Investors entered 2021 with high hopes, as the Covid-19 pandemic was improving amid the rollout of vaccinations and altered habits among the general population. Some of those hopes have materialized. Consumers are awash with cash, corporate earnings have been strong, and travel, while choppy, appears to be rebounding. Supply chains have been strained, but demand is strong, signaling the willingness of U.S. consumers to spend cash and support the recovery. However, the Delta variant of Covid-19 threw the economy for a loop while Congress debated a massive spending bill that threatened a government shutdown and possible default. In addition, it appears that supply chains will remain challenged though the holidays and possibly for some time to come.
Summary of Q3 2021
The economic recovery was challenged as the Delta variant brought Covid-19 concerns back to the forefront. Previously imposed restrictions, such as e-learning in schools and mask mandates, threatened to resurface. The unemployment rate, while improving, remains stubbornly above the 4% target that the Federal Reserve (the “Fed”) sets as part of its dual mandate. The second part of the Fed’s dual mandate is inflation, for which the Fed sets a target rate of 2% annually. Inflation has been elevated, but the Fed has maintained that it will allow inflation to increase during the economic recovery. The Fed would prefer to have to raise interest rates to cool down a hot economy, partly to have the ability to decrease rates in the future.
Earlier in the year, “value” stocks outperformed “growth” stocks. However, in the third quarter, the Delta variant of Covid-19 plus strong earnings reports from technology companies led investors to rotate out of value stocks into growth stocks. Stocks corrected in the third quarter due to a few main factors, including the Fed’s planned tapering of asset purchases and worries of possible Chinese market contagion due to the Evergrande crisis and a regulatory crackdown in China. Stocks continue to trade at elevated valuation levels from a historical perspective.
Our commentary
The economic recovery is a result of a shutdown due to the pandemic, not a recession. This distinction is important not only from a historical perspective, but also because recessionary recoveries usually look different than the current recovery. Recoveries from a recession typically feature intact supply chains. Locking down the economy, however, threw complicated supply chains into a tailspin. Restarting them is not as easy as it sounds. The ongoing recovery will likely feature supply chain issues for some time, but consumer demand and cash levels remain healthy.
Unemployment remains stubbornly above target, and employers have more than just employment issues to contend with. As employment increases, money changes hands, lifting all boats. We would like to see unemployment closer to 4% soon. Rising inflation remains a concern, and the best way to battle rising inflation is by increasing interest rates. As interest rates increase, borrowing becomes more expensive, thereby reducing corporate earnings, in theory. Recall that the stock market is forward-looking; as interest rates rise, the market will adjust earnings expectations lower. We are still bullish on stocks, but we are closely monitoring inflation and the interest rate environment for changes.
GDP for 2021 is expected to be much higher than normal, and we expect stocks to continue to trade at elevated valuations as the recovery continues. As long as interest rates remain low relative to earnings, stocks should continue to benefit, although their relative attractiveness should moderate as we move further along in the economic recovery.
Until next quarter,
-Investment Committee
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