Fire Capital Market Update - 4Q 2021

TWO STEPS FORWARD; ONE STEP BACK

As we start the final quarter of 2021, the global economy finds itself in a familiar position. Consumer demand remains strong, while companies struggle to keep pace. The employment picture is improving, yet large gaps remain. The recent Delta variant outbreak of COVID-19 appears to be subsiding, but the Winter cold season is around the corner. Monetary and Fiscal policy are at a crossroad, and inflation is reflecting multi-decade highs. In the U.S., bi-partisanship is giving way to in-fighting. As a result, equity and fixed income markets are contending with strong underlying fundamentals against a backdrop of a heightened sense of uncertainty. Taken together, we contemplate how our “dance” choreography has laid out our path as two steps forward; and one step back.

Robust Global Growth

Expectations for global economic growth continue to reflect improved fundamentals from the depths of the recession.  In the U.S., manufacturing & service sectors reflect robust expansions. Further, third quarter GDP has been revised slightly upward for the U.S., and the IMF estimates 2021 global GDP growth at an impressive 6%. This is the largest annual global growth rate since the IMF started publishing this data in 1980. Overall, aggregate demand remains robust heading into the final quarter of 2021.

China’s Growing Pains Towards Common Prosperity

After a long period of rapid growth, China has taken steps toward delivering its vision of prosperity for the, “common man.” This shift has not been without turbulence.  Multiple industries have been subjected to abrupt regulatory changes intended to even the playing field and redistribute gains captured by larger successful businesses.  Additionally, real estate development giant, Evergrande, is in the midst of an opaque recapitalization process that may leave foreign investors impaired.  As a result, markets have recalibrated their risk appetite towards the world’s second largest economy (for an in-depth discussion, please see our recent discussion HERE). Despite China’s growing pains, there is enough potential in the U.S. to bolster global GDP growth.  

Resilient Consumer

As the largest component of the U.S. economy, the consumer has remained resolute and is well-positioned to increase expenditures.  Personal Income and Savings remain elevated with disposable income as a percentage of savings sitting above the long-term average.  Worth watching, consumer sentiment remains below pre-pandemic levels, ebbing & flowing with reported cases of COVID-19.  However, recent data indicates the latest COVID-19 outbreak is residing, priming retail for success from the demand side of the equation as it enters its most important season.  

Output Bottlenecks

Though, demand is only half of the battle. Supply chains remain impaired and the lingering effects of the pandemic’s initial supply shock threaten the restoration of aggregate production.  While orders and output reflect continued expansion to meet demand, cargo ships around the world’s busiest ports remain backlogged – some weeks behind schedule – as they are unable to unload their containers. Extraordinary efforts are being implemented to elevate the bottleneck and workers are at a breaking point. Shipping rates for large vessels are at all-time highs and companies are resorting to contracting their own supply lines to avoid further delays and disruption.

Labor Shortage

It’s not just materials that are in short supply, human capital is scarce as well.  As a result, wage growth has far exceeded typical patterns for the current level of unemployment.  Ultimately, wages are a function of opportunity cost for the employer. As wages grow, the relatively high upfront cost of implementing automation is a more palatable alternative.  This dynamic is no more apparent than in the lower end of the skilled labor pool where employment and wage growth disproportionately lag the broader market.  With the extra unemployment benefits having expired at the beginning of September, weekly initial unemployment claims hit 18-month lows.  While this is an encouraging sign, as people transition to new employers, unfilled positions remain near historic highs. Unfortunately, for those who remain displaced and on the sideline, current rates of inflation may be outpacing wage growth. On a positive note, the displacement caused by the pandemic has also provided new horizons. Early retirements are on the rise and, in 2020, new business applications increased by more than the last fifteen years combined.  

Inflation and Fed Monetary Policy - Taper

In the face of these elevated input costs, many companies have naturally resorted to raising prices.  The net effect of the shortage of labor and goods has led to inflationary pressure across a wide swath of the global economy.  Energy prices have increased substantially this year.  Heading into the Winter season, when consumption increases, global natural gas prices have already reached prices not seen since before the Global Financial Crisis.  In the U.S. and Europe, the current rates of inflation are reaching highs not seen for decades.  Fed Chairman Jerome Powell has acknowledged that a recent spell of higher inflation might last longer than central bank officials had anticipated, but he repeated his expectation that the price surge should eventually fade.  Nonetheless, discussion of the Fed reducing bond purchases in 2021 has entered the picture.  Thus, the Fed Chair has begun a delicate dance of avoiding a repeat of the Taper Tantrum of 2013 while appropriately adjusting policy to deliver full employment and price stability.  The deeply divided political environment is adding complexity to the matter, where rumblings of new appointments, including the Fed Chair, are growing.    

Fiscal Policy – Reconciliation Process, Fiscal Budget  

Continuing with the theme of a divided government, at the time of this writing, the U.S. Congress remains deadlocked on the size and manner in which fiscal spending will take shape.  Although an agreement has been reached to fund national spending until December, the can has merely been kicked down the road.  The U.S. has long run a fiscal deficit which requires that the Federal Debt Ceiling (AKA Debt Limit) be raised for the government to meet its existing obligations. If it is not raised, the country may face a potential financial crisis; up to and including defaulting on the national debt.  Ultimately, since Democrats possess sufficient votes in the House and the Senate to pass the increase, the probability of such an event is relatively low.  

However, larger fiscal packages that are more directly tied Biden’s policy agenda have become conflated. During the negotiation process, a $1T bi-partisan infrastructure bill, passed in the Senate in early August, is now being linked to a larger and broader bill covering: 1) Social safety net (e.g., child tax credit, paid family leave); 2) Health care; and 3) Energy/climate change. Because this larger bill will be secured by the Democrats through the Reconciliation process, additional revenues will need to be generated through tax hikes.

We have summarized the proposals in the charts below:

Yield Curve

Meanwhile, bond markets are adjusting to a compound of higher inflation expectations, less monetary accommodation provided by the Fed, an unclear fiscal picture, and elevated economic growth expectations.  The net result should add pressure for rates to move higher across the yield curve. However, the precise path and shape may take many forms in the process.  To the extent inflation is being delivered by outsized growth, the higher rates may be constructive, and we expect to observe an upward sloping yield curve.  While shorter-term rates have risen to flatten the curve, it is worth monitoring how longer-term rates adjust as more clarity is provided on the fiscal package and how that impacts growth expectations.  We observe the recent movement in rates to project the bond market is beginning to price in inflation to last longer than monetary and fiscal authorities have thus far communicated to the markets. A meaningful reset in broadly accepted inflation expectations would almost certainly have negative implications for equity market valuations.

Equity Valuations

After achieving multiple new all-time highs in U.S. equity markets this year, investors grappled with stretched valuations in the face of near-term uncertainty.  Despite negative equity market performance for the month of September, the trailing Price to Equity (P/E) multiple is one third higher than what it was prior to the start of the pandemic.  However, we continue to be encouraged by signs that technological advancements during the pandemic are raising future earnings expectations.  For the third consecutive quarter, consensus estimates have increased well in advance of release.  Given elevated valuation levels, a continuation of this trend is not only welcomed but necessary to finish the year out on a positive note. Historically, this correlates well with beating expectations, in which case current valuations will moderate.  With the prospect of sustained inflationary pressure and higher rates, we prefer the growth potential of equities to the fixed income stability of bonds.  We also acknowledge that proposed corporate tax increases may have a material impact on earnings.  Additionally, higher rates are typically not conducive to the multiple expansions that markets have experienced to this point.  All considered, we are constructive that the economy remains strong and are cognizant that, for shorter periods of heightened uncertainty, the equity market may diverge.  We contend that well managed businesses who can compound earnings at higher Return on Equity (ROE) will outperform in the long run and see much of the near-term volatility as buying opportunities.    

Conclusion

As we forge ahead for the remainder of 2021, we are engaged in an intricate dance with multiple partners - one wrong move and someone will be stepped on.  The global economy is growing at a rate not seen in decades.  Businesses and consumers are well-capitalized and eager to adapt to a rapidly evolving world.  Pent-up demand and supply constraints are pushing & pulling inflation to levels of yesteryear.  Monetary & Fiscal Policy path(s) appear to be on opposite trajectories.  The externalities of politics and COVID-19 complicate matters further. Equity and Bond Markets are adjusting in real-time and volatility provides opportunity.  Yet through it all, we may likely find a few new dance moves – but for now, it’s two steps forward; one step back.

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