Stocks tried to recover from Monday’s decline, the sharpest since May, but failed in the end. Monday’s drop was precipitated by the potential collapse of Evergrande, one of the two largest Chinese real estate developers. While that collapse still remains a probability, most investors have reached the conclusion that the damage will be contained. Nonetheless, structural trading patterns and ongoing economic concerns are keeping investors on edge.
In college, I was an accounting major. Accountants look at two sides of a ledger. I will do the same for the market this morning.
I will begin with the positives. These are overwhelming and dominating. That doesn’t mean over a short period of time the negatives can’t combine and take over. The tailwinds I am about to list are key forces that should prevent any serious enduring collapse in asset values.
1. Earnings continue to grow at an accelerated pace. While the rate of year-over-year growth has peaked, it will likely remain robust through next year.
2. Interest rates remain low and show few signs of significant increase. The 10-year Treasury yield remains planted near 1.3% despite stock market turbulence. It isn’t rising on escalating inflation fears, and it isn’t falling with investors fleeing to a safe harbor.
3. The Fed continues to invest $120 billion per month into the market. Other central banks are doing likewise. It is hard for markets to decline on any sustained basis worldwide with over $300 billion of new money entering the marketplace each month. While the Fed will begin the process of setting a roadmap for tapering its pace of future purchases at its FOMC meeting today, the actual process isn’t likely to begin much before the end of the year. The Fed will still be an active buyer of bonds at least until the middle of 2022.
The list of negatives, or concerns, will be a bit longer. The fact that the list is longer doesn’t mean the negatives overwhelm the positives but heightened concern does mean near term volatility until many of the negatives in the list below are resolved.
1. Inflation. The Fed predicted that inflation would rise into and through the summer, but to this date, it has labeled that inflation transient. Due, in part, to the huge safety net draped over our economy by the Federal government over the last 18 months, the recovery from the shutdown imposed by the Covid-19 pandemic has been swift. The speed has created imbalances between supply and demand. Think back to the toilet paper shortages last year. The pandemic didn’t make us go to the bathroom more, but it did change where we went. We needed more rolls of toilet paper for our homes, and less in offices and other commercial settlings. It took suppliers a few months to adjust. Consumer fears of running out heightened demand at a time when supply was tight. But once toilet paper showed up on shelves again, everyone calmed down and life returned to normal. The same thing applied to housing. Suddenly, when doors reopened and real estate agents were allowed to show homes, demand surged but supply didn’t. Buyers freaked out. Some gave up. Others overbid. That too calmed down after a few months. There is still a shortage of homes for sale but it is less than in the spring. Higher prices have brought out more sellers. With all that said, in some instances, there is a case to be made for sustained higher demand, or sustained lower supply. Natural gas prices today are surging less because demand is rising and more because less is being produced. Producers seeing the move away from fossil fuels are doing less exploration. One of the key questions to be resolved over the next 12 months is how much of the current inflation is transient and how much is permanent? The bond market says most is transient. Surveys of consumers and business executives say more may be permanent.
2. Supply chain disruptions. Part of this is supply and demand related. Part is political. Economic barriers between the U.S. and China seem to be getting bigger, but the bigger issue is supply and demand. When the recession began, companies focused on hoarding and building cash. Inventories were down close to zero just as demand was preparing to surge. Car dealer lots were bare by early this year. The obvious answer was to increase production, but key components, notably semiconductors, were not available. Supply chain disruptions have gotten progressively larger and more pervasive. Dozens of huge cargo ships are moored off our West Coast waiting to unload. The pace of unloading has slowed as the Delta variant has spread. Workers who remain on the job are exhausted. What I just said for dock workers applies to health care workers, truck drivers, teachers, garbage men, bus drivers, etc. In the spring, some said car lots would be full by year end. They meant year-end 2021. Now we aren’t sure they will be filled by year end 2022.
3. Labor. This ties into the supply chain problem. The Fed has said repeatedly that it will remain accommodative until we get closer to full employment. Today’s unemployment rate is still well above the rate prior to the pandemic. There are still over 7 million fewer Americans employed than were employed prior to the pandemic. In contrast, companies like Wal-Mart# and Amazon# are offering huge incentives to get workers. McDonald’s# and Costco# are raising wages. CVS# is holding job fairs to fill over 20,000 vacant positions, particularly in its pharmacies. Last night, FedEx# released disappointing earnings despite a 16% growth in revenues. The problem was labor. Packages are being rerouted from depots lacking workers to others far away that have enough workers to sort packages. This is going to be a common theme as companies report third quarter earnings. Hopefully, the problem is short-term in nature. Expanded unemployment benefits have ended. So has summer vacation. Schools have largely reopened. Hopefully, the labor situation gets better before it gets worse.
4. China. China has been the world’s growth engine since the mid-1990s. Debt-to-GDP in China is over 3.3 times. Its birthrate is 1.3 per family. 2.1 is needed to sustain today’s population. Japan got rich, then it got old. China faces the real risk of getting old before it gets rich. President Xi is trying to lower wealth disparity and impose other socialist ideals at the same time its economy is stretched by too much debt. The Evergrande problem today can be contained, but it is a clear warning sign of problems associated with too much debt. Excess leverage takes down badly managed companies first, but ultimately it embroils more. What you see in China today resembles the sub-prime mortgage crisis in the U.S. more than a decade ago. The Chinese situation doesn’t have to end so badly. But leverage is probably near its limit. Combined with bad demographics, the obvious conclusion is that China is destined to grow at a significantly slower pace going forward. Worldwide demand, which was growing close to 3% pre-pandemic, will likely grow at a slower pace in the future.
5. The Fed. Short term, the Fed will begin to taper its pace of bond purchases. Whether it begins in December or January hardly makes a difference. The real questions are (1) will it complete the tapering process without meaningful disruption in the bond market, and (2) when might it need to increase interest rates in an attempt to rebalance supply and demand? No one knows the answer to either question but both answers should become clearer over the next 12 months.
6. Fiscal Policy. We now know the ask. $3.5 trillion in new spending, mostly to support large new entitlement programs plus over $2 trillion in new taxes. That doesn’t include $1.2 trillion for infrastructure, largely unpaid for. The spending that ultimately passes will likely be materially less. The taxes will get cut, but not by as much. Democrats are going to have to do this on their own and they have no wiggle room. One dissenting vote in the Senate kills any bill. Thus, progressives may not like the pushback from a handful of moderate Senators but they will have no choice but to compromise.
Look again at the negatives. The fiscal policy debate will be settled most likely before Christmas. The Fed tapering should begin within a month of year-end. The Evergrande debacle in China will stabilize within weeks. The longer term issues, lower growth and less leverage, will take time but the path isn’t that opaque. The top three issues, inflation, supply chain and labor shortages, are going to take longer to resolve. The components of inflation that are transient will evidence themselves within months. Supply chain may take quite a bit longer to resolve than one thought a few months ago, but as 2022 progresses, these pressures will ease.
Perhaps the biggest conundrum is labor. I think the Fed has to acknowledge, perhaps as soon as today’s post-FOMC press conference, that there are serious labor shortages across our economy that need to be resolved for the economy to grow near its potential. There are simply too many businesses, from FedEx to your local restaurant that can’t operate fully because it cannot get adequate numbers of workers. One side of this debate is clearly wrong and it becomes more apparent every day that it is the Fed that is incorrect. There are 1.3 job listings today for every unemployed American. Anyone who wants to work can get a decent paying job. Wages will rise faster than inflation and faster than they have for more than a decade. It is time for the Fed to take its foot off the accelerator. If it waits too long it risks the possibility that it might have to step on the brakes and raise interest rates before the end of next year.
The three positives remain strong and pervasive. The negatives are real and must be resolved. How that happens will dictate the course of stock prices over the next year. The Fed has to make the right choices and not let brief market corrections stifle its forward progress. If the Fed is right, markets will react positively. Growth is strong, consumers are in a good mood, but they won’t stay in a good mood if shortages persist, if businesses can’t fill job openings, and if inflation accelerates. What I will be looking at from the Fed today is at least some recognition that inflation, labor shortages and supply chain disruptions are impacted by Fed policy. All three to date have been more persistent than the Fed believed in the spring. The Fed has to begin to adapt policy to rectify these issues.
Today, Andrea Bocelli is 63.
James M. Meyer, CFA 610-260-2220