Hello friends, welcome to the Twelve Points’ October Market Outlook. We hope this note finds you well, you’ve settled into fall and had a productive end to the quarter. Where does the time go? I for one am shocked to be sitting here contemplating what the end of the year has in store for us. But without further delay, let’s jump in. As regular readers remember, we predicted a summer lull, to the point that investors could skip off in May, check back in at the end of August, and find that not much had changed. We also foresaw that investors would want to be buckled in come September as the narrative was changing and we’re about to experience pockets of weakness due to a multitude of factors. Both forecasts came to fruition. But hindsight being 20-20, where does that leave us? Today we hope can provide you with some clarity.
The market has been on a tremendous run (minus the month of September). But, presently, we face a number of headwinds- rising taxes, rising inequality, goods inflation, service inflation, labor inflation, declining corporate profit margins, a slow moving congress with no bi-partisan support, exploding government and corporate deficits and on and on. Now, this does not necessarily mean we are bearish. By no means are we predicating a catastrophic or black swan event- although Evergrande, and China in particular, merit watching. The slowing of the Chinese economy, the engine of global growth of the last decade, should not be taken lightly.
One serious risk to all markets is inflation. Regular readers know that we were never in agreement with the transitory inflation camp. Inflation is just as much a psychological factor as it is physical. Once inflation becomes unanchored, it’s very hard to get it back under control. Even if it got out of hand, I’m not sure we have a central bank that would follow Paul Volcker’s strategy today, and that leaves us with limited options.
Let’s bring inflation into the equation so we can understand how it affects growth. Economists talk about “nominal” and “real” GDP, the latter of which is adjusted for inflation. Higher inflation pushes real GDP lower. An economy showing 4% nominal growth and 1% inflation would have 3% real growth, not bad. But if nominal growth stays exactly the same but inflation rises to 4%, real growth would be 0%. If nominal growth falls just a little, say from 4% to 3%, then a 4% inflation rate would push real growth down to -1%, recession territory. A little bit of inflation can amplify a mild setback into a serious one in real terms. We used a 4% inflation rate because that is exactly where we are when we look at PCE (Personal Consumption Expenditures) inflation, the Federal Reserve’s favorite measure.
These potential problems could develop into actual problems. The economy is way too close to stall speed to weather a combination of these storms. Unfortunately, growth isn’t just slowing here, but across the globe as well.
By now, most market participants should be aware of the labor shortages and rise in real wages. Per Goldman Sachs, wages are clearly on the minds of corporate officers and therefore investors. A recent note from Ben Snider finds that management talked about the risk to profits from wages rising at the fastest pace in over a decade. There are now 10.9 million job openings in the US, the highest level ever. We have more job openings than we do unemployed. Frankly, I have yet to hear a sound strategy on how we move forward from here and get folks back to work. From a goods standpoint, we drastically need the supply chain to recover. Our core market view is that the consensus forecast for S&P profits is too high because of the issues we just mentioned. Morgan Stanley even recently downgraded Amazon. And it’s not looking like a friendly environment for their social media peers and other high growth names. In fact, value is outperforming growth, and has been for most of this year. The questions investors should be asking themselves are: Do I own the right companies, industries, and asset classes? Can my portfolio survive a stubbornly high inflationary environment? There are no guarantees in this industry. But, if I had to pick one, it would be that what worked for the last decade won’t work for the next. Tread cautiously, this might be the best opportunity investors get to protect their portfolios.
One last note on the Fed- at their last meeting they maintained the status quo for the time being of 0% rates and $120 billion bond buying per month. However, they alluded to the upcoming taper (a moderation of asset purchases may soon be warranted). The announcement could come as early as their next meeting (November 3rd) with implementation as soon as December. The punch bowl is slowly leaving the party.
Stay diligent out there and please reach out with any questions.
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