Heading into the closing months of 2021, we are hopeful for an upbeat finale. We may not have much company given the decline in investor sentiment amid the lack of market pullbacks and corrections. However, we continue to rely on the strength of the consumer to drive earnings and economic growth in the fourth quarter. Plus, there is the added benefit of it being the seasonally strongest quarter of the year.
No doubt, many of the risks that weighed on the minds of investors for much of this year will still be present: inflation, Fed policy and the trajectory of growth. The wall of worry is growing, too. Supply chain disruptions have brought the prospect of “transitory” inflation into question, and fiscal policy remains a wild card.
There are positive smoke signals, though. The 10-year yield has rebounded off lows, vaccination rates are increasing, demand for labor is solid, and oil prices are rebounding as demand for travel is expected to improve.
How does all this shake out in the fourth quarter? Let’s dive in.
Supply Chain: Key Risk
Supply chains have been bottlenecked since the start of the pandemic. The result has been a mismatched supply and demand situation, which was intensified and prolonged with the rise of the Delta variant.
Now, there are container shortages (used in shipping the goods), ports are backed up amid labor shortages, and shipping costs have been on the rise. A reduction in inventory has resulted. Ultimately, this could have an impact on demand and economic growth. After all, if there is nothing to buy, sales won’t be registered. This is concerning as we enter the important holiday shopping season.
All this puts pressure on prices, too. Inflation has been elevated this year, though the latest reading of CPI inflation showed growth easing slightly due to a slowdown in reopening activity. Additionally, import prices eased for the first time in 10 months in August, which is a positive indication that inflation could ease in the months ahead. It would be helpful if price increases level off in the coming months and prove to be “transitory” as the economy moves past the early stages of recovery.
Much of the pricing story will rely on the resolution of supply constraints. In the driver’s seat is the development of the virus. Encouragingly, cases have begun to recede more recently, and with more people getting vaccinated, there is hope that economic activity will return to more normal levels. We’ve also seen some early signs that the supply chain constraints could be easing as China’s exports rose faster than expected in August.
While supply side headwinds won’t be solved overnight, we are encouraged by recent data and are hopeful that the situation will improve as we progress through the fourth quarter. The consumer, companies and the market will benefit if the pressures on this situation continue to ease at a steady pace.
The Fed: Moderating Risk
Much of the market’s attention, and anxiety, has been on the Federal Reserve’s “will they or won’t they?” tapering timeline. The Fed ripped the band-aid off on September 22 by strongly hinting a taper announcement could come in November. Fed Chair Jay Powell confirmed the economy has almost hit its “substantial further progress” threshold, even though COVID has caused a deceleration in economic momentum. To us, that sounds like the Fed thinks the slowdown is temporary and could resolve itself as this COVID spike cools down.
At this point, there’s a good chance the market has moved past tapering worries. We saw a spike in 10-year yields earlier this year, and the market reacted well to Powell’s obvious hints in last week’s meeting. That’s the same roadmap we saw in 2013: angst before the announcement but relative calm after. In a vacuum, tapering won’t do much to move markets, either. Even though bond buying will slow, the Fed’s balance sheet will be about double what it was pre-pandemic.
However, the market has a new worry to grapple with: rate hikes. Powell has done his best to assure investors that the Fed will be patient on hikes and will likely wait until after the taper is finished. And so far, only half of the Fed’s voting members think rate hikes should start sometime in 2022. Don’t take too much stock in what the Fed’s “dot plot” says. The economic situation is evolving quickly, and it’s tough to know what the world will look like once mid-2022 rolls around.
For now, don’t fear the Fed. Officials are acting diligently to make sure their next moves are communicated well, and there’s little risk of them losing control of the markets. Historically, the Fed has run into trouble when they’ve been caught flat-footed in higher-rate environments. Today, that doesn’t seem to be the case.
Consumer Health: Still Strong
One theme that has been consistent throughout 2021 has been the strength of the consumer. Financially, the consumer is better off than they were entering the pandemic, and despite concern over the rise of the Delta variant, they remained resilient. Retail sales rebounded in August with back-to-school shopping season proving that the consumer will spend when there is an event or need, despite virus fears. This could be a good sign for holiday shopping.
The setup for the consumer is solid entering the fourth quarter. Deposits at banks are still at record highs, reaching $17.2 trillion in the second quarter. That has helped keep the US savings rate elevated at 9.6%. Home prices continue to notch new highs, which bodes well for the consumer. And because the labor market is so tight, wages are on the rise.
However, we must acknowledge consumer sentiment has fallen sharply from July to August. Consumers’ largest worries are about COVID, but they are also raising concerns about higher prices. When the consumer isn’t feeling confident, they don’t spend. Spending is a key to economic growth, and sentiment can be an indicator of change in an economic environment.
Ultimately, we still expect consumer demand to remain strong through the end of the year, given the health of the consumer. Higher demand means higher spending, so long as supply can keep up with consumption.
Earnings: The Culmination
Earnings have been one of the biggest trophies for this market.
S&P 500 profits grew a whopping 88% year over year in the second quarter – the best quarter in 11 years. That could be the peak in profit growth this cycle. Investors generally understand that growth will return to more normal rates the further you get into a cycle. The bigger question is whether estimates for future quarters will maintain the unusual trend of increasing as the year progresses.
Given the backdrop described above, executives are facing more questions about impacts of supply chain breakdowns, higher costs, labor shortages and potential tax policy changes. The topic of price increases is also growing in frequency as a way to offset these concerns. Growth still looks decent over the next few quarters (in the mid-20% range), but as earnings growth normalizes, investors prefer to see margins at least hold steady.
Higher expenses are likely to start weighing on margins – or how much the company is generating in earnings before interest and taxes per dollar of sales (also called EBIT margins). According to S&P Capital IQ data, EBIT margins for the S&P 500 are expected to reach 16.2% in the fourth quarter, the highest rate since at least 2005. Pre-pandemic margins averaged 14.3%.
Some companies have already reported the pressure higher costs are putting on margins. FedEx said higher wages and increased transportation expenses weighed on margins, which declined to 6.8% from 8.5% in the year ago quarter. General Mills called out cost inflation and higher supply chain costs as part of the reason EBIT margins declined. Other companies like Lennar and Darden Restaurants reported expanding margins on industry tailwinds and structural changes, respectively.
Executive’s comments on growth plans and cost management will be key in third-quarter earnings. It won’t be a one-size-fits-all discussion, and investors are likely to continue to reward high quality companies that prioritize top line growth, cost mitigation and solid cash management.
The Bottom Line
While we’re heading into the seasonally strong fourth quarter, there are a host of issues that need to be resolved before Santa Claus can take the reins in December. The key to the fourth quarter will be deciphering between signal and noise as headlines cross the tape. The market has done well hurdling most negative news this year, thanks to a strong consumer and above-average growth.
As investors look to 2022, a focus on which sectors can thrive in a high-demand, high-cost environment will be key. The potential for reopening prospects and the resulting growth should benefit some of the cyclical- and value-oriented sectors that have underperformed in the past several months. We expect stocks to keep logging healthy returns in the upcoming year, even if there are a few bumps along the way.
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Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.
Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.
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