Early Tricks — Week of October 12, 2021

As of market close October 8, 2021. Returns in percent.

Early Tricks 

October is off to a better start than usual. Oh, wait, we said that about September, too. Not that we are to blame for a 5% correction. Last week’s market action was all about outside events. Monday’s 1.3% kick in the shins was led by tech. Facebook fell 4.9% thanks to the service outage and whistleblower testimony. Most big tech names were about 2% lower. The mid-week rebound was all about D.C. drama moving to December.

Certain

Six weeks into football season, you know what kind of team you are. There may be a surprise win or loss, but your personality is set. The same philosophy holds for this year’s markets. The Recovery Race was handily won by government stimulus and spending through the first half of the year. The third quarter’s economic scoring drives were reduced to field goals thanks to the delta variant. We have markets that are sensitive to outside events and wary of inflation.

We are certain that some third-quarter activity got pushed back into this quarter and early next year. New orders in government and private surveys continue to rise and are hitting records. Inventories remain low. Yes, we know that in GDP, accounting inventories are a subtraction. But the activity to create the inventory still factors a positive. When orders trend above inventories, growth should be the next positive. 

We have written about natural gas and coal shortages. Prices have spiked and should continue to stay elevated. OPEC+ will remain disciplined in sticking to its 260,000 barrels per day production increase. It appears determined to get its inventories back down to the 2010 – 2014 levels. Last year demand collapsed, sending inventories back toward all-time high levels. Demand has recovered close to 2019 levels in many countries, catching suppliers and producers on the wrong foot. 

If OPEC+ can successfully modulate inventories, then U.S. shale producers will have a tough time trying fill in the margins with additional productions. The 2019 12 million-plus barrels of U.S. production may be a memory. Without the “quick response” of additional U.S. shale barrels to pressure prices, we expect OPEC will be able to keep prices higher longer than consumers will like. Think of high oil and natural gas prices as a preview to a carbon tax. 

Labor costs rising is also a near certainty. Bank of America last week became the latest large employer to announce starting wages well above the $15 per hour sought by activists a few years ago. Higher wages are starting to flow into national-level data. Average hourly earnings are up 4.6% year-over-year but still trail CPI levels north of 5%. August job openings, released this morning, sit at 10.4 million, versus the 7.7 million unemployed. We estimate that of the 7.7, at least one million do not have the necessary skills, another one million do not want to move and another one million are just staying home. That means two job openings for every “available” unemployed person. Wages will continue to rise, crimping margins, and likely be passed on to customers. 

We believe interest rates will rise somewhat in the coming months. Continuing improvement in the economy and the prospect of the Fed lowering its purchases in the coming months lend less support to rates markets. We are not entirely sold on the idea that rates will rise to the moon or even 3% on the 10-year Treasury. Regardless, the Fed will not raise short-term rates any time soon.

Uncertain

We are less certain about the direction of several key variables. China real estate accounts for nearly 70% of the savings of many Chinese citizens. No 401(k) or Social Security – just selling off the apartment in the future. In the very near term the woes of Evergrande and Fantasia are a threat to China’s GDP. Power shortages and factory shutdowns have made GDP predictions for the world’s #2 economy uncertain. Longer term, the declining birth rate in China may pose a threat to real estate values. 

For the next couple of years at least, we will keep virus variants on our risk board. Prior upper respiratory virus outbreaks at times did reappear as mutations in subsequent years. 

The labor market remains a bit of a mystery. For many months, economists assumed the ending of stimulus support would show up in the September report as a jump in new jobs. Not so. Friday’s headline number of 194,000 net new jobs in September masked a three-month average private gain of 487,000. Not bad, but not near enough to make headway against 7.7 million unemployed. 

The headline number was the smallest increase of the year. Seasonal adjustments always factor into BLS figures, and this time the expectation was for 1.5 million teacher jobs. Instead, “government” only registered 1.3 million so after adjustments government hiring showed a net job loss. July and August numbers were revised higher, but the slower than expected trend is disappointing. 

Another key to growth is the labor force participation rate. Over the last year it has basically flat-lined near 61.5%. This is below the pre-pandemic level of 63.3% and well below the 67% level of the late 1990s. Perhaps some of the dip is due to restaurant workers not able to work and/or baby boomers retiring. Higher participation leads to higher levels of spending and tax receipts. Will the Fed look past the headline number to growth in private payrolls and average workweek? We think so and will announce a bond purchase tapering program at their November meeting. 

Powell Percentages 

A few weeks ago, Fed Chairman Powell looked to be a lock to be renominated as Federal Reserve Chairman by the Biden Administration. Last month, disclosure filings at the Fed revealed that two Fed Presidents were trading stocks during the pandemic. While within the Bank’s rules, the trades were taking place during the Fed’s pandemic emergency programs. At the very least the optics of possibly knowing what markets would be affected by the Fed's actions are poor. The resignations gave some measure of closure.

Before last Monday’s opening, the government’s ethics office released forms that Vice Chair Richard Clarida shifted at least $1 million out of a Pimco bond fund into the Pimco Stocks Plus fund and another stock index fund. The problem is timing: he made those trades the day before Powell issued an emergency statement on February 28, 2020, trying to reassure worried markets. In the days following, the Fed started several market bailout programs that boosted stock markets. No word yet on a resignation letter. 

Now there are two regional Fed bank president openings and one Fed Board of Governors opening. Clarida's and Randal Quarles' terms as Vice Chairs end soon. Quarles' term ends this month. Clarida’s term ends in September 2022. Both positions must be confirmed by the Senate in a separate vote from their seats on the Board of Governors. The Biden Administration now has at least three and perhaps four seats to alter the course of monetary policy. From our vantage point, this is a golden (pun intended) opportunity for the Administration to keep rates lower for longer and tilt policy toward “Modern Monetary Theory.” PredictIt markets peg the renomination of Powell at 70%, still high but not the shoo-in from a month ago. Powell’s term ends this coming February, and his lower percentage chance of renomination adds to market uncertainty. 

Earnings

On a happier note, earnings season gets underway this week. Although there are always a few firms reporting earnings throughout the quarter, the roughly six week “season” when most report starts in the middle of the month after calendar quarter end. On Wednesday the 13^th, the big banks get the party started. J.P. Morgan, BlackRock, and Schwab lead off. Wells, Citi, Morgan Stanley, and B of A follow on Thursday. Merger and corporate bond activity have been strong, plus the yield curve has steepened slightly so we look for good results. This quarter is all about company management’s views on supply chain problems and finding workers. 

Wrap-Up

Breadth and other internal market measures remain slightly bearish. Investor sentiment is still near the “dumps” level, which is bullish. Large and mid-cap stocks have rallied back to their 21-day moving averages. If the major selling of this downturn is over, then we would chalk up a mild 5% correction. In “normal” years one would expect five to seven 5% reversals. This would be a first since March. 

This week’s economic numbers will not add much to the slower growth theme of the third quarter. CPI and PPI inflation remain elevated, running above 5% year-over-year. Retail Sales will continue to be strong, but the headline number will be pulled down thanks to falling auto sales. No cars, no sales. 

The key to earnings and consumer confidence is the glide slope of the Recovery. The snapback above GDP trend growth peaked early in the year and the downtrend started mid-summer. Pro-cyclical investors bet on value, industrials and materials. Return to 1.5% “slow growthers” bet on tech, consumer durables and healthcare. Both were wrong: energy, real estate and financials have led the way the last six months. As always, we try not to forecast, but remain with the markets’ waves. They are keeping us fully invested and patient.
 

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Greg Kalb is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts from The University of Texas at Austin.

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