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October 2021 Investment Commentary
The third quarter exhibited increasingly choppy trading, with portfolios generally giving up period gains in a sharp final week sell-off. The S&P 500 shed 4.7% in September, its worst month since March 2020. Heightened risk awareness broke through the summer haze.
Underlying concerns were not necessarily new in September, but more acutely recognized. The reopening turned markedly more challenging courtesy of the Delta variant, which quickly pushed the daily COVID case count sharply higher after it had hit early-July pandemic lows. President Joe Biden’s deep Afghanistan plight not only undermined regional and geopolitical stability, but also drew down his political capital in Washington during a delicate phase of negotiations around his signature infrastructure bills. And persistent supply issues kept inflation elevated and pushed up interest rates, sending bonds lower while also threatening the strong economic and corporate earnings recovery.
|Third Quarter||Year to Date||Five Years (ann.)|
|Developed International Stocks||-8.1||-1.3||9.2|
Investors were put on edge late in the quarter by missed interest rate payments by large Chinese property developer Evergrande, servicing an offshore debt horde on the order of $20 billion. This sparked more general concerns about the country’s highly leveraged real estate sector, which accounts for a quarter of China’s economy. The emerging market sell-off shown in the table incorporated the Evergrande worries, but most of the damage in fact was done in July. The weakness was triggered mainly by China’s regulatory crackdown on its leading technology, gaming and educational software companies, including anti-monopoly rules and new data watchdogging. Taken initially as a heavy-handed threat, the rules later were viewed as more defensible, and maybe even a preview of things to come here, for Facebook and its brethren.
The Biden agenda hung in the balance as the third quarter flipped to the fourth. The $1 trillion “traditional” infrastructure bill, targeting roads, bridges, airports and broadband, passed the Senate with 69 votes in August, but quickly became mired in the House. The 95-member Progressive Caucus’s insistence on tacking on the $3.5 trillion “human” or “social safety net” infrastructure package (including universal pre-K, paid family and medical leave, tuition-free community college, and clean energy projects), as a condition for supporting the smaller bill, shone bright lights on and crystalized a rift between Democratic progressives and moderates. This has created legislative roadblocks in both the majority-thin House and the 50/50 Senate. Votes have been tabled as fence-mending efforts carry on.
On the COVID front, it was difficult to see the setbacks after we came very close to “containment”, defined as 10,000 cases a day as a weekly average, in early July. The Delta variant then tore through the unvaccinated population, pushing cases back up to 160,000 a day by September 1st. Fortunately, the curve has since improved, hitting 103,000 a month later, giving indications that Delta has peaked. Vaccination progress surely has helped, those fully inoculated now representing 55% of the nation, up from 46% three months ago. Among the highest-risk 65-plus year-old group, 83% are fully vaccinated. The Biden vaccine mandates should push the numbers up among younger age groups. But as we’ve all learned, COVID’s nature keeps optimism in check.
Globally, the pandemic’s impacts remain far-reaching. In Asia, recent COVID spikes have shackled the manufacturing sector, prolonging supply chain bottlenecks. This has been felt particularly acutely in semiconductor production, where shortages are vexing the auto sector along with numerous electronics markets. Further, the transportation piece of the supply chain has its own set of challenges, including worker shortages and pandemic-related red tape in shipping. One example: seafarers are forced to take multiple vaccines because there is no universal approval across countries. Anyone wanting to see the chain’s dilemma in real life only has to travel to Long Beach, where 55 cargo ships at last count, plus 30-odd within 20 miles, are floating, waiting to unload.
With supply issues persisting, an inflation resurgence that began early this year is taking on a look of greater permanence. August marked the fourth straight month in which the all-inclusive Consumer Price Index’s 12-month change breached the 5% level. Jay Powell and his Federal Reserve coterie have recognized this reality, having gently, but overtly, taken a hawkish turn. This included a September meeting statement that it is “almost time to taper” the bank’s $120 billion monthly bond purchases, an aggressive easing program initiated during COVID’s early crisis phase. This followed similar comments made at Jackson Hole in August. The drumroll approach is informed by history: an unexpected May 2013 taper comment by Ben Bernanke provoked the infamous tantrum, including a four-month spike in the 10-year Treasury from 1.65% to 3.0%. Today’s markets seem calm by comparison.
Overall, economic prospects have shifted compared to three months ago, but in a way that could prove beneficial. Growth forecasts generally have eased for 2021, mostly thanks to the third quarter Delta impact on the pace of reopening. The Organization for Economic Cooperation and Development recently trimmed its 2021 U.S. growth projection from 6.9% to 6.0%, within a global down-tweak from 5.8% to 5.7%, while the Fed dialed back its current-year U.S. estimate from 7.0% to 5.9%. Both entities see this as a push-out, however, raising respective 2022 U.S. estimates from 3.6% to 3.9% and 3.3% to 3.8%. In short, the Delta variant is expected to slow the recovery while not preventing it. It in fact has created a smoothing effect on economic projections over this and next year, which could provide the benefit of a more sustained recovery.
The economy’s general health may be undermining the prospects for Biden’s two infrastructure bills. Usually, fiscal spending on a massive scale is reserved for periods of severe stress or economic downturn. We just saw this with the $6 trillion COVID recession response. But the result was an increase of similar magnitude in our national debt, to $28.4 trillion. This figure represents about 135% of our GDP, well above the previous high of 113%, at the end of World War II. Revenue offsets, mainly higher taxes, are part of the current legislation, but each new trillion in debt would take us another 5% or so further into this uncharted territory. We’re seeing resistance not only to the bills but also the next debt ceiling renewal, due October 17th. We expect a first-ever debt default to be avoided -- the Democrats can use a partisan maneuver if necessary – but the bills will be scaled back significantly.
On this backdrop, both stocks and bonds have become a bit cheaper. The S&P’s recent pullback has been accompanied by continuing robust earnings growth, the latter expected to exceed 40% for 2021. This has given rise to a market price/earnings ratio in the low 20s, compared to mid-20s a year ago, and more in line with historical norms in the high teens. Next year’s earnings will be up against the robust 2021, possibly with increased inflation and interest rate headwinds, and a potentially higher tax rate. Growth of closer to 10% is expected. Operating conditions and corporate performance could however be aided by an improved economic picture owing to the delayed reopening effect. For now, our inclination is to hold our equity positions, choppy though the ride is likely to continue to be.
Within the equity book, we are maintaining weighting parity versus the ACWI index with regard to the U.S. (60%), as well as emerging markets (low-mid teens) and China (around 5%). Following its weakness, the emerging space trades at respective price to book discounts of 56% and 70% to the S&P and NASDAQ. As for China’s Evergrande issue, the prospects of Lehman-level contagion seem low. While Lehman was built on esoteric financial derivatives, which spiraled toward zero value, Evergrande’s primary asset is land, whose valuation is far more tangible and transparent. (The company is apparently close to announcing large asset sales to fund debt service.) Property development in China may cool down as wary lenders push up funding costs, but overall ongoing GDP expansion still looks to be in the mid-upper single digits.
The bond price drop, with the 10-year Treasury rate breaching 150 basis points for the first time since June, prompts a slight add to duration and core exposure. Our conservative, flexible-mandate, low-duration posture has been effective so far in 2021, the bellwether bond book achieving a modestly positive return against significant index losses. Now, with rates having moved higher, we feel there is a more attractive opportunity in taxable bonds. We are adding both active and passive exposure. It is a moderately sized trade, however, and the bond mix continues to provide valuable portfolio defense.
Many thanks for your continued support and trust. Please feel free to reach out to us at any time with any questions or concerns.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.