The St. Nicholas Viewpoint: 2021 Fourth Quarter Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist October 13, 2021
Third Quarter Performance Review
US equity markets finally took a breather in the third quarter. Fortunately for stock investors, it turned out to essentially be a flat quarter. US markets haven’t experienced a materially negative quarter since 2020’s Covid/lockdown-induced first quarter. Still, YTD returns remain in double digits, and the prospects for continued positive growth remain high. Although the disparity was low, the best quarterly returns in US markets were credited to the S&P 500, with total returns at just 0.60%. NASDAQ was very close, down 0.40%, followed by the DJIA, down 1.5%. YTD, those three indices fall close to the same order, with the S&P 500 up 16%, and NASDAQ and the DJIA both up about 12.1%. Internationally, Japan’s recovery from a bout of Covid resurgence pushed its Nikkei up 2.3% for the quarter. This was well above the other major international indices, with Developed International (MSCI-EAFE) down almost 5%, Emerging Markets (MSCI-EM) down 14.1%, and China’s Hang Seng down almost 15%. Developed International leads YTD returns at 8.4%, followed by Japan at 7.3%. Emerging Markets and the Hang Seng remain negative for the year, down 1.3% and 9.8%, respectively. Bonds continue to vacillate within a very tight range, with the Bloomberg Barclays Govt/Credit Bond Index essentially flat for the quarter and down almost 2% YTD.
At the Fed’s most recent meeting in September, they made deliberate efforts to flag their intent of tapering the bond-buying program starting sometime in the fourth quarter. As a refresher, the Fed has been buying bonds in the open market for a very long time, with the effect of introducing more liquidity and thus keeping interest rates subdued. The Fed really only has a few tools for monetary policy and quantitative easing (open market bond purchases) is utilized when either rate reductions aren’t enough or – as is the case today – rates are already at zero and there is simply no economic benefit to taking them into negative territory. The logical next step for the Fed before actually raising rates would be to stop injecting liquidity. Their intended program is a “taper” – a graduated reduction in the monthly purchases to diminish liquidity slowly and thus prevent an interest rate shock which could derail the economic recovery. They have not been any more specific about the timing, magnitude, or duration of the taper. All we can interpret for certain is that it will begin this quarter and last throughout most if not all of 2022.
Of course, the Fed has another effective tool in its monetary policy tool box – one that typically serves as its primary go-to weapon. The Fed also tries to control economic growth using interest rate changes. The Fed controls the underlying rates charged to banks, who in turn control the rates charged to businesses and individuals. Lower rates mean easy money – push rates lower when the economy needs stimulus. Higher rates discourage business activity and consumer spending, and are used to slow economic growth and control inflation. We all know rates have been at zero (or near zero) percent for many years. However, with economic growth roaring back post-Covid, the Fed will be looking to raise rates in order to maintain sustainable growth and avoid an overheating, inflationary economy. They have again flagged their intention to consider raising rates next year, but have been vague regarding when and how much. Our best guess is that quantitative easing will cease completely some time next year, and that the Fed will begin small rate increases closer to the end of the year.
Longer term, expect rate increases to continue throughout 2023 until the Fed realizes it’s intended economic equilibrium. If rate increases worry you, fear not. While borrowing rates will indeed be rising, the extent of those increases in the long run may keep us at fairly stimulative levels. Consider this: let’s say the Fed surprises us and makes two quarter point increases in 2022. That would change the Fed Funds rate from its current level of 0% to 0.5%. Now, suppose they continue to surprise and raise rates four more times in 2023. That would make six increases in a row, and result in a Fed Funds rate of 1.5%. On a percentage basis, 1.5% is materially higher than the current level, but realistically…it’s still only 1.5%. If we can get away with moderating the economy by increasing short rates to only 1.5% (obviously, consumer rates will be at higher levels), we’re still looking at a pretty reasonable scenario. The real issue the Fed has with rates at only 1.5% is that if/when there is a need to stimulate the economy with lower rates, there’s only a limited number of cuts before we’re back at zero. That’s pretty much where we’ve been the past several years, but we can cross that bridge again when we get there.
The Equity Markets
While it may sound like a broken record, it is worth repeating that the components and construction of stock valuation metrics during any part of the Covid collapse and recovery cast a cloud of confusion over the underlying analyses. Although we are starting to see a bit more consistency in the financials of some companies, we are still working with what essentially amounts to a year-long black hole of comparative data. Even if we had a company with clean data and future visibility, we still would have lost any measure of a reasonable base for historical comparisons. Companies that excelled during the shutdown – like Peloton, Zoom, Domino’s, or Clorox for example – show what amounts to be explosive growth for most of 2020. Now, many of those stocks’ exorbitant valuations have collapsed as a result of the pent-up recovery of the normal economy charging ahead. Similarly, companies whose earnings collapsed because they were completely shut down for months – like hotels/casinos, cinemas, cruise lines, and all facets of the airline industry – have had huge recoveries this year. So now the typical analyst conundrum is how to compare any mix of these types of volatility to some sort of pre-Covid baseline?
Unfortunately, there is no easy answer. And, the fact that we are still dealing with an open-ended continuation of Covid-related economic impacts makes it very difficult to gain reliable insight into the future prospects of most publicly-traded companies. New labor cost inputs have to be estimated without knowing not only where average wage increases will land, but also not even knowing whether a company will even be able to maintain the size of workforce necessary. Supply cost estimates are being impacted by rising energy and shipping costs, and supply line issues create the inability to gauge whether needed materials can even be found. Product shortages are becoming a very large problem, and it’s a pretty good guess that most of us will witness those impacts first hand this coming holiday season. Many companies still work primarily from home, so who knows how the cost of returning to offices/headquarters will impact earnings?
All this said, we still believe our portfolios are in a fortunate position relative to most other companies. Our stock selection strategy left us with names that, for the most part, did not experience huge fluctuations in business activities in the past two years. Coincidentally, many of those companies also have much more visible earnings, mainly because they do not rely so heavily on the ups and downs of economic cycles. Yes, there is business cycle volatility with almost all companies, but we’ve ended up with a book of stocks that have found smoother paths through economic tumult. This is not to say that some won’t have higher energy and transportation costs or experience supply shortages of raw materials – they will. However, in the end, we’ve maintained a portfolio of holdings that have better visibility going forward…even if our own valuation metrics continue to be blurred due to the Covid data anomaly we’ve often mentioned.
Regardless, the truth will be found in earnings – as it should always be in the long run. Third quarter earnings reports will begin to flood the markets next week, and we’ll be looking for re-affirmation that consistency and reliability offer lasting rewards in spite of short-term cyclical spikes. We expect negative earnings surprises to increase in the coming quarters as some of these cyclical rebounds peak and begin their descent to normalcy. We also expect positive surprises to continue for many of the healthier growth names, but have no reason to expect that those positives won’t sometimes be couched with “cautious outlooks” for the coming future quarters. We’ve seen this already with some bigger tech names this year like Apple, Amazon, and Microsoft – and, although the short-term stock reaction is often unpleasant, the long-term effect is positive given that forecast warnings generally lower the expectations bar for future quarters. Mostly, we want to see consistency in forward progress. Quarter-to-quarter hits and misses aren’t nearly as important as having the long-term earnings trends remain on track. This is the expectation for the names we own and this is what we’ll be looking for over the next two-to-three quarters especially.
We had already cautioned our fixed income investors that we would be holding higher than average cash reserves based on our outlook for rising interest rates and thus deteriorating bond prices. We understand that it is very difficult to see your cash sitting in Schwab Bank Deposits, effectively earning almost nothing. Our rationale has been that it simply isn’t worth extending maturities several years just to get only tenths of a point more in yield. We’d rather hold what we have – earning nothing on the cash – than lock-in 30 to 50 basis-point yields for three years, only to see our bond prices drop this year and next as the Fed continues to hint at constrictive monetary responses that result in higher rates. We’re only three fourths of the way through 2021, but bond investors should ask themselves this question: Would I rather have my bond portfolio produce a tiny income stream but decline in value 2% so far, or would I rather have cash earning nothing but not falling in price? We think the 2% drop is only a start and strongly recommend patience with bonds as yields begin to inch their way higher through 2022 and beyond.
However, as discussed in the Fed section of this newsletter, don’t set your sites too high. Even with the combination of a halt in quantitative easing followed by multiple rate increases, the yields we’ll eventually see won’t exactly be at table-pounding levels. Yes, they will be substantially higher than zero, but we’ll still only be looking at yield levels in the 2%-3% range. While that may suffice for some that rely solely on bond investments for cash flows, it won’t work for many. Some of those folks will simply cut back and adjust their spending, while others will look for riskier strategies. Bonds are still an integral part of many portfolios, but more so as volatility reducers rather than cash flow creators. We’ve done a very good job of individually tailoring client portfolios to match cash flow needs, but be sure to contact us if you think your cash flow situation needs to be re-evaluated.
There’s no denying we are living in difficult times. Society is changing, and with change comes conflict. I was only a child during the late sixties, but history presents some parallels – the environmental push; anti-war/anti-terrorism sentiment; massive civil rights unrest; distrust of the media; a delicate economy with looming inflation, and; anger and distrust of government and politicians. In hindsight, the economic circumstances of these challenges did not bode well for the decade of the seventies. We can only hope for a better resolution of our own trials, and that the rest of the 2020s turn out much better. There was no Covid in the 60s, and hopefully we’ve learned from several other past mistakes, but the eventual outcome of our country’s future remains to be seen. We are continually troubled by the political, social, civil, and economic unrest, but still hope and work for a better future and a happier dynamic than what currently exists.
P.S. We would like to remind clients that all of our written Policies and Procedures are available upon request at any time. We are also required to notify clients of the availability of our regulatory Investment Advisor Brochure/Form ADV and Form CRS on an annual basis, so please contact us at 904-470-0102 with any requests.