How Patient Are Investors?

by | October 11, 2021

After a challenging September, global equity markets bounced back last week, aided by a Senate agreement to temporarily lift the US debt ceiling. Bond yields continued to grind higher, while the dollar and cryptocurrencies rallied. Energy prices extended their recent rally.

While investors will keep a close eye on the prospects for US infrastructure spending, the focus now shifts to the Q3 corporate profits reporting season. More so than usual, economists will join company analysts and equity investors in digging through the earnings numbers. That’s because the focal points will be on supply disruptions to output and shipments, as well as on how companies are addressing rising energy, materials, and labor costs. For once, stock pickers and top-down observers will share a keen interest on whether cost pressures will be absorbed in margins, passed along to consumers, or offset by rising productivity.

Normally, investors would relish the arrival of another solid reporting season. Superficially, that will be the case. According to FACTSET, the consensus of equity analysts forecasts more than a 27% gain in Q3 earnings for the S&P500. But given already high equity valuations and several quarters of 2021 robust earnings already in the books, the bar is quite high. Misses are likely to be punished and beats may enjoy less of a bounce than usual.

Moreover, low inflation and agreeable monetary policies can no longer be taken for granted. Price and wage inflation are both rising faster and for longer than most observers – including the Federal Open Market Committee (FOMC) – believed likely only a few months ago. In theory, higher prices and wages were supposed to induce an ‘elastic’ supply response. Production would rise and workers would flood back into the labor market drawn by the prospect of higher incomes.

That’s not yet happening. Instead, the headlines are replete with anecdotes of new and familiar shortages. China and Europe are suffering energy shortfalls in coal and natural gas, respectively. Ports remain clogged with ships waiting to offload cargo. The US labor force participation rate remains stagnant, despite strong nominal wage growth, declining Covid infections and the reopening of schools. Those factors were supposed to unleash more workers into the job market, but that is not how it is playing out, at least not for now. Last Friday the Labor Department’s job report showed September represented the lowest number of jobs added of any month this year. Moreover, more than 300,000 women over the age of 20 left the labor force last month. This is troubling in that this is the last report before the Fed’s November policy meeting, when it is expected to announce a tapering of its asset purchases that was predicated on a continued healing of the labor market. 

As noted, rising input costs must either be absorbed in margins, passed along to consumers in the form of higher prices, or offset by higher productivity. In the long run, firms can rejig production to maximize productivity (efficiency), but in the near term some margin compression and additional inflation are all but inevitable. 

Neither margin pressure nor persistent inflation is good news for investors. But, for now, the bigger risk for markets stems from inflation. That’s partly because, as noted previously, firms still enjoy strong earnings growth and rising revenues as economies bounce back from the pandemic recession. Some ‘cushion’ therefore exists to absorb higher costs and still deliver solid profits growth. 

Also, margin pressure is likely to be firm- or sector specific. Some sectors (e.g., energy, materials, or industrials) may be able to pass along price increases to customers. Margin compression, in other words, is more likely to lead to a greater dispersion of returns, rather than pose an overall risk for equity markets.

But inflation is another matter. Bond markets are already showing jitters that inflation could prove longer lasting, which in turn could lead to more uncertainty about the stance of monetary policies in major economies.

For instance, long-term inflation expectations have been climbing. US Treasury five-year, five-year forward measures are flirting with their highest levels since 2017. To be sure, current expectations (circa 2.35%) are not significantly above the Fed’s inflation target. However, further advances in long-term inflation expectations from here could expose already clear splits between hawks and doves at the FOMC. Growing monetary policy uncertainty could then weigh on investor sentiment.

So far, the Fed and other central banks have held their nerve, continuing to emphasize that inflation overshoots will be temporary and that monetary policy adjustments will be gradual. Yet monetary authorities can only remain credible if the data—on which such pronouncements are dependent—back up their ‘transitory’ mantra. If, on the other hand, goods, materials, energy, and labor supplies do not soon respond to higher prices and wages, investors may begin to doubt the ability of central banks to tolerate inflation overshooting. The Fed must walk an unsteady balance beam, resting on the contrasting ballasts of a labor market that isn’t performing as it should and inflation running higher than expected. Bond and stock markets are not priced for the risks implicit in this dynamic. 

Investor patience may be tested by the earning season. Across many industries and markets, supply is less responsive to increases in demand. As a result, prices and wages are rising at a faster clip. So far, investors have been willing to side with the judgment and patience of central bankers, but it is becoming clear that their wisdom has its limits. Everyone is now data dependent. Let’s hope the data in Q3 earnings reports doesn’t test the limits of investor patience.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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