It’s been eighteen months since the markets bottomed in the early stages of the pandemic, and the recovery has been nothing short of remarkable. Asset prices have reached new highs and economic growth has rebounded sharply. But uncertainty remains, and it appears the “easy gains” have likely already been made. Further progress will require clarity on a number of factors, including global supply constraints, inflation threats, new Covid variants, political divide in Washington, the direction of interest rates, and the potential for asset bubbles. Investors certainly have much to worry about.
It seems the global economy lately can be summarized as – shortages of everything. This includes labor, parts, housing, household goods, shipping capacity, microchips, and automobiles. The supply chain shutdown due to Covid was followed by a massive surge in demand as the economy reopened. This has led to the greatest supply/demand imbalance in memory. And although the Federal Reserve has characterized the inflation that has resulted as “transitory,” we can’t help but believe higher prices might be a bit more enduring.
The employment picture is improving, as workers are slowly coming back into the labor force. The unemployment rate has dropped to 5.2%, and should continue to improve as job openings remain at all-time highs. Confidence remains mixed. Consumers have moderated their spending with the Delta variant and a choppy reopening, while business confidence has rebounded. The manufacturing sector is seeing a strong recovery, with demand surging, but the outlook is clouded by labor and component shortages, delays, surcharges, and rising prices. Companies have been lowering expectations because of raw material challenges and inflation headwinds.
As always, a key driver for the economy and the outlook for asset prices will be the direction of interest rates. The end of September marked the 40-year anniversary of the beginning of the bull market in bonds. The yield on the 10-Year U.S. Treasury Note peaked at 15.84% in 1981. Today it stands at around 1.5%. The Fed has indicated that their bond-buying program would begin to taper in November. This quantitative easing taper should take several months, likely delaying the need for the Fed to raise interest rates for a while. But the duration of this supply/demand imbalance and the resulting inflation spike could potentially lead the Fed to reassess their rate policy timeframe.
The U.S. stock market has nearly doubled since the pandemic lows of March 2020. The economic recovery, improving earnings, massive liquidity, government stimulus, and a lack of suitable alternatives have been driving stock prices higher. But volatility has recently returned and the outlook has become slightly more tenuous. Gridlock in Congress surrounding the debt ceiling and the president’s infrastructure plans, along with uncertainty about future tax rates, have rattled the markets a bit.
We’ve tried to remain focused on the earnings picture, the appropriate multiple investors ought to be paying for those earnings, and the level and direction of liquidity in the system. Earnings growth continues to be quite healthy, but the pace of gains appears to be slowing. Valuations are mixed, stretched in some sectors and reasonable in others. But at 21x next year’s anticipated earnings, we wouldn’t say the overall market looks cheap. And on the liquidity front, the money supply is still growing at a healthy rate, but much slower than earlier this year. So while we remain optimistic in our intermediate-term viewpoint, as is often the case with so many conflicting variables, the market will have to climb the proverbial “Wall of Worry” in order to continue to make new highs.
The Partners of Autus