For the three months ended September 30, 2021, equity account performance was flattish and in line with benchmark returns. Concentration in the financial sector offset weakness in consumer discretionary stocks. Year to date returns remain in the mid-teens. Balanced accounts were also roughly flat for the quarter.
After sharp recovery from the depths of 2020’s lockdowns, economic growth remains strong but momentum (rate of change) has moderated. A mid-cycle slowdown would fit the classic pattern. Consumer demand has recovered so rapidly that it is difficult to identify remaining pockets of pent-up demand and consumers are facing sticker shock on many big ticket items. However, COVID-19 is still placing its unique footprint on this cycle, making historical analogy less useful. The emergence of the Delta variant earlier this year played a significant but unquantifiable role in slowing momentum. The recent peaking in new cases may soon provide a tailwind for sub-segments such as restaurants and travel. Ongoing supply shortages resulting from COVID induced factory closings also make this cycle a bit atypical.
An important idiosyncrasy of COVID’s impact may also be seen in the labor market. It is estimated that 7.7 million people are unemployed at the same time that 10.9 million job openings exist. Many (just ask a local restaurant manager) point to supplemental unemployment benefits as the cause of this discrepancy. However, difficulty in securing childcare may be a longer lasting obstacle to labor participation. According to the Bureau of Labor Statistics, total U.S. employment in August of 2021 was at 96.5% of February 2020’s levels while childcare jobs remain below 88% of pre-pandemic levels. A logical conclusion is that wages need to increase for the overall labor market to solve the current imbalance. In fact, the September jobs report (10/8/21) reported that Average Hourly Earnings increased at a 4.9% annualized rate while the unemployment rate has dropped from 5.9% to 4.8% over the last three months. This wage pressure begs the question of how long is the Fed’s version of “transitory inflation.”
Perhaps the Fed also considered this when it telegraphed near term tapering (reduction of bond purchases) in their September communication. Regardless, the 10- Year Treasury yield has increased roughly 0.3% since and now looks to be in an uptrend. We do not know how high is up, but inflation-adjusted interest rates remain negative and Fed bond buying is likely to be finished in 2022. The fixed income portion of balanced accounts prepared for this scenario earlier in the year by lowering maturities.
On the equity side, our overweighting in bank stocks is also positioned for higher interest rates. Higher yields are likely to expand net interest margins; a portion of the P&L that is currently depressed. In the meantime, banks are continuing to create significant capital and are committed to returning that capital to shareholders through dividends and buybacks.
We do not believe that the economic cycle is over. In fact, we view this as a self-sustaining expansion driven by the lagged effects of “easy money,” breathtaking consumer net worth and a tight labor market creating gains in income, and, in turn, end demand. However, the environment has become more difficult. Year over year earnings comparisons (particularly top-line) are no longer easy, supply bottlenecks can create short-term upsets, and wage pressure is a threat to margins. Consumers are also being pressured by rising costs including energy. In sum, the environment is a mixed bag. The upcoming earnings report season will be crucial, and you can be sure that we will be laser focused.