• US stocks hit an all-time high in October as earnings season for many of the world’s largest companies kicks off.
• Core PCE, the Federal Reserve’s preferred inflation measure, came in at 3.64%, its fastest pace in 30 years.
• The US Treasury yield curve flattened in October, signaling investor concern about slowing future economic growth or inflation prints that result in sooner-than-expected rate hikes.
• In early November, the Federal Open Market Committee (FOMC) announced it will begin tapering its massive bond buying program.
After falling in September, the S&P 500 Index rebounded in October to notch its best month of the year and finish at an all-time high. The S&P 500 gained 7.0% and the Russell 2000 Index returned 4.3%. The market was buoyed by strong third quarter earnings. According to BCA Research, nearly two-thirds of S&P 500 companies have now reported third quarter earnings and 83% of them have beaten Street earnings expectations. Not only that, nearly 77% of reporting companies have also beaten revenue expectations. Both numbers are well above long-term averages. However, two of the larger S&P 500 constituents did stumble last week. Apple and Amazon.com reported lower-than-expected revenue numbers, both citing supply-chain disruptions as headwinds for their businesses.
Foreign equity markets were positive in October but lagged US stocks. Developed international stocks returned 2.5%, while emerging-market stocks posted a 1.0% gain. Concerns about China’s property sector eased slightly in the month after property developer Evergrande made coupon payments on its offshore bonds to help it stave off default. In the meantime, a handful of other Chinese property developers either defaulted or asked for a grace period on coupon payments in October. This led to a spike in yields on Chinese high-yield bonds—which touched nearly a 24% yield-to-maturity in mid-October before coming back down toward 20%. Investors have now shifted focus toward the potential for systemic impact and how the Chinese government might respond. The MSCI China Index gained 3.2% in October.
The yield curve flattened in October. The two-year US Treasury yield jumped to 0.48% from 0.28% in September. The 10-year rate also increased—however, it only moved up three basis points in the month to close at 1.55%. The longest end of the curve, the 30-year Treasury, actually decreased in October—going from 2.08% to 1.93%. The market is increasingly ratcheting up its expectations for rate hikes in 2022, which has pushed up the short end of the curve. According to CME futures data, there is currently a 76% probability that the Fed Funds Target Rate is 0.50%–0.75% (two 25-basis-point federal funds rate hikes) by the end of 2022. This is up from just a 27% probability at the beginning of October. And this can be compared to just half of FOMC members whose September dot plot indicated only one rate hike next year. On November 3, the FOMC announced it is beginning tapering of QE by $15 billion per month, with the expectation it will conclude by mid–2022. There is a growing narrative that the Fed may then immediately start to raise rates, despite Fed chair Jerome Powell saying there is no link between tapering and rate tightening. Core bonds (Bloomberg US Aggregate Bond Index) were flat in October and remain negative for the year (down 1.6%). The core bond index has not had a negative calendar year since 2013 (the year of the “taper tantrum”).
If we enter a period of persistent and increased inflation (above market expectations), our portfolios are tilted toward reflationary asset classes. However, one counterpoint to continued high inflation is the winding down of pandemic-related assistance programs. Unlike previous recessions, personal income levels have continued to increase over the past year-plus. As it stands today, government transfer payments make up about 20% of personal incomes in the United States—this is down from nearly 30% earlier in the pandemic. Pre-pandemic, government assistance accounted for about 15% of individual incomes. Higher incomes resulted in an increase in consumer-goods purchases, which coincided with pandemic-related supply-chain disruptions. So, both supply and demand have contributed to the sharp jump in inflation this year. As personal incomes return to trend (see chart to the right), demand-side pressures on inflation should soften and, in due time with continued progress against COVID-19, supply-chain problems should recede as well.
Assuming government transfers are not a permanent feature in normal times, the key question around continued high inflation rates is whether wages increase. Wage inflation has increased in recent months but has not yet shown signs of spiraling out of control. If inflation expectations and wages start to self-reinforce one another, there’s a scenario for sustained higher inflation, which will likely be followed by tighter-than-expected monetary policy. As always, we will continue to watch the data and adjust our views as necessary.
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