging markets due primarily to the strong regulatory crackdown and eroding credit conditions in China.
US economic data was mixed. The US Index of Consumer Sentiment dropped precipitously from an already low 85.50 reading in June to 72.80 in September. This is unusual given the falling unemployment rate (4.80% in September down from 5.9% in June). Likely it is due to two other larger issues. First, the Atlanta Federal Reserve GDP Now Forecast of Q3 2021 is (as of 10/19/2021) estimated at 0.5% down from 6.7% in the prior quarter. Second, inflation continues to stay elevated - above 5% each month of the quarter.
The US 10 year Treasury Note interest rate rose only slightly during the quarter from 1.45% to 1.52%. The US dollar index strengthened slightly from 92.35 to 93.96.
Austin Private Wealth Model Changes
Each of the past two commentaries have focused on the elevated level of US inflation and what the impact is on financial markets. As it appeared that the temporary nature of inflation was leading to something more prolonged, markets have started to adjust accordingly. In particular, we are seeing a number of trends that are creating both real current inflationary pressure and the presumption of longer-term inflation. Some of the issues include:
There is an old adage in the commodities markets that seems applicable to the current reality. “The only thing that solves higher commodity prices, is higher commodity prices.” This is because as prices rise, demand begins to fall. We believe that most of what is going on is really due to the after affects of the global liquidity expansion and demand shock coming out of the pandemic. Below are two charts that tell this story - 10 year charts of US imports and US Total Net worth of Households and Non-profits.
As can be clearly seen, demand for products is exploding higher. US consumers are awash in wealth and still somewhat reticent to spend it on services and travel. As a result, supply chains are being overrun. These kinds of supply chain problems can be worked out with time. Already last week the Federal government stepped in to facilitate the Long Beach port moving to 24/7 unloading. Other steps related to trucking congestion, lack of truckers, and even Chinese electricity production are temporary in nature. In addition, as vaccines continue to improve the COVID outlook we would expect to see a reversion to more normal historical spending patterns which should reduce product demand and therefore strains in global supply chains.
While some investors see rising wages as a problem for stocks, we see no evidence that is happening. In fact, the opposite is true. Profit margins are surging even higher than what we already thought of as record levels.
Whether labor force tightness continues indefinitely is the one area of current news that we do worry about. There has been about a 2% reduction in labor force participation rates that has been consistent throughout the pandemic. It is not clear that conditions have changed sufficiently for those that exited the workforce to all come back. If they don’t, we will likely see the rate of wage growth continue to stay elevated.
Probably the most important implication of these trends is that the Federal Reserve has indicated that it will initiate a slow reduction in monthly bond purchases (“the Taper”) starting in mid-November. This effort is likely to put upward pressure on interest rates. Even modest increases in rates into the 1.75% - 2% range on the 10 year US Treasury should begin to reduce the surging consumer demand and put some light headwinds into extreme asset prices (e.g. cryptocurrencies and speculative growth stocks).
Global financial markets are in a very complex window of time. As strategic asset allocation investors we don’t think of certainties, we look at probabilities. The odds still lean towards US inflation moderating in 2022, interest rates drifting slowly higher, and global profits continuing to improve. As a result, we think that US equities continue to look better than bonds. We do also anticipate emerging market equities beginning to recover as investors appear to have mostly digested the news flow in Chinese equities. If the Chinese government can avoid a debt default spiral and no additional escalation in regulations/rhetoric occurs, valuations appear to be attractive relative to the growth outlook.
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