The third quarter was a positive one for the markets, even though economic growth slowed due to the spread of the Delta variant, global supply constraints and labor shortages. The Delta wave of COVID appears to have peaked in early-mid September and cases are now falling. We hope this will be the last major COVID wave as the current percentage of Americans with some level of immunity is estimated to be in the 80% – 90% range and the Pfizer vaccine for use in children between the ages of 5 and 11 is expected to be approved in the fall. With kids back in school and the end of enhanced unemployment benefits, we expect labor and supply side shortages to ease in the fourth quarter, but it will take time.
The US economy grew significantly in the first half of the year with real GDP growing 6.3% in the first quarter and 6.6% in the second quarter. Economic growth slowed in the third quarter with estimates by the Federal Reserve Bank of Atlanta falling to 3.2%. GDP is particularly sensitive to auto sales, which plummeted in Q3 due to a relatively short supply of new vehicles caused by the ongoing computer chip shortage and the increase of the Delta variant disrupting supply chains. Consumer demand for automobiles remains robust but coupled with low supply, prices have been driven higher. This simple example of what is occurring in the auto industry is representative of what’s going on in the economy at large. Healthy demand with supply shortages has resulted in a headwind for growth and higher prices fueling inflation. We think some of these supply constraints will ease in the fourth quarter causing GDP to increase back to the 6%+ growth rate seen in the first half of the year.
Throughout the COVID-19 pandemic, we have been watching some of the high frequency data to better understand the fast-moving nature of the economy. The below table illustrates some of this data:
The improvement in this data waned in the third quarter as the Delta variant spread impacted the labor market and particularly hurt the travel and leisure industry.
Inflation has picked up, largely due to elevated demand and global supply chain issues. Headline CPI is likely to stay elevated through the fourth quarter near 5% level. We have been of the opinion that much of this inflation will be transitory. For example, the surge in the price of building materials earlier in the year has largely subsided. The travel component of the CPI number will also likely be transitory as it is measured against travel prices a year ago, which were significantly discounted because fewer people were traveling. Going back to the automobile example, once supply chains are repaired and production is ramped up, the supply of automobiles may exceed the demand, driving prices lower, which we could also see with goods and services. Some parts of the inflation picture may prove to be a little stickier than previously thought. Increased wage expectations and rents are likely to stay elevated through this economic cycle. In the last economic cycle following the financial crisis, we struggled to achieve 2% inflation. In this cycle 2.5% – 3%
inflation is possible, if not probable.
Equities have recovered nicely from the COVID driven crash, with the S&P 500 now nearly double its March 2020 low. They continued to do well in the third quarter before hitting some September weakness. Typically, in the early stages of a recovery, stocks go up on multiple expansion, as the market prices in better days ahead. We saw this occur last year and were left with an expensive market to start 2021. Since then, valuations have come down, even though the S&P 500 is up 16%+/- year-to-date. This is due to one of the fastest earnings recoveries in history. S&P 500 earnings are now 27% greater than their 2019 high and are up 63% this year alone. Analysts estimates call for another 10% – 25% earnings growth in 2022. The recovery is now mid-cycle, and mid-cycle equity returns are typically driven more by earnings growth and less by multiple expansion. The bond market continues to be challenging, making stocks the more attractive alternative. While this leads us to be bullish of stocks in the medium term, a correction of 10%+ is possible given the magnitude of the gains we’ve seen. This type of correction is typically healthy for the market as long as it’s not caused by a larger economic problem.
Interest rates remained low for most of the third quarter but began to increase in September. This increase drove down the price of long duration bonds and contributed to the sell-off in growth stocks we have recently seen. Socha Financial Group has made moves throughout the year to further decrease our interest rate exposure on the bond side of the portfolio in anticipation of an eventual rise in rates. The Federal Reserve (FED) announced at the September FOMC meeting that it will soon begin to taper its bond purchases. We think this means they will announce a taper program at the November meeting and begin tapering its purchases by $15 billion a month in December. It is important to note that tapering is not tightening, so monetary policy remains accommodative. The FED’s dot plot, and composition of its voting members, suggests that the first rate hike will be at the end of 2022 or beginning of 2023.
In conclusion, economic growth slowed in the third quarter driven by supply chain constrains, a shortage of labor and a second major wave of COVID. We think these headwinds will ease in the fourth quarter, growth will pick up and unemployment will fall. Volatility is currently elevated in the markets and pull backs are possible, but our medium-term outlook remains positive.
Take care and be well,
The Management Team
Michael, Michelle, Jolie and Nina
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