Third Quarter 2021 Economic Outlook
The end of the third quarter 2021 marks a turning point in the economic cycle. It’s the point where, despite the pandemic still being a part of daily lives, investors should accept that the global economy may be exiting the recovery phase. On a positive note, there has been significant progress in the acceptance and distribution of the COVID vaccines in recent months. Global vaccination rates continue to improve in developed countries ex-U.S. and the emerging markets, regions that had previously lagged. Despite this progress, economic activity in the third quarter failed to reach its potential as the Delta variant slowed mobility and had a negative impact on the global economy.
After large gains in economic data in the beginning of 2021 we have begun to see a normalization. The domestic economy is past the real GDP prints in the 30 percent range and earnings growth of nearly 100 percent. In fact, global economic data generally fell short of expectations in the third quarter of 2021. Purchasing Manager Indices have trended below 60 (>50 still indicates growth) with labor and supply chain constraints as the major impediments. In the U.S., expectations of a double-digit real GDP print for the second quarter of 2021 were ultimately tempered by a reported 6.7 percent growth rate. Finally, employment reports in the third quarter of 2021 have been volatile (1mm+ in July but 200k in August) but remain on track to average the same job growth as the prior quarter. Nonetheless, we still believe the U.S. consumer has the potential to propel economic activity higher. In the coming months, an improving pandemic situation should spur renewed consumer optimism while a resilient jobs recovery should support income growth. Healthy household finances along with excess savings should help support consumer spending growth well into 2022.
The resurgence in corporate earnings in the first half of 2021 has tempered the lofty valuations caused by the P/E driven rally of 2020. Earnings for S&P 500 companies in the second quarter of 2021 topped expectations with an aggregate growth rate of approximately 92 percent and more than 86 percent of companies reporting growth. This earnings growth was led by the materials, industrials, financials, and consumer discretionary industries. Results were positive in all 11 underlying GICS sectors. Corporate earnings for the third quarter of 2021 are expected to remain positive but at levels closer to the historic averages. Supply chain bottlenecks, climbing energy prices and inflationary labor costs present the biggest headwinds to corporate profitability. In fact, 18 of the 26 companies in the S&P500 that reported results in September cited supply challenges in their earnings calls. Analysts expect earnings to grow 27 percent year-over-year in the third quarter of 2021 with net profit margins at 11.6 percent, below the 12.2 percent seen in the first half of 2021.
Domestically, equity valuations are elevated relative to other geographic regions, however, we remain comfortable with an overweight position to US stocks. Select corporate sectors have demonstrated a greater ability to pass through higher costs to the consumer. However, there is still the probability of Congress raising corporate taxes which represents a source of downside risk. Periods of market weakness are likely to get dampened by accelerated buyback programs and positive retail flows, given “excess” personal savings. Internationally, profitability could be impaired by stubbornly high energy prices in China and Europe. Chinese government officials have demanded state-owned energy companies ensure adequate supplies at all costs for the coming winter. In Europe, a similar shortage of natural gas supplies has caused electricity prices to rise astronomically, which could impact consumer sentiment.
Just as the global economy is ending the “peak recovery” phase so too are central banks preparing for the end of the “peak accommodation” phase of the COVID era. The Federal Reserve is likely to begin tapering its asset purchases in November and conclude the process by the middle of next year. There’s also a chance that an interest rate liftoff will occur before 2022 is over. In general, interest rate, equity and credit markets have all experienced positive returns during previous Federal Reserve tightening cycles. The Federal Reserve is not the only central bank paring back accommodation. The European Central Bank announced a “moderately lower” purchase pace in its Pandemic Emergency Purchase Program in September and there have been more than 30 emerging market central bank rate hikes in 2021. It is likely the emerging markets will keep tightening to control inflation; however, developed central banks continue to see inflation pressures as transitory and are being less aggressive in reducing accommodation.
China’s “Common Prosperity” campaign has unleashed an unprecedented regulatory regime on many of the industries that have been key drivers’ of economic growth. As China became an economic powerhouse, inequality increased, especially between urban and rural areas, a divide that threatens social stability. The push for common prosperity has encompassed policies ranging from curbing tax evasion, and limits on the hours that tech sector employees can work, to bans on for-profit tutoring in core school subjects and strict limits on the time minors can spend playing video games. The goal of common prosperity is to speed China's economic rebalancing towards consumption driven growth while reducing reliance on exports and investment. However, these policies could prove damaging to growth driven by the private sector. They could also have negative implications for foreign investment flows, as investors could shy away from ongoing policy risks on top of economic risks. Nonetheless, China remains a source of global growth and innovation and should not be discounted.
As economic growth shifts from the recovery phase to a more sustainable long-term growth period there are still many scars left to heal from the pandemic. The rebound in growth has given way to higher inflation. Supply chains slowed by the pandemic are struggling to recover, impairing industries that rely on component parts from around the world to complete everyday consumer goods. This has also called into question the efficacy of trade globalization and the true costs associated with achieving comparative advantage. The recovery in the labor markets also seems to be lagging as of late. True, there has been a precipitous drop in the unemployment rate, but that doesn’t tell the whole story. Corporations are struggling to hire as potential employees are constrained by vaccine mandates or the inability/unwillingness to return to work/life balance they knew prior to COVID-19. A shift in monetary policy, onshoring of overseas production and an increasingly automated labor force are likely solutions. However, these fractures will take time to heal as there is no single solution.