Stocks fell yesterday, although they finished well off their worst levels of the day. Despite a wave of bad news, there was little emotion to the selling. Bond rates fell as investors sought temporary shelter.
Sometimes bad news comes in waves.
1. Delta variant surges are affecting behavior. Schools reopening are facing escalating infections among unvaccinated children. Airlines and restaurants are seeing a setback in traffic, although both are operating well above pandemic levels.
2. Retail sales reported for July saw a 1.1% drop, more than triple expectations. Clearly, the Delta variant had some impact.
3. While there are signs that the situation at the Kabul airport is a bit more stable today, the situation remains uncertain as Americans and allies leave at a slow pace. While the situation in Afghanistan has only tiny economic implications, the images of a weak American exit clearly encourage others to press forward with anti-American activities. Right now, no one knows where President Biden’s red line might be when it comes to aggression from countries like China, Russia, and Iran.
4. Volatility in the bond market confuses equity investors looking for direction.
5. Fed minutes from the July meeting will be released today. Given their age, they are likely to offer little forward-looking guidance.
With that backdrop, it’s surprising stocks didn’t do worse!
We are just finishing earnings season, with the major retailers reporting this week. Results still look good. While managements look to the impact of the Delta variant to offer some caution about the future, life continues at a reasonably normal pace. With that said, third quarter GDP, which had been estimated by some just a couple of months ago to grow at a 6-8% pace, now looks likely to grow by less than 5%. That’s still marching forward at a healthy rate, just not as healthy as it might have been if Covid-19’s impact was truly fading away. Near term there are legitimate concerns. Broadway’s reopening is impacted, as are live indoor concerts. As noted, there is increased reticence to fly by some. Masks are reappearing, particularly indoors. Offices are delaying reopening, but for most of us life continues at a fairly normal pace. There is little quarantining like we saw in the spring of 2020. The Delta variant will pass, probably quicker than some now expect. The pattern of all Covid-19 surges has been a rapid ascent followed by an equally rapid decline. There are clear signs that geographies that got hit the hardest first, are already seeing steady declines. By the end of September, most areas should be past the peak for this surge.
If that is so, the long-term impact to corporate values will be modest. The Delta variant may scare investors for a few weeks, but is unlikely to impact long-term values, as that depends on the future course of earnings, inflation, and interest rates.
The bond market is starting not to fear inflation. I don’t know if the true message is masked by ongoing waves of central bank bond buying or not. Tapering might begin this Fall. We will know a lot more over the next several weeks as the Fed outlines its plan. Inflationary pressures are rising, at least when it comes to two important components, wages, and the cost to shelter (i.e., rents). Neither is rising at worrisome rates right now, but both are accelerating and bear watching. While U.S. rates should rise as the Fed slows its pace of bond purchases while Treasury needs borrowing to accelerate, the world still has over $9 trillion in sovereign debt trading at a negative yield. Those holders may be very happy to buy U.S. bonds yielding a fraction of 1%.
As for economic growth, clearly the pace of recovery will slow as the economy normalizes. While parts remain well below par, mostly in the travel and leisure sectors, other parts are currently operating at above normal paces as they try to catch up with post-pandemic demand. The imbalance between supply and demand remains in many areas. Car lots remain barren. Simply said, where demand is hot, supply is often scarce or non-existent, but some of the rebalancing has happened. The image of multiple home buyers having bidding wars well above the asking price has moderated. Prices remain well above year ago levels, but there is clear flattening to the curve. In industry, the biggest issue remains the shortage of key semiconductor components. That will take time to solve and could last well into next year.
Which brings me to foreign policy, and here I dance on eggshells to my own peril. I have no interest in discussing the gut-wrenching images coming out of Afghanistan. Suffice it to say, we could have executed a better exit strategy, but those images matter. They display weakness. They encourage those pressing for an advantage against the U.S. to press harder. That doesn’t mean tomorrow, but nations like China, Iran and Russia will clearly press. Logically, they will take two steps forward, meet some level of resistance, and take a small step back to alleviate any pressure. We have seen this in the Middle East with sporadic Iranian aggression. We have seen it from Russia in the Ukraine, but the real economic enemy is China, a nation that has made it clear that it wants to become the world economic leader under President Xi. China has pressed in Hong Kong, stepped back a bit, and pressed again. Right now, it is pressing against the largest and most successful Chinese businesses. President Xi is the de facto Chairman of the Board of every one of these companies. In time, he may want to pressure Taiwan, the world’s largest home to semiconductor manufacturing. He may want to pressure U.S. tech companies operating in China. The events of this past week can only encourage him to press harder. President Biden does not like confrontation. Few do, but he will be pressed by his adversaries. How he reacts may well define supply chain disruptions and necessary changes in the future. American companies are already moving supply chain components out of China. Some parts either can’t be moved or will take significant time. Relocating semiconductor production isn’t a trivial exercise, it takes years. At the same time, recognize that China is a major exporter. The world still operates in dollars. It can only push so hard without hurting itself. Thus, we are likely to see a two step forward, one step back approach. The only difference from the past is the size of the steps. The events in Afghanistan won’t help. They can’t be defined at the moment which means the stock market isn’t discounting them right now. They are more like Black Swan possibilities we must pay attention to. So, let’s pay attention and watch what China does in particular.
In the meantime, over the next few weeks attention will move from Afghanistan, earnings and the Delta variant to the size and timeline of the Fed tapering roadmap. Right now, the expectation is that the August Jackson Hole meeting will set the stage for a September announcement and probable start before year end. The process should wind up sometime about a year from now, or a bit later, leaving the door open for a rate increase before the end of 2022 if needed. It will be a very fluid road made conditional based on changes in the rate of economic growth and inflation. This is all new ground. We have never wound down a bond buying program of this size, much less during a strong economy. There has never been so much cash on the sidelines. How it plays out will dictate market behavior for months to come.
Today, Andy Samberg is 43. Edward Norton is 52. Robert Redford turns 85.
James M. Meyer, CFA 610-260-2220