by Franklin J. Parker, CFA
The Summary
- A little over half of the S&P 500 companies have reported earnings for Q3, and so far the news is quite good. Companies are beating their expectations by a pretty healthy margin, and analysts have been revising their Q4 estimates up, a bullish signal (historically, analysts revise estimates down in the first month of the new quarter). Energy has been the winning sector for revenue growth, although that should be little surprise given where energy prices were in 2020. Materials are a close second, with revenue growth of over 30%. Utilities and consumer staples have been the laggards, though they are still reporting growth. The winner/loser pattern is indicative of an inflationary environment—commodity producers tend to outperform while consumer producers (especially discretionary sectors) tend to lag as consumers moderate spending in the face of higher prices.
- It is jobs week! Friday we get the unemployment report. Increasingly, the actual headline figures are less important than the details of the report. Investors will be especially watching the number of people leaving the labor force (defined as no longer looking for work). Last month, this was a significant driver of the lower headline unemployment rate. Obviously, these figures influence not just the broader economy, but also the Federal Reserve response. Fewer workers means supply constraints may last longer than they otherwise would (because fewer people are making and moving stuff), it also means a smaller customer base for goods and services.
- Historically, when fighting inflation, the Federal Reserve raises interest rates. Famed investor Stanley Druckenmiller pointed out the obvious a few weeks ago. If interest rates come back to just their long-run average of 4.9%, the US Government would be spending some 30% of the annual budget on interest payments alone (I have not confirmed his calculations). The Fed, then, may well be constrained in their ability to raise interest rates as it could force spending austerity with congress. It is an interesting thought—how exactly will the Fed fight inflation without the use of their traditional tools? That is a question that has considerable impact on our investment decisions, and it is a question I am wrestling with on an ongoing basis.
The Details
Earlier this year, I published an inflation playbook—a look at where inflation bites hardest and where it creates opportunity. Interestingly, as inflation has developed through the year, we have begun to see some of this play out. This is an indication that investors are repricing their inflation expectations in anticipation of it being with us for a while.
What should investors do, then, in an inflationary environment?
In general, bonds take a beating when inflation expectations increase. Of course, the bond market is a big place. High-quality, long-term bonds are typically the hardest-hit in such an environment. Floating rate bonds and short-term bonds usually hold up much better. A tilt away from the former and toward the latter is warranted in this environment.
For stocks, we typically see energy, commodity-producers, and financials benefit the most from rising inflation expectations. From a bigger perspective, we see a preference for small and mid-size companies over large companies, though large companies hold up fairly well. The caveat to this is technology, which may have trouble coping with higher interest rates, and technology is the biggest percentage of most large-cap indices.
Commodities, of course, perform well. However, gold, despite the popular narrative, does not move in response to inflation nearly as much as other commodities, like industrial metals, foodstuffs, or energy. Commodities are volatile, and it is difficult to gain direct exposure (most funds are based on commodity futures). Even so, an overweight to commodities is not unreasonable in this environment.
Of course, your goals will dictate which risks you should take on in your portfolio—these are only generalizations. But, keeping up with the big-picture is important during a time when the economy and markets are undergoing some big shifts.
Chart of the Week
This week’s chart comes courtesy of the Wall Street Journal, showing the share of the US population that is retired. As the chart clearly shows, Covid accelerated the number of retirees, bumping the number above the five-year trend. This is both good news and bad news. Bad news because it means there are fewer experienced workers in the workforce to help alleviate supply constraints and wage costs. It is good news because one central challenge over the past decade has been the inability of younger workers to move up in their careers due to older workers maintaining their senior positions for much longer. With older workers retiring, younger workers are now able to backfill those positions, and a sense of upward mobility can be maintained.
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