October’s equity market performance was the trick-or-treat equivalent of receiving full-sized candy bars. It took just 13 trading days to recover the losses from September and return to all-time highs. Expectations were low due to inflation concerns, supply chain issues, and political gridlock, which gave corporate earnings season and fundamentals a chance to outperform. Now all eyes turn to the Federal Reserve next week and potential implications for bond and equity markets.
Happy Halloween! There should be nothing too scary in this week’s Insight as equity markets continue to rebound from their September lull to fresh all-time highs. It took just 13 trading days (October 4th to October 20th) for both the S&P 500 and MSCI All Country World indexes to recover from 5%+ drawdowns, which is tied for the fastest comeback out of the 11 recoveries in the post-Financial Crisis period. It barely qualified, but it was officially the first 5% pullback in more than one year – the previous low point was September 23, 2020.
The corporate earnings season has been a nice positive distraction from political wrangling and inflation concerns for market participants. Per Refinitiv, of the 279 companies in the S&P 500 that have reported earnings to date for third quarter 2021, 82.1% have reported earnings above analyst estimates, compared to a long-term average of 65.8% and prior four-quarter average of 84.7%. While the pace of better-than-expected reports and raised guidance has been slightly weaker than prior quarters, so far, there has been better broader market performance, especially relative to the last couple of reporting periods.
It all comes down to the expectations equation (performance = reality – expectations). In recent earnings seasons, analysts and investors have been much more optimistic heading into the reporting period, which set the bar high. However, this quarter all the discussion was around supply chain issues, inflation, and labor shortages impacting corporate results. Naysayers along with the first 5% pullback in a year just as we were heading into earnings season set the bar pretty low.
Fed on Deck
The Federal Reserve’s Federal Open Market Committee will wrap its next meeting on Wednesday, November 3rd. It is widely expected that Chair Jerome Powell will announce that they will start scaling back their $120 billion per month bond-buying program (quantitative easing or QE), which has helped hold down interest rates and provide liquidity since the beginning of the COVID pandemic.
Powell has emphasized that the QE tapering step will not necessarily be linked to the timing of interest rate hikes; however, traders will likely draw their own conclusions about when rate increases might begin based on the scale of the reductions. It is expected that the Fed will not be tapering QE and raising rates at the same time. Powell has talked about wrapping up tapering by mid-2022, but a faster pace could bring forward the window for rate hikes. If so, this action could imply greater concerns about inflation, which has the potential to inject volatility.
On Thursday, the Bureau of Economic Analysis reported that U.S. real gross domestic product (GDP) increased at an annual rate of 2.0% in the third quarter of 2021 according to their advanced estimate. The 2.0% growth rate was marginally below expectations due to several factors, but the biggest deceleration came from goods consumption, led by auto sales and auto parts sales. Other detractors included fixed investment (flipped from last quarter), net trading, and federal government spending. Positive contributors included strong inventory re-stocking, services spending (slower than last quarter but still growing), and strong state and local government spending.
To add some color to the weakness in the auto industry, it was the fourth-largest negative impact to GDP from motor vehicle consumption on record. Auto sales have fallen from an 18.8M annualized pace to below 13M in September. The drop in production due to shortages of semiconductors and other supply chain issues meant fewer cars were available to purchase. Total inventories are down 33% from their peak in the first quarter of 2020, which is the second-largest decline in inventories on record. In its earnings call, Volkswagen said it expects “chip supplies to ease as soon as Q4”. Hopefully, alleviating chip shortages allows factories to gear back up and meet the strong demand from consumers. Inventory re-stocking is likely to be a tailwind for GDP contribution over the next few quarters.
Anticipation of Fed tightening activities and economic growth deceleration led to flattening across the U.S. Treasury yield curve. Fixed income investors started to aggressively buy the long-end of the interest rate curve and sell the short-end. The difference between 2-year and 10-year Treasury yields narrowed by 0.13% just on Wednesday. Cornerstone Macro estimates this was among the biggest one-day moves in the yield curve since 2000. I should note that the 2- and 10-year are not close to inverting and sending up panic signals. The 20-year and 30-year Treasuries did invert this past week, but it is likely due to weak demand for 20-year bonds, which were new as of May 2020.
Just to reiterate, we are not concerned about the start of the Fed’s tapering cycle. It is not a black cat. Jerome Powell is not going to come to the press conference on Wednesday wearing a Leatherface mask with a chainsaw in hand. Historically, equity markets have performed reasonably well in periods of tapering and into the start of interest rate hiking. It is only policy decision surprises and over-tightening at the end of a rate-hiking cycle that creates volatility.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist