October 2021 | Equity Commentary
Published on November 10th, 2021
The U.S. equity market selloff was pronounced in September, with the S&P 500 recording a 5.1% decline from September 2 to October 4. The round trip back to all-time highs did not take long, however. In early October, the S&P 500 took just 12 trading days to reclaim the September 2 peak, and stocks have continued notching all-time highs since. The selloff in September may be attributed in part to seasonality, but also because of lingering concerns over supply chain issues, rising prices, and an economic slowdown in China. Those concerns remain in place today, but equity market and corporate earnings resilience in October may signal these issues are indeed temporary.
As expected, the Federal Reserve announced on November 3 its plans to gradually ‘taper’ its quantitative easing (QE) program. The equity and bond market response was largely muted, with the S&P 500 moving slightly higher and the 10-year U.S. Treasury bond yield rising 4 basis points on the day of the announcement, from 1.55% to 1.59%. Markets tend to pre-price widely known and expected events, and the Federal Reserve has been clearly telegraphing this move for months. In minutes from the Federal Reserves September meeting, it outlined the plan for “monthly reductions in the pace of asset purchases, by $10 billion in the case of Treasury securities and $5 billion in the case of agency mortgage-backed securities (MBS).” November’s announcement followed this outline exactly, with the taper set to conclude in June 2022.
We believe consumer and investor sentiment appear somewhat anchored to supply chain and inflation worries, but corporate earnings and other gauges of economic activity continue to point to sustained levels of demand, production, and growth. There is arguably a growing disconnect between expectations for sustained inflation and holiday shopping shortages and the reality of record economic activity and profits. This disconnect appears likely to open the door for positive growth and earnings surprises, which have historically worked in equity markets’ favor.
The Institute for Supply Management’s services index rose to 66.7 in October from 61.9 in September, signaling very strong economic activity – readings above 50 indicate expansion. All 18 services industries reported growth, with new orders and business activity posting their highest readings since 1997. We believe this is a clear sign that the economy is accelerating as the Delta wave recedes. To be fair, we believe some of this activity is being driven by companies fast-tracking orders in anticipation of supply chain-induced delays. But strong demand – and the drive to increase production capacity to meet it – is clearly a priority across this significant part of the U.S. economy.
Labor shortages continue to weigh on business efforts to meet demand, but there are signs of continued improvement to the U.S. jobs picture. The Labor Department reported 531,000 new jobs added in October. Jobless claims also dropped to 290,000 at the end of October, which marks a new low in the pandemic recovery. Continuing claims, which measures how many people are still unemployed and receiving benefits, also fell to a post-pandemic low. The end of expanded federal unemployment benefits may continue nudging unemployed workers back into the labor force, and higher wages could make job-seeking more attractive. Wages rose 4.2% year-over-year in Q3, the fastest pace in 30 years.1
Rising labor and input costs have thus far had little noticeable effect on corporate earnings. As of this writing, 82% of the S&P 500’s market cap has reported Q3 results, and earnings are besting expectations by 10.5%, on average. 79% of reporting companies have reported better-than-expected results, with Financials generally posting the biggest beats. Supply chain issues, rising input costs, labor shortages, and wage pressures all pose challenges, but it appears corporations continue to demonstrate the ability to navigate them.
On the government spending front, the Biden administration’s Build Back Better agenda continues to face barriers in Congress, with Senate moderates Joe Manchin and Kyrsten Sinema objecting to key provisions and the overall price tag. What was once a $3.5 trillion bill has been slashed by 50% to $1.75 trillion, and even then, the fate of the bill is largely unknown. Spending at this level over a 10-year timeframe is likely to only have modest implications for the overall U.S. economy in our view, and the reductions in the overall size of the plan have taken many of the major tax increases down with them – reducing risk of a significant tax-related headwind.
Our concerns regarding the Chinese economy did not abate in October. The major property developer, Evergrande, avoided default in October by making a missed bond payment within a 30-day grace period, but its bonds continue to trade at about 25 cents on the dollar. Other property developers are also experiencing distress, and pressure is mounting on Beijing to manage an orderly industry-wide restructuring in this important sector of the economy. Energy shortages are also posing a problem across China, but the country has responded by reopening coal mines and reportedly resuming some imports from Australia, which they had previously banned.
Adding to these challenges, Covid-19 cases in China have flared up over the past month, which typically means lockdowns, quarantines and/or restrictions on travel and public gatherings. In recent days, more than half of the flights at Beijing’s airports have been canceled. Collectively, these headwinds do not bode well for an economy that has seen slowing manufacturing activity since the spring. We continue to monitor developments in China closely for potential negative impacts elsewhere.