3rd Quarter Commentary From the Desk of Arthur D. Lyons, CIO
May 23, 2022
The third quarter saw further advances in the Covid recovery, but also uncovered concerns about the U.S. debt ceiling, foreign relations, inflation, labor markets, and the Federal Reserve (the Fed) activity. That’s a lot to worry about! We don’t believe things are as negative as many would have you believe, and continue to remain optimistic for the remainder of the year. Here’s how we see the various areas:
Our GDP forecast of 3.5%+ for 2021 remains on track. Year over year inflation (CPI) recently reached a 5.3% rate through August. While that number lingers at this high level currently – and longer than we originally expected – we remain in agreement with the Federal Reserve that these inflation levels are temporary. The labor market continues to mystify economists, as it shows uneven improvement, with weakness in some areas and strength in others. For example, while the unemployment rate dropped to a staggeringly low 4.8%, the labor participation rate fell to 61.6%, indicating fewer people in the labor market. Sure, the unemployment rate is declining, but that is primarily due to the fact that more workers have stopped looking for work. This statistic only measures those who are actively looking, while labor participation includes those who can/could work, but are not, for whatever reason.
Jobless claims are falling, wages are rising at a 3.4% annual rate, but only the 16 to 25-year-old age group is receiving the bulk of that increase, as unskilled labor rates are soaring. Above age 55, wages have actually declined 1% this year. Available job openings continue to expand – and go unfilled. The question no one seems to be able to answer is: “Where have all the workers gone?” Back to school? Retired? Where? It is a mystery as 3 – 6 million pre-Covid workers are nowhere to be found, made all the more mystifying now that many government benefits have expired. Also buried in the labor recovery, is the fact that workers over 55 years old are permanently leaving the workforce in higher than expected numbers. This means that the most experienced and productive labor is gradually diminishing. It remains to be seen if this trend will reverse or diminish, but when that age group drops out of the labor force, it is usually permanent.
The inflation scenario, as predicted by the Federal Reserve, has thus far unfolded according to their script. As the economy has reopened, the pent-up demand and supply bottlenecks have brought on inflationary pressures, both at the producer and retail levels. The Fed believes, as do we, that this surge will be temporary (their word is “transitory”), probably lasting until the 4th quarter of this year. As supply imbalances eventually become in line with demand, prices should revert to normalized levels. Already, we have seen dramatic declines in certain commodity prices at the producer point (grains, palladium, gold, and lumber) with copper stabilizing in the $4.20 area. The energy complex (oil, natural gas, gasoline, and heating oil) has captured recent headlines, since government energy policies (U.S. and overseas) have brought on distortions in supply. We believe energy prices will remain elevated at these levels for the foreseeable future, and perhaps correct modestly over the next year. We do not see runaway oil prices, unless government policies continue to hamper our ability to produce in the U.S.
In the meantime, a number of commodities that experienced out-sized price increases earlier this year, have already retreated significantly from their recent highs, indicating that supply imbalances are beginning to dissipate. We are forecasting a return to a 2 – 2.5% annualized inflation rate by year end or the 1st quarter of 2022. The Fed’s inflation picture for the remainder of the year has not wavered from their original outlook, despite criticism for this so-called “rigid” stance in the face of higher inflation data. We disagree with that viewpoint, and believe that eventual modest inflation is the most likely scenario over the next 6 – 18 months.
The Federal Reserve has made it very clear that they will keep short-term rates low for the next 16 – 28 months, but have recently sent a subtle message to the fixed income markets that they will begin to scale back their open market purchase of bonds. This is referred to as “tapering,” and frankly, is no longer needed by the Fed to provide market liquidity. It was very useful during 2020, but the economy is on much firmer footing now, so the right move is to scale back this strategy. Tapering expectations has already had the effect of pushing interest rates modestly higher, although, in context of the past ten years, rates are still extraordinarily low.
Despite this unprecedented visibility, the bond market has reacted quite emotionally at times, as investors try to discern when the Fed bond purchases will end. For example, the 3rd quarter began with a 1.48% yield on the U.S. 10-year Treasury. Thirty-two days later, the yield had dropped to 1.13%, with pundits looking for a return to sub-1% yields. It never happened. On September 30, the yield was back where it started, at 1.49%. Since then, the past ten days have seen an increase to the 1.6% level, as the Fed indicates it will taper bond purchases. The markets have taken it in stride in an orderly fashion. We continue to believe that intermediate and long-term rates will advance modestly for the remainder of the year, reflecting a modest increase in inflation.
The risk/return profile for bonds continues to be unfavorable. With interest rates at historically low levels, bonds have little-to-no yield safety cushion for principal, should rates rise. For the quarter, the bond index was virtually unchanged, and YTD, the intermediate bond index is negative by approximately 1%. Longer duration bond indices are down over 5 -7%, as they are far more sensitive to interest rate changes. Complicating other areas of this market is, first, the fact that credit spreads (the yield difference between high-yield bonds and U.S. Treasuries) are historically very low. Second, international investors continue to invest in U.S. Treasuries, due their high relative yield and weaker U.S. Dollar. These factors, along with our inflation view, have convinced us to remain with our very defensive fixed income position. We have a large position in short-term treasuries, have eliminated high-yield bonds completely, and have added to floating rate positions. This has enabled portfolios to lower duration (2.97 yrs.), increase credit quality (66% is now AAA), and remain somewhat yield-competitive (approx. 2%). The modest inflation forecast from the Fed calmed the bond market for the time being, but spreads remained wide between short- and long-term interest rates. This reflects some of the anticipated inflation levels that Chairman Powell referred to. AAFMAA Wealth Management & Trust LLC (AWM&T) believes that interest rates will move modestly higher during the year, as inflation trends higher, reflecting global economic growth. The Fed has said in years past that this is a good thing. Modest inflation, as currently anticipated, reflects renewed economic growth that we are all hoping for.
For the 3rd quarter, markets continued their super strength through July and August, gaining nearly 6% in the U.S. large-cap markets. September, usually the worst performing month, gave back nearly all those gains, with the S&P 500 Index eking out a 0.58% gain for the quarter. There continues to be an enormous amount of short-term noise, but the longer-term scenarios are still intact. Our opinion is that valuations are not stretched, as earnings surprises for the S&P 500 are averaging 24% above expectations. With equity prices moving down a bit and earnings growth continuing, this has had a very positive valuation effect on the S&P 500 Index. The forward P/E ratio has moved from 23.5 at the beginning of this year down to 20.5 currently. This should remove any investor perceptions about a market gone out of control and overvalued.
Overall, equity market fundamentals remain very strong, as the economy rebounds and credit conditions remain favorable. The “growth versus value tug of war” continues on an almost daily basis, as investors struggle to determine future inflation and interest rate levels. The 3rd quarter showed a marked improvement for growth stocks, and they closed the gap significantly on their value-based counterparts. In the short term, it is hard to say which sector will come out on top, but in the longer term, we believe the market will reward companies with strong earnings growth.
Although year over year comparisons will become more challenging, as we get closer to year end, corporate earnings, on the whole, have not disappointed. Manufacturing bottlenecks are a challenge for short-term earnings growth, but that issue should be repaired by year end. Market valuation concerns have subsided somewhat, as sector rotation takes center stage. This growth/value rotation has kept a bit of a lid on the overall market indices, as some stocks advance, while others decline, resulting in a moderate valuation. In other words, not all stocks are being lifted equally in this bull market, at least for now. This view, however, may change significantly in the months ahead. We’ll weigh in on that in detail during our year-end report. Our portfolios, while emphasizing (earnings) growth, have a significant segment in the value area. We are comfortable with this mix through the end of this year, as we believe so-called value stocks (energy, financials, and industrials) will continue to perform well.
All in all, low interest rates, increased economic activity, and moderate inflation, make for an excellent equity environment. AWM&T continues to be fully allocated to equities and relatively defensive in fixed income duration. Unless the Federal Reserve drastically alters its outlook (and they have given visibility through 2023), we expect to remain status quo for the foreseeable future.
Unfolding For the Remainder of 2021…
The equity markets continue to operate in the favorable environment of low inflation and low interest rates. As markets adjust to the recent, sudden interest rate move, we believe growth companies will resume their outperformance of so-called “value type” companies. We continue to look for U.S. outperformance versus the world, and a resumption of large-cap versus small-cap outperformance. Keep in mind that on any given day, week, or month, strong sector “rotations” can occur. It has not been unusual to see institutional investors move large funds from one sector to another. This reflects an investor uncertainty and volatility that is historically short-term in nature. In the longer term, we look for reduced volatility and strong corporate fundamentals from our equity allocation.
The bond market has struggled, due to higher rate movement, and we anticipate a tough year for bonds. Already in the first nine months of this year, the intermediate bond index was -1% on a total return basis. As economic data unfolded during the quarter, AWM&T made portfolio adjustments to reduce interest rate risk. Additionally, we have taken advantage of very narrow credit spreads to reduce both investment grade and high-yield positions, replacing them with short-term U.S. Treasury and adjustable rate securities. While we cannot promise a positive return for the year, we can say that we have taken steps to reduce the level of interest rate and credit risk to the portfolio. This could benefit portfolios from a risk/return standpoint.
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