What I Care About This Week | 2021 Oct 11

Photo by Quang Nguyen Vinh on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • Earnings season is upon us! The next four weeks or so, investors will be able to digest how companies are handling everything from the Covid resurgence, to the difficulty finding labor, to increased costs due to inflation, to supply shortages. Many analysts are predicting slower earnings growth, though that is not particularly noteworthy after last quarter’s blockbuster gain. All in, earnings are expected to grow a little over 27% for the quarter. This week, JP Morgan, Delta Airlines, and United Health Group, report earnings, along with several others.

  • Lawmakers reached a deal to extend government funding to December. This is a bit of can-kicking, but markets welcomed the news. I was a bit surprised how much the debt ceiling debate was weighing on investor minds—it happens all the time, the brinksmanship is nothing new, and lawmakers always figure it out at the last minute. Of course, the risk is not zero that they fail to figure it out in time, and a default on US Treasury debt would be catastrophic for financial markets. So, we will pick the issue up again in late November.

  • The jobs report for September was a big disappointment. Though the headline figure dropped to 4.8%, the drop was entirely due to people leaving the workforce rather than from jobs filled. There is a confusing dichotomy at the moment. The US has 2.75 job openings for every one unemployed person, yet these jobs are not being filled. Before the end of extended unemployment benefits the argument was that people were paid more if they did not work than if they did, but we have not seen a rush to fill job openings as these extended benefits expired (though the next jobs report will have the final say on that point). It is just another odd paradox of the current economic environment.

  • The recent market pullback has held in-line with my expectations. As I mentioned before, this does not appear to be a major risk-off event. Rather, this appears to be some sideways trading as investors reprice the Fed and await earnings. If I had to guess—emphasis on guess—I would say that current prices are near or at the top of the sideways trading range. I think we may see prices fall before they rise again. My expectation is that the real move higher begins in early November, but, clearly, I will be watching the data closely. Again, for long-term investors, this is not worth taking tax consequences to avoid.

The Details

The Biden Administration has tightened many of the tariffs on goods imported from China. Companies and investors who hoped for a change of policy after Trump’s trade war have been quite disappointed. The Office of the US Trade Representative has said it would consider granting tariff waivers for 549 product categories—only about 25% of the number of categories exempted by the Trump administration.

Investors have been dealing with the China trade war for some time. However, it is becoming clear (if it wasn’t already), that decoupling from China is now a bipartisan consensus. I have talked here before about some of the consequences. It might be time to review some of them.

First, and most critically, the Chinese Communist Party (CCP) is not eager to allow US companies to sell goods and services into their consumer market. China is the largest consumer market in the world, so companies unable to operate there face a significant growth ceiling. Apple and Google, to name just two, have made concessions to the CCP in order to be allowed to operate there, but not all companies are willing or able to do so.

Second, China’s manufacturing capacity has been the world’s inflation absorber for the past 30 years. Companies facing higher costs for raw materials and labor have been able to lower costs by sending their manufacturing to China. This has kept consumer prices considerably lower than they otherwise would have been for the past 30 years. A decoupling from China is likely to create upward pressure on prices (some of which we have already seen), though some companies will be able to shift to other places in developing Asia.

Third, China has been as dependent on US businesses as the US has been on Chinese manufacturing. As the two decouple, the risk of conflict escalates. Taiwan becomes a notable example. A few days ago, President Xi announced his desire to seek “peaceful reunification” with Taiwan. US foreign policy with respect to Taiwan has been largely built on ambiguity: neither power is certain what the US would do if China tried to invade the island. With less to lose in a military conflict, the possibility of a conflict, or a proxy conflict, increases.

The merits and demerits of decoupling from China can and will be debated. My purpose here is not to argue for one or the other. Rather, investors should prepare portfolios for the ongoing decoupling between China and the US, and that may turn the tables on winners and losers.

Chart of the Week

I heard a veteran bond manager speak at a CFA event last week. He was quite convincing that 10-year US Treasury yields could reach 3.75% in the near future. While bond investors have mostly insulated themselves from such a dramatic rate rise, equity investors appear to be pretty complacent about this possibility. Many equity sectors could be badly bruised if rates begin to run away. P/E ratios would be the first to contract (which has already begun), but tech and real estate stocks stand to get hurt the most. I would expect other stocks to help make up the difference: namely bank stocks and other financials. Higher rates means more profit for traditional financial businesses.

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