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M&R Capital Management 3Q2021 Market Update - John Maloney

The equity averages ended virtually unchanged in the third quarter, as stocks pulled back in September. The emergence of the Delta variant of Covid slowed the reopening of the economy, particularly those sectors that were previously impacted by prior waves, such as travel, hospitality, and restaurants. As the quarter progressed, we saw a marked decline in the estimates for growth from most economists, with both Covid and supply side bottlenecks restraining activity. The “Blue Chip” consensus of economic growth began the quarter anticipating a GDP increase of 7.25%. By the second week of September, that growth estimate had fallen to under 5%, and was clearly headed lower. Similarly, the Atlanta Fed’s “GDP Now” forecast, which is based on real time data, has fallen from an expectation of 6% growth in the quarter to barely 3%.

The surge in the highly contagious Delta variant bears a significant share of the blame for this slowdown, as new cases in the U.S. ballooned from about 16,000/day at the end of June to over 285,000/day by mid-September. However, in the past two weeks new cases have declined sharply, to about 120,000/day, with particularly large declines in hard-hit Florida and Texas. So, sectors like travel and tourism should rebound as the current wave recedes. Also, supply chain bottlenecks in areas like semiconductors should gradually dissipate, albeit at the cost of higher input prices for manufacturers of everything from automobiles to washing machines.

We view price inflation as potentially more troubling than Covid and supply bottlenecks. So far this year, the consumer price index has risen at a 6% annual rate, which is far above the Federal Reserve’s target of 2.4%. Producer prices, after registering virtually no gain in the prior five years, have vaulted at a 10% rate this year. The difference in the rate of price growth at the consumer versus the producer level suggest that profit margins may be squeezed as companies are reluctant or unable to raise prices so dramatically. Perhaps the biggest contributor to price inflation now is the tightness in the labor market. There are now 10.9 million job openings, versus 8.7 million unemployed and the labor market has clearly returned to its pre-recession tight condition. With state and Federal unemployment benefits just ending, employers in the restaurant and travel sectors hope to hire thousands of workers for businesses that have been severely constrained by labor shortages.

The Federal Reserve has reacted very slowly to these signs of inflation, and has just begun to “talk about talking about” raising interest rates, as one wag put it. The Fed remains steadfast in its view that supply bottlenecks and inflation are transitory and that some categories like food and energy are inherently unstable, and should be excluded from official inflation calculations. This strikes us as dubious logic at best and we recall that Fed Chairman Arthur Burns did the same thing in the 1970’s until out of control inflation brought a new Fed chair, and a change of policy. Inflation has always been a monetary phenomenon, and the broad measure of the money supply, or M2, is still rising at an 8.5% rate, which is at least a decline from the galloping 25% rate earlier in 2021. The Fed has telegraphed that it likely intends to gradually taper its monthly purchases of $120 billion in order to absorb some of the excess liquidity in the financial system. While this is a sign of a necessary if not overdue policy adjustment, the Fed may find its efforts confounded by the enormous excess reserves banks keep on deposit with the Fed, which currently total $1.4 Trillion and are nine times the level of required reserves. This might make the Fed’s efforts to control inflation more difficult, and will likely necessitate more drastic policy responses to bring inflation under control.

The current “lower for longer” state of interest rates has elevated asset prices generally but has been particularly good for growth and technology issues, whose values rely more on future earnings and cash flows, which are being discounted at historically low interest rates. In the third quarter, growth issues outperformed value stocks yet again as the ten-year Treasury yield drifted lower for most of the quarter but began to stabilize and climb again as Covid abated in mid-September. If this trend continues, as seems likely, we would expect value and financial issues to perform well.

Lastly, we believe we would be remiss not to mention a potential threat to global prosperity, which is the developing insolvency of Evergrande, the second largest Chinese real estate developer. In recent years, we have watched the development of a classic bubble in real estate investment in China, where such investment attracts a proportionately much higher share of savings than it does in the US (60% of savings versus 33%). Evergrande saw robust demand for its projects, and many middle-class Chinese channeled their savings to investment properties, which often sit empty. The Chinese government has implemented new rules to discourage real estate speculation, such as caps on real estate lending. The government is facilitating a “debt restructuring” of Evergrande, and is trying to push investment toward stocks in companies in growth industries, such as the internet and health care. It remains to be seen whether the woes of Evergrande and the real estate sector portend a “Lehman moment” for China, and pose a threat to the current Chinese growth model.

In sum, while inflation remains a real concern, the river of liquidity in the financial system will likely continue to elevate asset prices, which should be able to absorb the effect of moderately higher interest rates provided the Fed’s policy shifts are gradual. “TINA” (there is no alternative) to stocks will remain in effect until interest rate increases make fixed income investments more attractive. With the U.S government’s spending and future plans for the same in high gear, enabled by an accommodative Fed, we expect stocks prices to trend higher.


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