Over the past few months, markets have been buffeted by economic and policy crosscurrents that left them rangebound and trendless. We’ve been forecasting this dynamic in greater detail, along with the underlying causes, for months now. Broadly, the delta variant resurgence, China’s growth struggles, inflation, as well as monetary and fiscal policy uncertainties are all coming to a head. Combined, they’ve worn down investor confidence, and fears of a correction are causing many to proceed with caution.
There’s a lot going on — and all at the same time. These fears are not without merit. Supply chain logjams and rising prices have caused growth to decelerate (albeit from exceptionally elevated levels). Federal Reserve Chair Jerome Powell recently conceded that inflation is sticking around longer than originally forecast. It’s all given financial markets reason to pause. There are plenty of reasons for investors to be pessimistic, which, to us, is a clear contrarian signal for optimism (we’ll explain).
There are plenty of reasons for investors to be pessimistic, which, to us, is a clear contrarian signal.
Our outlook remains unchanged. The current sluggishness in markets is a temporary pause; cloudy skies will eventually clear, and fundamentals will pull markets higher. So, what gives us confidence when so many are growing more pessimistic by the day? Allow us to first address the major concerns hanging over markets, and then briefly outline four tailwinds that we believe will prevail and allow investors to put many of their concerns in the rear-view heading into Q4 and beyond.
First, the fears.
Fiscal policy negotiations have emerged as a prime driver of market volatility, but these may be the most fleeting of the market concerns we’ll outline here. Market drawdowns rooted in Congressional wrangling have historically served as strong incentives for “negotiators” to reach a deal, and quickly. Politicians often talk tough until the rubber meets the road. Once the consequences of vacillating become tangible, no elected official wants to shoulder the blame. We think investors who sell based on the current fiscal turmoil, unfortunately, will likely miss the upside that ensues once lawmakers strike deals.
While Congress appears to have agreed on lifting the debt ceiling and pushing the debate into December, it’s not the only point of contention. There’s also the infrastructure bill and a broader spending bill to iron out. Our view is that the price tag will be dramatically scaled back from $3.5 trillion to around $2 trillion dollars — still nothing to sniff at. Even a scaled-back spending plan will have broader tax and economic implications, but we don’t foresee this becoming a detriment to economic growth in the near term.
Inflation worries continue to plague markets, with key price gauges pushing to the highest levels since the early 1990s. The Federal Reserve’s preferred inflation indicator, the Core Personal Consumption Expenditures Index (Core PCE), rose 3.6 percent, year-over-year, in August. Inflation will be a hallmark of this economic cycle, but we reiterate our view that the current inflationary spike is transitory. Importantly, we don’t define the term “transitory” as being solely about time; rather, it is also largely a function of the root cause: supply chain congestion. But that will heal in the coming quarters as COVID-19 cases alleviate, workers return, and incremental demand is shifted back to services from goods that need to be moved around the world. We believe inflation becomes persistent only when the economic fundamentals allow it — that is, when the U.S. economy runs out of slack or productive capacity. We aren’t there yet.
From what we’ve gleaned from the data, plenty of idle productive capacity (slack) remains. On the machinery side, capacity utilization currently resides at 76.4 percent, which remains well below levels at which previous inflationary periods took hold. For example, the last economic cycle saw utilization push toward 80 percent before it was abruptly interrupted by a trade war and COVID-19, and prior cycles approached 82 percent before peak utilization.
While labor markets are tight, we believe people will be incented to re-enter the workforce as extended unemployment benefits cease and excess savings are drawn down. While we have had fits and starts on the labor front, we are making progress: On average, nearly 500,000 workers are being added to payrolls every month, with the three-month average recently accelerating to roughly 750,000.
The Federal Reserve
With inflation accelerating, each Fed policy meeting stirs worries the central bank will suddenly strike a hawkish pose. September’s meeting, especially, awakened those fears given the inflationary backdrop and improving labor market. While the Fed pushed the ball forward on plans to taper its $120 billion in monthly asset purchases, it came up just short of the goal line. It’s clear the Fed is pivoting on policy, but it’s doing so at the pace of a tanker ship rather than a Ferrari.
In lieu of a formal tapering announcement, the Fed laid out a roadmap for the next few years. Chairman Powell announced the Fed would reduce its asset purchases of Treasurys and mortgage-backed securities by $15 billion a month once the process is started. Given the current $120 billion per month pace, those purchases won’t completely wind down until mid-2022. It’s important to emphasize that tapering is not tightening. The Fed’s overall balance sheet will continue to expand because it will be reinvesting proceeds and interest payments from the assets it already purchased.
The Fed also released its notorious “dot plot” in September, which illustrates when each FOMC member expects interest rate hikes to begin. But the dot plot is just a forecast, and rather than getting hung up on precise dates, we like to focus more on the Fed’s overarching mission or intent. We fully expect the Fed to remain measured and patient, with a focus on erring on the side of doing too much rather than too little. We’ve viewed Fed policy within this framework for two years now, and the Fed has yet to surprise us.
Even amid this inflationary spike, the Fed believes rate hikes will begin in late 2022 or early 2023, but even then, forecasts call for just three 0.25 percent rate increases a year — quite underwhelming. Importantly, the year end 2024 dot shows the Federal funds rate at 1.75 percent, which, coupled with the Fed’s 2.1 percent inflation forecast, means two things:
- Real interest rates will remain negative, which is stimulative.
- The Fed will not reach its forecasted longer-term neutral rate of 2.5 percent (when policy is neither stimulative nor contractionary).
While these are uncertain forecasts, they do reflect the Fed’s primary reaction function. This is a Fed with a strong bias to do more, a Fed that’s focused on the labor market first, and a Fed that’s willing to hold the long view on inflation. This is also a Fed that pays heed to markets. You’ll recall the Fed expected to hike rates in 2019 but ended up pivoting and cutting rates, not because its economic forecast changed but because it was “listening” to markets and they were screaming for a course reversal.
For nearly the entirety of Q3, COVID-19 cases in the U.S and in many countries around the globe were rising — even to levels near 2020 in some places. This impacted not only supply chains but also demand. Consumer spending slowed as confidence plunged, but this is a double-edged sword. It cuts demand, which leads to lower current economic growth. However, it also pushes demand out further into the future, potentially alleviating the mismatch between supply and demand that exists today while saving some growth for tomorrow. It’s worth noting that COVID-19 cases appear to be rolling over, and we are hopeful this will bring workers back and loosen supply chain constraints.
It’s clear the Fed is pivoting on policy, but it’s doing so at the pace of a tanker ship rather than a Ferrari.
For those worried COVID-19 will once again cause economic wreckage, take a moment, and compare the current environment to what existed in 2020. Last year, COVID-19 and the measures to control its spread affected every sector of the economy. Today, that impact is increasingly concentrated to a few niches of the U.S. economy. Last February and March saw complete uncertainty which led to a historic market plunge. Contrast that with today and the economic, market and public health adaptations that help us operate amid a pandemic. The level of uncertainty is drastically reduced, and any market decline tied to COVID-19 would, in turn, be far less severe. If equity markets hate uncertainty, then COVID-19 is unlikely to be the culprit that obscures the outlook and leads to a massive market disruption.
Concerns about growth in China also came to the fore in Q3, particularly regarding China’s response to the potential bankruptcy of property developer Evergrande, and aggressive regulatory maneuvering by China that’s tied to its Common Prosperity drive. Recent developments indicate that China will work to contain the damage from Evergrande, and we believe the country has the resources to do so. Furthermore, a systematic demolition of Evergrande would run counter to the country’s Common Prosperity initiative.
It’s also worth noting that in September China loosened fiscal and monetary policy to help cushion any potential economic blow from Evergrande’s woes along with a deceleration in growth caused by COVID-19 cases. Keep in mind, China is hosting the 2022 Winter Olympics, and the country’s leaders will want to showcase to the world a thriving economy, not one on its heels.
Longer-term worries persist about the divide between the U.S. and China from a political perspective. The continued delinking of the two economies isn’t bad, but it won’t be easy or end quickly. Tensions will, from time to time, boil over, much as they did during the trade war in 2018-19.
As you can see, there’s a lot on the plate for investors to digest, which is why we didn’t see a definitive move in either direction for much of Q3. Fortunately, these fears aren’t new, and markets have had months to “chew” on them. While we’ve still got some ground to cover before we can say we’re above the clouds, none of the headwinds we’ve described are strong enough, or persistent enough, to alter our outlook for the rest of the year and into 2022.
In contrast to the fears described above, we contend there are four major tailwinds that are poised to bolster investor confidence. And, once the noise dissipates, these four factors will gain their share of the spotlight and provide the basis for bullish sentiment and lift markets higher.
Economy has momentum
We are in a transition period following the V-shaped recovery of 2020. Everything policymakers did last year and into 2021 was an effort to spur an economic revival. Well, we’re there. But now that we’ve accomplished the objective, investors are debating the potential side effects of all the stimulus and what the next bullish narrative is for the country and economy. We think traditional economic metrics can capture the narrative because the economy retains significant momentum, ample liquidity and strong underlying fundamentals.
The most recent Conference Board U.S Leading Economic Index (LEI) clocked in at a 13.7 percent six-month, annualized growth pace. As a reminder, the LEI forecasts future growth. A read of 13.7 percent is a historically strong print and is an encouraging sign of what’s to come.
If you’re worried about an imminent recession, this may calm your nerves: Of the nine recessions that occurred since 1960, seven began with an LEI in negative territory. What about the other two? The recession that began in April 1960 started with the LEI at 1.4 percent, although it had turned briefly negative in November of 1959. The pandemic-induced recession that began in February 2020 saw the LEI hit 0 percent, although it was slightly negative in the prior months at -0.2 percent.
Consumers are healthy
Not only is economic momentum strong, but the most critical components fueling growth remain healthy. Consumers are as strong as they have been in decades.
The Consumer debt-to-net worth ratio rose to just over 23 percent in late 2008 and into 2009, but (in the aftermath of the Great Recession) consumers spent the past 12 years cutting this ratio nearly in half to roughly 12 percent, near levels last seen in the early 1970s. This trend accelerated during the pandemic, and consumers have hoarded an additional $3.9 trillion of liquid assets.
With interest costs near or at all-time lows, the household income statements look just as healthy. The cost of monthly payments relative to disposable personal income (known as the Federal Reserve Financial Obligation ratio) is at all-time lows going back to 1980. This too has been on a similar downtick since it reached a peak of 18.41 percent back in Q4 2007. Currently, it resides at 12.8 percent. And for those worried about any impact from potential rising rates, we note that 65 percent of consumer debt is mortgage debt, and consumers have heavily favored fixed-rate mortgages since the Great Recession.
Consumers are as strong as they have been in decades.
Undoubtedly the stimulus enacted during the past year has played a role in the deleveraging and low interest costs. However, the reality remains that the consumer is in decent shape and has ample spending power and a handoff to employment and wages is currently underway. The government debt that has resulted from the stimulus is a future risk, but we aren’t there yet.
Corporations are healthier
Corporations have recently taken on additional debts but are also locking in low interest costs, just like consumers. Interest coverage ratios (the ability to pay interest on debt with cash) remain at historically high levels. Earnings remain incredibly strong and margins (which may come under pressure in coming quarters due to rising prices) are near record levels. Add in strong new orders, large backlog of orders and low inventory levels and you have a picture of strong future growth.
Markets have washed out weak hands
We believe this strong economic growth will eventually fuel a rising equity market. While stock prices remain elevated compared to earnings, that ratio has declined throughout 2021, as prices have risen less than profits. We believe future equity returns will be a function of profit growth, meaning more muted but still positive returns going forward. With the 10-year Treasury ending the quarter at 1.48 percent, stocks remain attractive, on a relative basis, compared to bonds.
The concerns we’ve outlined have driven investors from euphoria to pessimism over the past few months. However, investor sentiment is often a contrarian indicator (when investor sentiment is at its lowest, that typically means the worst has already past and vice versa). The American Association of Individual Investors sentiment survey spent the beginning of the year with more than 40 percent of respondents indicating they were bullish, even pushing above 50 percent for much of April. As we closed the quarter, investor sentiment took a bearish turn, with just 22.4 percent in the bullish camp on Sept. 16. In the 34 years of weekly data, there have been only 89 readings lower than that, and in nearly all cases one-year returns from that point were positive. Similarly, bearish sentiment rose from 19.8 percent in early June to 40.7 percent to end the quarter.
The concerns we’ve outlined have driven investors from euphoria to pessimism over the past few months.
We still have many questions to answer and the potential for a correction exists. However, our research shows that corrections not tied to economic recessions tend to be short-lived. That’s because a growing economy eventually pulls the market along with it. With so much cash on the sidelines, we think any near-term pullback would be viewed as a buying opportunity, further reducing the duration of a swoon.
Today: unique, but not different
Each economic cycle is unique, but not different. Here’s what we mean.
The formula for every economic cycle is simple: First, the U.S. economy runs out of slack, which leads to rising inflation and compels the Fed to raise rates (historically, pre-emptively and aggressively) to keep it at bay. The recipe won’t change in this economic cycle, but how the ingredients come together will.
First, this economic cycle may see slack ebb aggressively. Think about the massive fiscal and monetary stimulus that was deployed to cushion the downside, which has allowed the economy to recover its recession losses quickly. Policymakers are still pumping the gas to foster continued growth, which threatens to potentially create a shorter economic cycle as we tick though our economic cycle formula quickly.
The long-term potential growth rate of the U.S economy is simply how many people work and how productive they are. As one might expect during recessions, the U.S. economy falls well below its potential long-term growth rate, often dramatically, and then plays catch-up by re-engaging idle capacity. Eventually, we recapture lost growth and move above that long-term potential growth line. At that point we are exceeding the economy’s speed limit, which is the formula for sustained inflationary pressures.
During this cycle, we have aggressively and quickly clawed back those losses, and the current stimulus is threatening to push us above the economy’s speed limit. Think about the “slack” comments we made earlier. We have 10 million job openings in the U.S. and only 8.3 million unemployed workers. Theoretically, we could soak up every unemployed person tomorrow and be out of slack on the labor front, which could form the basis for lasting inflation that so many now fear.
Diversification remains the best hedge for uncertainty, and the best means to capture upside in a future that cannot be predicted with great accuracy.
But, even here, there’s good news. If the economy runs out of labor to hire, businesses can boost the speed limit, or long-term economic growth potential, by enhancing productivity — making existing workers more efficient using advanced technology and training.
Healthy companies continue to invest in capital goods, which is increasing productivity (pushing the speed limit higher). U.S. capital goods shipments (business investments) are currently up 13.2 percent year-over-year, which continues a trend that began in 2016 but was interrupted by trade wars and COVID-19. We don’t believe it’s an accident that worker productivity has been in an uptrend the past few years. Ultimately, increasing the growth speed limit can yield a longer economic cycle.
The other factor that’s unique about this cycle is the Fed. It is deliberately ignoring inflation and is not going to pre-emptively tighten policy as much as it did in the Paul Volcker era, which was plagued by oil price surges. Today’s Fed believes pre-emptive hikes meant to tame inflation in recent history may have cost additional economic and employment growth by acting too soon.
These nuanced differences from past economic cycles provide the backdrop of risks — and potential opportunities — for investors. We don’t believe it’s a coincidence that our historical research shows each economic cycle was led by different asset classes (see our commentary here). Market leadership is different in every cycle, which underscores why diversification is critical to long-term investing success. Investors are not well served turning to the rear-view mirror to position portfolios. Diversification remains the best hedge for uncertainty, and the best means to capture upside in a future that cannot be predicted with great accuracy.
We have stated our belief that this economic cycle would be different from the past, as inflation pressures supplant fears of deflation that haunted prior cycles. We continue to express our belief that this means different asset classes, including a few that disappointed in the last cycle, would perform better in this cycle. While it’s only a small sample size, we are not surprised that the worst-performing asset class in the last economic cycle, commodities, is the best performer so far 2021.
While this cycle will be unique and asset class leadership will likely be different, the formula for investor success remains the same: Work with a financial advisor to craft a plan that serves as a roadmap for how you are going to invest when times are good and, more importantly, when times inevitably turn bad.
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