The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Fourth-Quarter Outlook:
- U.S. economy: Stimulus wearing off but growth remains solid. More workers needed.
- Global economy: Slowing from its fastest pace in decades even as parts of Asia and the emerging markets are set to reopen.
- Policy watch: Policy is shifting from “extremely accommodative” to merely “quite accommodative.”
- Fixed income: Income generation remains a challenge as rates rise gently from very low levels.
- Equities: Valuations have come down but remain high relative to history; earnings growth will be key to returns.
- Asset allocation: Balance the risk of hotter inflation with that of slower growth.
Quote of the week:
“The past is never dead. It’s not even past.” – William Faulkner
U.S. equities have earned their excellent 2021 returns
U.S. equity indexes have hit new all-time highs in the fourth quarter and, despite last week’s modest pullback, have delivered returns in 2021 well in excess of their long-term averages — and our expectations.
Why have stocks done so well? It boils down to fundamentals — in particular, strong earnings. Corporate profits have grown at several times the rate analysts estimated back in January. This has contributed to rising stock prices while also helping lower 2020’s sky-high valuations, as measured by price-to-earnings (P/E) ratios. While the average “P” has risen substantially this year, the average “E” has risen even more.
To illustrate, in the third quarter of 2021, S&P 500 companies generated earnings that were 42% higher than they were in the same quarter a year ago.4 That red-hot pace was slower compared to the second quarter of this year but remained, well, red-hot.
It’s not hard to see why earnings have soared on a year-over-year basis. Large parts of the economy were barely functioning throughout most of 2020 due to COVID-related restrictions. But the pace of the U.S. economic recovery in 2021 has surprised investors and analysts. Coming into the year, consensus expectations for S&P 500 profits growth was about 17%. As of last week, they stood at nearly 50%, and the fourth-quarter earnings season, which begins in January, could potentially lift that number higher.5 And earnings weren’t the only upside surprise in the third quarter. The average bottom line of S&P 500 companies beat expectations, too, outpacing forecasts by more than 9%.6 This explains the stellar performance of equity markets in October after a lackluster September.
The earnings comeback has been fueled by the most cyclical (that is, economically sensitive) companies. In the materials and industrials sectors, for example, overall earnings have soared by 91% and 75%, respectively, compared to the third quarter of 2020. In energy, another cyclical sector, third-quarter revenues grew by 74% year over year, thanks to greater demand and rising oil prices.7
Looking forward, the annual rate of growth for company profits will undoubtedly slow in 2022 as a result of tougher comparisons (2021 was a better year than 2020, to say the least), in addition to higher labor and production costs. Many firms have raised wages or are planning to do so, but not all can pass this added cost on to their customers. This lack of pricing power in the face of increased labor costs could eat into profit margins, which — for now — have remained quite steady. Amping up investment and innovation to boost productivity is another option for keeping profits aloft, but that requires deploying capital, a process some companies have avoided during the pandemic.
As earnings growth decelerates in 2022, so, too, may total returns for equities. But just because the pace of earnings growth has likely topped out for the 2021 cycle doesn’t mean that earnings themselves have peaked. In fact, given our expectations for strong economic growth enduring well into next year, we’re looking for another solid – though perhaps not spectacular – year for equity investors.
Inflation isn’t going away — at least not yet
“U.S. Inflation Remains Low, and That’s a Problem,” the New York Times reported in July 2017.
At face value, such a notion seems to make little sense, as most people would like a dollar today to be worth a dollar a year later. But moderate levels of inflation are a sign of a healthy economy, which is why the Federal Reserve targets inflation of 2% over the long term.
But recently, inflation has continued to run, as David Johansen once sang, “hot, hot, hot.” Last week, the government reported that the headline Consumer Price Index (CPI) jumped 0.9% in October, after rising 0.4% in September. Core CPI, which excludes food and energy costs, also increased more last month (+0.6%) than in the month before (+0.2%). On a year-over-year basis, both headline (+6.2%) and core CPI (+4.6%) reached multi-decade peaks in October.8
While consumers have certainly taken note of higher prices, let’s take a step back and take a look under the CPI hood. Most importantly, inflation is not spiraling out of control. The biggest burst occurred in the second quarter of 2021, after which prices eased notably in the third. That said, October’s readings represent a worrying acceleration. Inflation has become more broad-based — an indication it’s likely to take longer to fade away on its own — and has remained high in sectors of the economy where we’d expected it to abate, such as in goods categories like cars and household furnishings.
Supply chain disruptions persist and are a major source of last month’s elevated CPI. They’re not the primary culprits, though. That dubious honor belongs to the overwhelming and ongoing increase in demand made possible by the government’s massive fiscal aid programs. Shortages of goods and workers are also to blame.
Against that backdrop, here are some of the notable contributors to October’s CPI:
- Used cars, as new car production remains hampered by a supply-chain-driven lack of microchips.
- Energy, which remains a key driver of inflation despite making up just over 7% of households’ consumption baskets.9 Oil and gas companies have tended to underinvest in production capacity and may elect to increase output only gradually, especially with the price of oil sitting above $80/barrel (as measured by the West Texas Intermediate benchmark).
- Food prices, and not only because of steeper prices at restaurants. Producers have struggled with bottlenecks, shortages, unfavorable weather conditions and labor woes.
- Medical care, which was hit by its highest month-over-month increase since May 2020.10
- Rents, as many people found buying a home unaffordable amid a paucity of housing inventory caused by soaring building costs and of qualified construction workers.
In contrast, the only major categories that fell in price last month were airfares and alcoholic beverages.
We believe the new year will kick off with inflation still running at multi-decade highs, and it will take some months for the goods inflation burst to roll off the year-on-year calculation. Markets — to their credit —remain quite sanguine about the long-lasting effects of this year’s inflation on the economy. The S&P has advanced 24.7% for the year to date, while longer-dated U.S. Treasuries like the bellwether 10-year note ended the week at 1.58%, precisely where it closed on October 7.11 Credit spreads haven’t widened noticeably. What explains this complacency?
- The Fed has continued to sound very dovish throughout the 2021 inflation surge, even going so far as to say that it cannot do anything to ease supply chain constraints.
- Even if they were compelled to raise rates in mid-2022, Chair Jerome Powell and his colleagues would likely do so only gradually to avoid creating a recession prematurely.
- Demand is going to fade even without help from the Fed. That should take care of some of the price pressures and give supply a chance to catch up.
Still, markets are not invulnerable to the risk that higher inflation will prompt the Fed to hike rates sooner rather than later. The yield on the 2-year U.S. Treasury note, for example, which often rises in anticipation of tighter Fed policy, jumped 14 basis points last week, to close at 0.53%.12
Lastly, there’s a political angle to inflation. U.S. consumers gauge inflation chiefly through prices for gas and food, the two things they buy most often and whose price changes they can most clearly process over short periods.
The trouble is there’s simply not much that can be done about inflation in the political realm, at least not over the next several quarters. The bipartisan infrastructure bill may make some needed investments that boost productivity and ease inflationary pressures, but those projects will take time to make an impact.
The good news is that there’s a light at the end of the CPI tunnel. Eventually, there will once again be surpluses of cars, gas and other items that have risen in price over the past year. That’s just how markets work. Whether voters will be patient in the interim is another question. It’s worth noting, though, that thanks to the federal government’s pandemic-related relief for individuals, nearly all Americans are better off than they were a year ago, or even before the pandemic began.