by Liz Ann Sonders, Jeffey Kleintop, Kathy Jones, and Kevin Gordon, David Kastner, Charles Schwab & Company Ltd.
Bottlenecks and rising inflation fears have narrowed the path forward.
Volatility from September carried over into October as investors found more to worry about, including labor and supply shortages and rising inflation. U.S. Treasury yields jumped as investors expect central banks to shift their focus away from economic stimulus and toward controlling inflation. Meanwhile, European leaders have been turning away from “austerity” policies, which may be positive for growth there. Finally, we take a look at inflation concerns and what investors can consider now.
U.S. stocks and economy: Bottlenecks
There were no shortage of risks conspiring to bring the market down a notch in September, including ongoing federal debt ceiling negotiations in Washington, fiscal policy uncertainty, monetary policy uncertainty (including over whether Federal Reserve Chair Jerome Powell will keep his position), global supply chain bottlenecks, slowing economic and earnings growth projections, and ongoing inflation fears.
The transition to the fall season also brought heightened volatility to economic data—as we saw in the recent unexpectedly weak September employment report. Only 194,000 jobs were added to U.S. nonfarm payrolls last month, well below the analyst consensus estimate of 500,000. However, the report had bright spots: The unemployment rate edged down to 4.8% from 5.2%, permanent job losses declined for the fifth consecutive month, and August payroll jobs data was revised upward.
The rub is that total U.S. payrolls are still five million jobs short of pre-pandemic levels. Additionally, the labor force participation rate ticked down to 61.6% and has moved sideways since last summer. With a large swath of individuals not yet returning to the labor force, employers have faced the mounting challenge of filling open positions. As you can see in the chart below, the number of job openings has not only recovered to pre-pandemic levels, but surged beyond its 2018 all-time high.
Job openings at fresh highs while payrolls lag
Source: Charles Schwab, Bureau of Labor Statistics, Bloomberg. Payrolls as of 9/30/2021. JOLTS (Job Openings and Labor Turnover Survey) job openings as of 8/31/2021.
Meanwhile, supply bottlenecks continue to weigh on companies’ future expectations, as both labor and materials have become scarcer and more expensive. The mismatch between labor availability and demand for workers has put upward pressure on wages—adding to the significant increases in shipping and sourcing costs brought on by jammed ports and a shortage of freight ships.
That in turn has stirred up concern over a potential hit to profit margins in the near term. As you can see in the chart below, upward earnings revisions have declined, reversing the climb since the pandemic began. This reflects analysts’ waning confidence that corporate earnings can continue to outperform expectations.
Earnings revisions turn lower
Source: Charles Schwab, Bloomberg, as of 10/8/2021. Revisions index measures the number of equity analyst revisions upgrades (positive) and downgrades (negative).
All in all, the path forward has gotten narrower. Consequently, we continue to believe that investors should maintain a focus on higher-quality segments of the market, which have outperformed this year. As you can see in the chart below, stocks with higher free-cash-flow yield and stronger earnings revisions (both higher-quality factors) have outperformed those with higher estimated long-term earnings growth (a lower-quality growth factor).
High-quality factors maintain the lead this year
Source: Charles Schwab, Cornerstone Macro, as of 10/13/2021. Factors based on sector-neutral S&P 500. Factors shown highlight stocks with higher free cash flow yield, stronger long term estimated earnings growth, and stronger upward revisions to earnings growth. Past performance is no guarantee of future results.
Fixed income: Yields on the rise
Persistently high inflation and the prospect of central bank rate hikes have sent bond yields higher across the globe in recent weeks. To date, the biggest increases have been seen in emerging markets, where U.S.-dollar-denominated bond yields have jumped by about 45 basis points1 since the end of August. However, bond yields in developed economies are also moving higher. We expect the trend to continue over the next few months as central banks shift from the extremely easy monetary policies put in place to address the pandemic to policies that are meant to address inflation.
Global yields are rising
Source: Bloomberg. Ten-year bond yields, U.S. (USGG10YR), Germany (GTDEM10Y), France (GTFRF10Y) U.K (GTGBP10Y). Data as of 9/29/2021. Past performance is no guarantee of future results.
In major developed countries, inflation often comes down to a policy choice by the central bank. If inflation looks likely to stay high, tighter monetary policy can be used to slow demand and dampen inflation pressures, even if it comes with the cost of higher unemployment and slower growth.
For the U.S. bond market, the question of how much inflation the Federal Reserve is willing to tolerate is a key factor in determining how high yields will go in this cycle. Long-term yields are based on a combination of expected short-term rates plus a premium to compensate investors for the risk of tying up their money.
The conundrum for the market, however, is that the Fed adopted a policy of “flexible average inflation targeting” in August 2020, near the depths of the COVID-19 crisis. After a two-year review of its policies, the Fed determined that its pre-emptive approach to curbing inflation had prevented the economy from reaching its full potential and kept the unemployment rate elevated. To correct that error, it signaled that going forward, it would allow inflation to overshoot its target for some “period of time” to make sure it didn’t curtail growth too much. The policy shift was announced in August 2020, and didn’t generate much market reaction at the time because inflation was running below 1% and the unemployment rate was above 8%. Now with inflation well above its target range, the market is grappling with whether the Fed is going to tighten policy enough to pull inflation back to its 2%-to-2.5% target range.
Inflation: Above target by any measure
Source: Bloomberg. Bloomberg. Consumer Price Index for All Urban Consumers: All Items (Overall CPI), Consumer Price Index for All Urban Consumers: All Items Less Food and Energy (Core CPI), 16% Trimmed-Mean Consumer Price Index % change at annual rate (FRBC Trimmed-Mean CPI), Sticky Price Consumer Price Index (FRBA Sticky Price CPI), Median Consumer Price Index % change at annual rate (FRBC Median CPI), Sticky Price Consumer Price Index, Less Food and Energy (FRBA Sticky Price CPI Core). Monthly data as of 8/31/2021. U.S. Personal Consumption Expenditure Core Price Index (Core PCE), U.S. Personal Consumption Expenditure Deflator (PCE Deflator), Monthly data as of 7/31/2021.
The short-term federal funds rate target is the Fed’s key policy rate. It is currently between zero and 0.25%, but the market is pricing in a higher long-run federal funds rate in the 2.0%-to-2.5% range, consistent with the Fed’s projections. If that is the case, it would imply that 10-year Treasury yields might rise to the 2.5%-to-3% region over the next few years, based on historical relationships.
Federal funds rate expectations: Fed vs. the market
Source: Bloomberg. The 12/15/2027 eurodollar futures rate was used for the longer-run market rate.
The Fed has announced it will likely begin tapering its bond purchases later this year, with an eye to ending the program in mid-2022. That shift in tone may reassure markets that the Fed will keep inflation under control, but tapering is not tightening. It is just less easing. Tightening policy won’t occur until the Fed actually begins to hike short-term interest rates.
Consequently, we see room for yields to move higher into mid-2022 as the economy has enough fuel to support growth and potential inflation pressure. However, we believe the Fed will not tolerate high inflation over the longer run. We suggest investors consider gradually increasing the average duration in their portfolios if yields continue to rise as we expect, but we don’t suggest waiting until the Fed actually begins tightening policy to extend duration. In the past three cycles when the Fed tightened policy, 10-year Treasury yields peaked as early as six to 12 months ahead of the initial rate hike.
Global stocks and economy: From austerity to abundance
While investors’ attention has been focused on the U.S. government budget debate, a dramatic fiscal change has been taking place in Europe that may be positive for growth.
In the last global economic cycle, gross domestic product (GDP) growth in the eurozone was slower than average, due in part to an era of “austerity.” Austerity was the word used at the time to describe tight budgets imposed to help ensure fiscal stability in the aftermath of the financial crisis of 2007-2008. In this global economic cycle, as Europe has emerged from COVID-19-related shutdowns, policymakers are taking the opposite path, loosening budgets for an era of abundance.
Why should this matter? Put simply, each incremental dollar spent by a government beyond what it collects should boost measures of economic output, like GDP, by at least that amount.
Looking back to 2011 through 2013, the early years of the last global economic cycle, we can see that the primary cyclically adjusted budget balance in Europe swung from a deficit to a surplus. This meant the government increasingly took in more money than it spent, leaving Europe a lonely outlier compared with the rest of the world, and resulting in a substantial drag on Europe’s growth. Surpluses were sustained through 2019. Fiscal policy is likely to be much more expansionary in this cycle than in the last one, especially in Europe. Current International Monetary Fund (IMF) forecasts for the years ahead stand in a sharp contrast to the previous cycle, with budget deficits expected in 2022 and beyond as government spending exceeds income.
Eurozone fiscal policy forecast to be more expansionary than
last cycle
Source: Charles Schwab, International Monetary Fund Fiscal Monitor April 2021.
The budget deficits may be even wider than the IMF forecasts, which do not include the sizable spending proposals yet to be signed into law, such as:
- increased spending by a center-left coalition government in Germany likely to emerge from last month’s elections;
- the newly elected Japanese prime minister’s platform proposals formulating a new fiscal stimulus package and pushing back the target timeframe for a return to a primary budget surplus;
- the U.S. budget reconciliation and infrastructure proposals working their way through Washington.
There are risks with running persistent deficits, like rising interest rates making the governments’ investment in the economy more costly to finance. A rise in the cost of borrowing could eventually curb spending. While rates have risen recently, the threat to budget deficits posed by interest rates remains reasonably low for the near term. Eurozone bond yields are still negative in Germany and well below 1% elsewhere, including Italy.
Global cost of debt is still low
Source: Charles Schwab, Bloomberg data as of 10/8/2021. Past performance is no guarantee of future results.
The spending picture could change dramatically if COVID-19 makes a meaningful resurgence, inflation turns out to be less transitory than currently believed, or the political climate toward government debt turns sour. For now, fiscal policies around the world are trending toward economic stimulus, supporting continued global economic expansion.
Inflation: Will the Fed’s response be right?
There’s a common thread running through this month’s Market Perspective: inflation. When the COVID-19 pandemic hit in 2020, the initial impact was deflationary—that is, demand for goods and services fell faster than supply. But as economies have reopened, the revival of demand has outpaced the recovery of supply, which has been inflationary. Supply chain bottlenecks have led to shortages of items like computer chips, which have affected automakers and other manufacturers. Prices for goods such as steel and lumber jumped in the spring, and oil prices recently surged. Tight labor markets have raised the prospect of rising wages. Although each situation has seemed short-lived, if the global economy persistently goes from one transitory source of inflation to the next, it may keep inflation elevated for longer than markets currently anticipate.
For some, this sparks memories of the high inflation of the 1970s, when the Federal Reserve acted too slowly to address rising prices. That led to toxic stew of lackluster economic growth and high inflation called “stagflation.” While it’s true that the Fed has prioritized employment support over inflation control in recent years, there are significant differences between now and then that make a return to 1970s-style inflation unlikely.
That said, the Fed is walking a narrow line. On one hand, it may be underestimating the potential for high inflation to persist: High prices resulting from supply chain issues are taking longer than expected to resolve, demand could remain firm as wages rise, and some of the longer-term factors that have helped keep inflation low—such as the expansion of the global workforce and trade—may be abating. On the other hand, there’s a risk the Fed may feel compelled to squash demand in order to narrow the time frame associated with supply catching up to demand—even though a faster end to accommodative policies or earlier rate hikes would not cure what ails global supply chains.
What can investors do in this environment? First, make sure your portfolio is appropriately diversified across various asset classes—including international stocks—and sectors. During periods of high inflation, sectors such as Energy, Real Estate, Health Care, Utilities, and Consumer Staples historically have benefited, while others, such as Consumer Discretionary and Financials, have struggled. However, the lopsided impact of the pandemic may alter usual patterns; for example, Information Technology historically has struggled when inflation was high and/or Fed tightening was beginning to slow economic growth, but technology has become so integral to daily life—especially during the pandemic—that the sector may react differently this time.
We expect bond yields to rise, with the 10-year Treasury yield likely to move up to 1.75% this year and above 2% in the first half of 2022. When yields do move higher, fixed income investors may want to add longer-term maturities to their portfolio to take advantage of higher yields. However, instead of trying to time the market cycle, we suggest using a strategy like a bond ladder to average into higher yields over time. Some investors also may want to consider short-term, fixed-rate corporate bonds as an alternative to waiting on the sidelines in cash.
1One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form, so 45 basis points is equivalent to 0.45%.
David Kastner, CFA®, Senior Investment Strategist, and Kevin Gordon, Senior Investment Research Specialist, contributed to this report.
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