While the worst of the COVID-19 pandemic’s economic effects may look to be behind us, the best of the pumped-up growth resulting from lockdown recovery also appears likely to be in the rear-view mirror. At Bowen Asset Management, we expect the U.S. economy to return to more normal growth rates in the second half of 2022.
The impact of the Delta variant of the COVID-19 virus on supply chains and domestic spending slowed economic activity in the third quarter of 2021. Consumer confidence dipped noticeably, and businesses’ outlook dimmed somewhat. Rising inflation caused by goods and labor shortages has also been a concern.
Risks stem from the uncertainty around the political battles in Washington, the future path of the virus, and the possibility that supply constraints could linger, weighing heavily on production and consumption. Problems in global supply chains have gotten worse. The Delta variant hit China and southeast Asian nations hard, which prevented the replenishing of inventories. The auto sector has been a particular casualty, as production was limited by a shortage of circuitry.
GDP Balloon Springs a Slow Leak
Economists were expecting 2.8% growth, but the U.S. economy grew at a 2% rate in the third quarter of 2021—its slowest gain of the pandemic-recovery era—as supply-chain issues and a marked deceleration in consumer spending stunted the expansion. Dynamics that helped gross domestic product (GDP) grow at a historically fast rate in the first half of this year—government stimulus, widespread reopening of businesses, and rising vaccination rates—also faded.
Consumer spending, which makes up 69% of the $23.2 trillion U.S. economy, increased at just a 1.6% pace for the most recent period after rising 12% in the second quarter. Overall spending was restrained due to limited availability of some products, especially long-lasting goods such as vehicles. Spending on services increased 7.9%, a reduction from the 11.5% pace in the second quarter.
The downshift came amid a 0.7% decline in disposable personal income, which fell 25.7% in the second quarter amid the end of government stimulus payments. The personal saving rate declined to 8.9% from 10.5%. Declines in residential fixed investment and federal government spending helped hold back gains, as did a surge in the U.S. trade deficit, which widened to a near-record $73.3 billion in August. Also in the third quarter, private-sector inventories added 2.07 percentage points to GDP growth, an improvement from the preceding months. Still, businesses have a long way to go to rebuild inventories after massive drawdowns this year.
As COVID-19 cases continue to subside and consumers consider spending more on in-person services, more growth may come in the fourth quarter of 2021. Supply-chain challenges, however, will likely continue until next year, making it difficult to satisfy increased consumer demand.
During the current earnings season, companies have noted the issues with supply chains. However, because many customers are willing to pay higher prices, inflation is now running close to its 30-year high. Most economists and Federal Reserve policymakers expect inflation to cool next year.
Estimates for growth for the fourth quarter are 5.0% with annual year-over-year growth estimated at 5.5% for 2021. Looking further ahead, experts predict growth in the U.S. will slow to 3.5% in 2022 and 2.9% in 2023.
Inflation: A Shock to the System
This year’s surge in inflation is primarily driven by a major supply shock—the vaccine-driven restart of economic activity from the pandemic’s shutdowns. Producers have struggled to meet resurgent demand, clogged ports have increased shipping costs, and surging commodities have added to price pressures. These dynamics mark a sea change from the environment many of today’s investors know best: decades of low inflation on the back of deepening globalization and technological advances.
The last time a major supply shock drove up inflation was in the 1970s when an oil embargo by producer nations triggered a spike in oil prices. Today’s oil-price surge naturally raises the question of whether the economy is headed for 1970s-style stagflation, a period of high inflation coupled with weak growth.
We think not. In fact, the growth situation today is in many ways the 1970s turned on its head. Growth is increasing at a rapid clip rather than stagnating as the restart rolls on.
With a surge in demand outpacing supply, inflation has been running uncomfortably high. Headline inflation remains elevated at 5.3% in the third quarter, but signs indicate that some of the transitory effects are starting to wear off. As supply bottlenecks clear and base effects continue to fade, inflation will decelerate; however, recent surges in housing costs and global energy and food prices could alter the trajectory. Energy prices around the world are shooting upward. The high cost of power is impairing factories in Asia, which may add to the supply shortages.
Shortages and bottlenecks could weigh on production, delay spending, and keep inflation high for months. About 45% of economists surveyed by the Wall Street Journal in October estimated that it would take until the second half of 2022 for bottlenecks to have mostly receded.
Earnings Growth Expected
More S&P 500 companies than average are beating earnings-per-share (EPS) estimates for the third quarter, and these companies are also beating those EPS estimates by a wider margin than average. The index is now reporting the third highest (year-over-year) growth in earnings since the second quarter of 2010.
Analysts also expect earnings growth of more than 20% for the fourth quarter and more than 40% for the full year. These above-average growth rates are due to a combination of higher earnings for 2021 and an easier comparison to weaker earnings in 2020 due to the negative impact of COVID-19 on a number of industries. The estimated earnings growth rate for the S&P 500 for fourth quarter 2021 is 21.5%.
At the sector level, all 11 sectors are reporting year-over-year growth in revenues. On a percentage basis, nine of the 11 sectors are reporting double-digit revenue growth, led by the Energy (74.5%) and Materials (32.0%) sectors.
Net profit margins for the third quarter grew by 12.9%, which is above the year-ago net profit margin and above the five-year average net profit margin. The improvement has spread across major industries, with all but energy and consumer staples posting better margins. Demand and pricing are strong, and margins remain resilient. The estimated net profit margin for the S&P 500 for the fourth quarter is 11.8%
The Fed Starts Tapering
Following the Fed’s November meeting, the governors made their highly anticipated announcement on “tapering” asset purchases, the first step in pulling back on the unprecedented support they provided markets and the economy early in the pandemic. Later this month, the Fed will begin reducing its $120 billion-per-month asset-buying program by $15 billion a month. At this rate, the program should end by mid-2022. It is worth noting that tapering is not tightening. Asset purchases will be diminished, but the Fed’s balance sheet will still be increasing.
The Fed has said it would keep interest rates near zero until inflation is projected to moderately exceed its 2% target and hiring conditions are consistent with maximum employment. Fed Chairman Jerome Powell indicated that the central bank has probably met the first goal because inflation has been running above its target this year.
The Fed governors generally still view inflation as transitory, though it is proving more persistent than originally expected. As a result, officials will pay close attention to hiring gains as they determine when to raise interest rates. October’s unemployment report suggests that if the current pace of hiring continues, that second goal could be achieved around the time the Fed has finished ending its asset-purchase program, which is on track for June 2022. But companies across sectors are experiencing labor-market tightness characterized in large part by surging wages, as reflected in the latest Employment Cost Index readings from the Bureau of Labor Statistics. There appears to be a shifting labor force, where lower participation rates may reflect structural changes that could keep competition for workers and wage pressures high.
Markets: Muddy Outlook
The market appears ready for a reduction in pandemic-related asset purchases, and central banks are likely to maintain an accommodative policy approach provided the “transitory inflation” hypothesis is credible.
As investors head into the fourth quarter and the effects of the Delta variant linger, bond portfolios face a multitude of variables that may impact their trajectory over the coming months. These issues are set against a backdrop of the recent hawkish tilt from the Fed, with tapering beginning before year-end and a potential rate hike next year.
While rate hikes may be off in the future, we do expect long-term rates to rise as the Fed starts to normalize policies and pandemic-related factors such as supply-chain disruptions, consumer demand, and employee shortages continue fueling inflationary forces—a situation that may be heightened during the holiday shopping season. Yet rates will still be low relative to historic standards, and on a real basis.
For the market in general, the U.S. fiscal situation is as muddied by politics as ever. Treasury default risks were temporarily avoided, after Congress agreed to raise the debt ceiling by $480 billion. But the increase in the limit will only be enough to fund the government into December. Congress still needs to pass a budget for fiscal year 2022 to avoid a government shutdown after December 3 (though both Republican and Democratic leaders have indicated there will be a temporary extension kicking the can a few months down the road).
Conclusion
Given our view for an upward bias on rates, we believe taking on any extended-duration risks to obtain a diminutive yield may not be a valuable trade-off in this market—from either an income or total return perspective. In order to achieve higher portfolio yields, investors typically need to accept exposures with increased credit risks that often exhibit higher correlation to the equity market. Credit has benefited from some of the same forces that have propelled equity markets, including still accommodative policies and supportive growth.
Going forward, you may find places to allocate fixed income portfolios to navigate the low—and still uncertain—return environment as the Fed starts to taper and the economy continues to reopen. Check with your financial adviser for specifics.
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