So much for the summer doldrums. The third quarter ended with a host of potential headwinds as well as some notable tailwinds. In the headwinds category, political gridlock around lifting the debt ceiling and infrastructure/social spending bills, massive supply chain issues, real estate woes in China, and repercussions from the Fed’s likely 4Q21 “taper” of bond purchases topped the list. At the same time, the Delta surge appears to be abating, the consumer is in excellent shape, job openings are at record highs, and near-term growth prospects remain solid. The outlook for inflation remains uncertain and will likely be a key driver for asset class returns in coming quarters.
Risk appetite was mixed during the quarter, with September results being the bleakest across asset classes; the notable exception was commodities (specifically natural gas). For the quarter, broad developed market equity and fixed income returns were flat, with U.S. dollar strength being a headwind for overseas investments. The dollar gained about 2% vs. a basket of developed market currencies. Emerging market equities sank, led by sharply lower returns from China and Brazil.
GDP for 2Q21 was revised up slightly to an annualized 6.7% (from 6.6%), but expectations for 3Q21 growth have moderated. Bloomberg’s monthly survey of economists showed that the median 3Q GDP forecast is 5.0%, down from July’s forecast of 7.1%. While still a strong number, it reflects how the Delta variant impacted consumer spending over the summer and the pace and consistency of the “re-opening” around the country. Cities and states differed with respect to re-openings, but across the nation many employees continued to work remotely. Worries over the Delta variant affected consumer sentiment; the Conference Board Consumer Confidence Index weakened for the third consecutive month in September and is down more than 15% over this period (though still much higher than its low in 2020). As further evidence of the moderation in growth, the Citigroup Economic Surprise Index has been below zero since July 2021 (a reading of zero indicates that data are meeting estimates).
On the COVID-19 front, we faced a grim reminder of the toll taken with deaths surpassing 700,000 in the U.S. alone. In the tailwind category, the vaccination rate continued to slowly climb, and confirmed cases and fatalities continued to ebb. A vaccine for children is in the works, and the recently announced antiviral pill from Merck adds to the list of reasons to be optimistic that the worst is behind us. Retail spending was up over 15% in August from one year prior; gas stations (+36%) and restaurants/bars (+32%) notched the biggest gains.
The Federal Open Market Committee (FOMC) left rates on hold at its September meeting, but Fed Chair Jerome Powell suggested that bond purchases would likely be cut back in 4Q with the goal of ending them by mid-2022. The FOMC has been transparent about its plans in this regard, so a repeat of the “taper tantrum” witnessed in 2013 seems unlikely. Nevertheless, fiscal and monetary stimulus will be reduced in coming quarters, and the economic ramifications of less support remain to be seen. The Fed’s new “dot plot” revealed that half of the 18 FOMC members now expect at least one rate hike in 2022. This is a significant change from the December 2020 meeting, when only one saw a hike in 2022 and five slated 2023 for the first hike. Notably, Powell disassociated the taper of bond purchases from rate hikes, suggesting that they would be considered separately.
The FOMC also lowered real growth expectations from 7.0% to 5.9% for 2021 but raised its inflation forecast for the year to 4.2% from 3.4%. The Fed continues to expect price pressures to be transitory and for inflation to fall back to 2.2% next year. As of August, U.S. headline CPI was up 5.3% year-over-year (core +4.0%), with Energy up 25% over the period. The PPI soared 8.3%, the highest 12-month rate in more than 10 years. Supply chain bottlenecks have affected prices for shipping, materials, labor, parts, and equipment. Ports and rail yards are clogged and ships are anchored offshore, waiting to unload. Truck drivers are in short supply, as are the chassis needed to offload containers. A prolonged shortage of semiconductor chips persists due to increased demand for electronics from automakers and is further exacerbated by a host of issues facing suppliers as well as transportation glitches. This supply chain dysfunction could persist through 2022 and falls distinctly into the headwinds category.
The labor market also shows signs of dysfunction. A large disconnect exists between job openings—which are at record levels—and labor shortages reported by employers. According to the U.S. JOLTS report, there were a record 10.9 million job openings on the last day of July. At the same time, there are more than 8 million people actively looking for work. The National Federation of Independent Business recently reported that 50% of small businesses have job openings they cannot fill. “Help wanted” signs proliferate in many of our communities. As the shopping season approaches, the largest employers will seek to hire hundreds of thousands of workers. There are a number of factors that have contributed to the mismatch between job seekers and job providers, some of which may be resolved with higher wages. Market participants are closely watching wage growth for its important contribution to inflation; the August jobs report showed average hourly earnings rose 4.3% YOY.
Inflation and supply chain issues are also evident overseas. Natural gas prices have surged in Asia, Europe, and Latin America as demand for the “cleaner” fuel and for manufactured goods that rely on this input has increased while supply has been constrained. In the U.K., post-Brexit issues and a dearth of truckers have resulted in a shortage of even basic supplies. But the economic picture has improved; euro zone growth was 9.2% (annualized) in 2Q21, ending five quarters of contracting growth. The ECB announced that it would “recalibrate” (i.e., lower) its asset purchases and also raised its GDP forecast for 2021, expecting it to reach the pre-pandemic level by 4Q21. The outlook for inflation was also raised, with the headline number expected to be 3.1% in 4Q before falling to 1.7% in 2022.
China faces several headwinds and remains top of mind given its part in the global economy. Its massive real estate sector (30% of its economy) is under stress, with the fate of property giant Evergrande unknown at this juncture. Widespread power outages have resulted from coal production not keeping pace with demand, and the country’s regulatory crackdown has taken a toll on several companies, erasing roughly $3 trillion in market capitalization.
While the recovery remains intact for much of the world, tailwinds from consumer spending and unprecedented stimulus may be thwarted by any number of headwinds in coming quarters.
The 2020 recession was the shortest and steepest on record, and the 2021 recovery has been the sharpest on record. While we don’t know what the near-term impact of the prevailing headwinds/tailwinds will be, it is widely acknowledged that growth will be moderating from the lofty levels seen earlier this year. We expect to see volatility increase given the number of political and economic uncertainties that lie ahead and, while welcome, the robust returns experienced thus far in 2021 are not likely to be repeated in the near-term.