We’re already well on our way into the last quarter of the year, the final few months that close the book on 2021. Our second pandemic year in the markets continues to surprise everyone – with the exception of that sharp decline and resurgence in March 2020 – by not being especially surprising.
The third quarter of 2021 was not without interest. The positive gains developed in the first two months were nearly wiped out by the softness of the last. With nearly 7 months of continuous gains, that month may have felt unusual and maybe a little frightening – certainly market sentiment tells us that a number of investors didn’t have the stomach. However, the reality is that this was the first 5% correction in 11 months; the 13th longest stretch of its kind over the last century. On top of that, September has a history of being the softest month of the year, and often leads up to a strong fourth quarter.
The question is: Will that be the case this year?
We’ve long known better than to try and forecast what the future will bring. There are opinion pieces, talking heads, and all kinds of information out there which try to throw darts and attempt guesses. Half of them will be right half of the time, and the other half will be right the other half of the time. That really doesn’t help anyone make great investment decisions.
What does help is getting to know what’s happening in the world, paying attention to the winds and the waves, and making incremental movements to maintain momentum.
So, here’s a look at what we see going on right now…
Global Supply Chain Disruptions
I just bought a new fridge the other day. It’s got all kinds of fancy technology in it – a “brain” of its own that links to an app. Now, instead of opening it and staring into the depths, trying to determine if I really want a snack or not, I can leave the door closed – saving energy – and remain confused on my sofa.
Driving that technology, and embedded in nearly everything else around us, are semiconductors. The factories that produce these are not here, in the United States, where we’ve really started to get a handle on the pandemic and are edging towards full capacity. Those factories are around the world, in countries like India, Taiwan, Vietnam and others, where the novel coronavirus continues to wreak havoc, and lockdowns continue. Those lockdowns shut factories, or at best have them running at much less than capacity, and this has slowed production of the goods we readily consume.
While visiting Los Angeles a few weeks ago, I noticed container ships lining the coast, waiting to enter port. I marveled at all the ships anchored everywhere, full of those products that the rest of the world is producing, waiting to be unloaded. They continue to wait, slowly inching their way to the docks. Why? Because our ports are not at regular capacity either. There are more protocols, elongating the time it takes to unload. There is a labor shortage, meaning fewer hands are there at the dock to move containers from sea to land, and there are fewer trucks picking up those containers and taking them across the country.
This continued stress on our supply chain is of course, creating issues. Americans are ready to spend, and American companies are ready to grow, but getting the goods in the door continues to cause strain on the balance of supply and demand.
In spite of these issues and the “America First” approach of the previous administration, globalization continues to be positive for the U.S., and for the markets in general. It’s still less expensive to have our goods manufactured in other countries and shipped into our ports. It’s still a positive for our businesses, and for our wallets – especially once the pandemic stops interfering with production.
Infrastructure and Interest Rates
As a country, we were expecting some large government spending on infrastructure this year. That spending not only improves the roads, bridges, and buildings we rely on – making it easier for us to get to work and run businesses – but also contributes directly to economic growth. However, the current political environment has stalled that spending, as bills are held hostage, being debated, and waiting for approval.
At the same time, the Fed appears to be signaling that they will start to taper their bond purchase program. This tightening of quantitative easing takes a big purchaser out of the market – or at least reduces their purchasing – and unless other buyers come in, interest rates will rise.
We’ve already seen that as interest rates have started to go up. That said, rates still remain historically low. While ½ a percent might feel like a big change, the reality is that the difference between 1.0% and 1.5% is markedly low.
Tech stocks, which take up a lot of room in our financial markets, tend to have a negative correlation with interest rates, as rate increases make borrowing for operations that much more expensive. As interest rates rise, tech stock prices start to fall, and vice versa. Those stocks were the ones that were beat up the most in September, despite being the biggest winners year-to-date.
Current expectations are that this advance in interest rates, and the subsequent reaction in tech stocks, will not prevent global equity markets from having a year-end rally.
Headlines have been blaring about the rise of inflation for months and, for the most part, it’s a debate as to whether the inflation we’re currently experiencing is “transitory”.
First, there’s the fact that inflation is simply comparative. The increase in costs is related to the fact that prices for many things dropped last year. Spending went down. Energy consumption went down. And prices dropped accordingly. As we return to some kind of “normal”, and spending returns, prices are going up.
Second, since we have a global supply chain issue, the basic supply-and-demand situation is one that’s putting the buyers (those demanding goods) at a bargaining disadvantage. With low supply and high demand, prices increase.
The question is whether prices will normalize when full capacity returns.
When we look at expectations for the next 5 years of inflation, they’re hitting right around 2.5%. That’s a level at which the Fed feels comfortable. That 5 year expectation has actually remained in that same zone for the past six months, even while we’ve seen significant changes in supply and demand.
While our grocery bills are markedly higher right now, and everyone is feeling the pinch, there remain many reasons to believe that what we are facing may not be runaway in nature.
Reopening, and Spending, Spending, Spending
Speaking of spending – while in Southern California – and with a grandchild in tow, we decided to visit Disneyland. Despite the continued caution around covid-19, the place was full.
Concerts and live performances have returned, with tickets selling out. Restaurants are full (and posting help wanted signs). Vacations are starting to feel normal again. All this activity means a great deal of spending, which is of course creating profits for businesses around the U.S. The economy is experiencing so much more activity now than it was, even a short six months ago.
Even so, the rise in interest rates and inflation, a bit of a sell off in the market, tapering of bond buybacks, increasing energy prices, global supply chain issues, and the continued pandemic concerns definitely have created negative sentiment in the market. It is understandable for some investors to feel nervous in the short term, with all of these overhanging fears, and unknown factors.
It’s often in times like these that outsized gains are achievable. In the 2 to 4 quarters that follow extreme pessimism investors who move in opposition to overriding sentiment have a good shot at coming out on top. The investor who goes against the grain and doesn’t follow the crowds is the investor who is rewarded.
At Topturn, we’re always looking for opportunities in unexpected places. We rely on process, practice, and experience to drive our decisions. The next quarter should be interesting, and we’re looking forward to the ride.
By Greg Stewart, CIO