Quarterly Commentary

3Q 2021

The headlines were as wild as ever this quarter. On the list: political chicken fights over the debt ceiling and infrastructure spending, rising prices and empty shelves while 50% of small businesses had job openings, a significant regulatory crackdown in China, and the Delta variant sweeping through the US – all impactful now and potentially far into the future.

Q3 review

By the middle of July, US and European markets were reflecting concerns about another wave of covid driven by the Delta variant. Stocks dependent on economic recovery and travel lagged for most of the quarter until it was clear that once again cases were declining. Rising prices and wages accompanied by supply chain issues continued largely unabated and featured prominently in companies’ quarterly reports.

Chinese stocks were a distant laggard during the quarter. Investors were faced with a regulatory crackdown and a potential real estate crisis. For now, the panic seems to have abated, but underlying issues remain. Some pundits were concerned enough to predict a Chinese “Lehman moment”, referring to the bankruptcy of Lehman Brothers during the great financial crisis in 2008. While we hope this is hyperbole, there is no doubt that big issues exist in the Chinese property market and the risk of global spillover is significant given the size of China’s economy and the important role it plays in the global supply chain.

By mid-September, most investors came to expect the Federal Reserve would start withdrawing some economic support this year. The Fed has been buying $120 billion of bonds each month, part of its effort to make loans cheap and readily available, hopefully stimulating consumer spending and business investment. Tightening monetary policy is a sign of the Fed’s confidence in the economy.

Interest rates responded to the tapering and inflation talk by edging higher over the course of the quarter. The yield on the ten-year Treasury bond had fallen from 1.4% to 1.15% by early August, and then rose to over 1.5% by quarter-end.

Looking ahead

While stock valuations are at the high end of their usual range, according to conventional metrics, they are also off recent highs. A look within the market tells a familiar story. There remains an historically deep valuation chasm between growth stocks and value stocks and the biggest companies still dominate the S&P 500.

We observe many stocks trading at low valuations relative to the market and their own history. Over periods measured in years, we believe a portfolio of stocks purchased at favorable valuations can deliver better returns than a portfolio that emphasizes today’s most popular stocks. Many investors are extrapolating what has worked and not worked recently – normal human behavior – and seemingly ignoring the possibility that the next decade might look quite different from the one that preceded the pandemic.

One possibility: a multi-year period of even moderate inflation accompanied by higher (although not high by historical standards) interest rates. Why do seemingly small increases in interest rates matter? It is not just the absolute level of interest rates, but also the change in rates compared to recent history, that is important. The entire economy has reset to expect extremely low rates. Any asset that “pays off” over an extended period of time might be vulnerable. Collectibles, cryptocurrencies, long-term bonds, and stocks that are valued based on a distant earnings stream are so exposed and should be owned carefully.

Housing prices have also greatly benefited from low interest (mortgage) rates. A house purchased for $500,000 in 2018 by someone who can afford to put 20% down and qualify for a 4.25% 30-year mortgage that costs $2,000 a month can now be sold for $600,000 to someone else who can “afford” to pay $2,000 a month in a 2.75% 30-year mortgage.

To be clear, there are many factors that determine house prices. The someone who could afford a $2,000 a month mortgage in 2018 might think a $2,200 monthly payment is affordable now (especially with the average US household balance sheet as healthy as it has ever been). The same sort of calculation applies to cars, RVs, appliances, home improvements and other purchases often made using credit. Hopefully, if interest rates increase and threaten this “virtuous” cycle, it is accompanied by economic prosperity that will soften the blow.

With many different causes of the current bout of inflation, it is possible we have years, not just months, of rising prices ahead. Supply chain issues will persist in 2022 and while they will eventually fade, permanent changes are possible such as higher transportation costs and some amount of “re-shoring” (we’ve lost count of how many US electric vehicle battery factories have been announced recently). Most commodity price spikes should be transitory, as higher prices elicit increased supply. However, there could be exceptions:

  • Will investors be willing to finance major oil & gas projects given the likely regulatory headwinds in the coming decades?
  • Can companies ramp up production of the minerals needed to make batteries fast enough to meet demand?
  • Are politicians willing to let the low-cost producer dominate the market for critically important commodities (i.e. China and rare earth metals)?

Perhaps most importantly, the balance of power in the US labor market appears to have shifted. Wages are increasing and workers appear to have the upper hand. All anecdotal and official measures we have seen indicate businesses are desperate for employees. Issues such as fear of disease and bank accounts padded with stimulus cash will fade over time. Others such as unavailable or unaffordable childcare and the opioid epidemic were pre-existing problems exacerbated by covid. Last, but certainly not least, according to the Pew Research Center, Baby Boomer retirements more than doubled from 2019 to 2020. While some of these pressures will abate and others can be tempered by productivity gains (including automation), we will not be surprised if strong wage growth persists in the coming years.

In Summary

It is natural to point to specific developments as responsible for market jitters and try to predict what may come next – as we have just attempted to do here. But as we observe time and again, market behavior is profoundly complex and unpredictable. Utilizing an active and thoughtful investing process that provides the conviction needed to ride out inevitable turbulence is our answer to the chaos.