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ECONOMIC OUTLOOK Q4 2021
2021 ECONOMIC OUTLOOK Q4
OVERALL MARKET OUTLOOK
OVERALL MARKET OUTLOOK
Despite inflationary pressures and lack of labor participation, the U.S. economy is still growing at a whopping 6.3%. In response to the 2020 pandemic, the Federal reserve injected over $10 trillion of stimulus into the bond markets. Undoubtedly this has had a lasting impact across risk assets. Since March 2020, I’ve been extremely bullish on U.S. Equities. In fact, at one point, I had 90% of my portfolio fully allocated. Now that the $SPY is up over 100% from 2020 lows, I’m no longer as optimistic as I once was. My long-term outlook remains bullish, but the short-term thesis holds that the market has gotten ahead of itself. Stocks are long overdue for a 5-10% correction. It’s unhealthy for the markets to move in one direction for such a prolonged period.
S&P Multi Year Chart
S&P Multi Year Chart
I have been patiently waiting for volatility to return to the equity markets. Throughout the last year and a half, I’ve maintained sizeable long-term core holdings. However, I’ve trimmed a decent bit of my exposure on the way up. As far as trading, I haven’t actively traded the markets for months. When volatility is this low, the risk verse rewards are heavily skewed. The upside is quite limited. The plan is to wait for a 5%+ move, and then we will start selling some bear put spreads on the $SPY. This is the highest probability strategy to take advantage of bearish conditions. Betting against the markets rarely works, and buying the dip seems foolish at these levels. Creating a bear put spread allows us to capture a high probability premium.
CPI(Consumer price index): CPI is the most common inflation metric used by economists. The CPI index looks at a basket of goods/ services associated with everyday living expenses for an average person. The index uses a weighted average. Right now, the CPI index is up roughly 5.5 % year over year. Inflation has doubled from its normalized 2-3% pre-pandemic levels. However, inflation has remained unchanged for the last three quarters. It’s worth noting that the CPI index can often overstate inflation by a few percentage points. Years ago, the fed came out with a study that suggests that consumers will replace or substitute higher-priced goods.
Jobless claims: During the 2020 pandemic, the United States had a jaw-dropping 6 million unemployment number. That was the highest number of jobless claims since the great depression. Jobless claims have since come back down to pre-pandemic levels. The most recent print was 310,000, down from the previous reported 345,000. Keep in mind these numbers can be misleading if we aren’t simultaneously analyzing labor participation rates. Although jobless claims signal a strong recovery, participation rates tell us a somewhat different story.
Wage Growth: One of the main concerns for small businesses right now is the rapid wage growth that we’ve seen over the last year. Wages have grown over 15% from the prior year. That’s the highest number that we’ve seen in over 20 years. Not only are we experiencing rapid wage growth, but also simultaneously lower labor force participation. Most of us would agree that the stock market’s performance doesn’t reflect the real state of the economy. Large corporations have come out of the pandemic stronger. Simultaneously millions of small businesses are struggling, and inevitably that will have a long-term impact. Small business makes up over 40% of all economic activity.
Participation rate: The fed has closely been monitoring labor participation rates. They claim that this is the reason they haven’t already tightened monetary policy. For the last five years, labor force participation has held steady at around 63%. During 2020 it dropped down to 60%. We’ve moved sharply off the lows but still have yet to regain 1-2% of pre-pandemic labor participation rate numbers.
CENTRAL BANK POLICY
Bond yields: Equity investors need to pay close attention to bond yields/prices. Most of the time, equity markets have very little correlation with the bond markets. I backtested U.S. stocks and U.S. treasuries, to find the precise correlation between the two assets. Over the last 5 years, we have seen a -.40 correlation between them. When you go further back and look at 20 years of data, there is only a 0.18 correlation. That said our backtested data suggest that the correlation increases substantially during higher volatility periods. Let’s take a look at the 10 & 20yr U.S. treasury bonds. The year before the pandemic, we start to see a steep drop in bond yield. The 20 yr dropped from 2.5% down to 1.25%. Currently, treasury yields are two basis points or .5% away from the pre-pandemic levels in 2019. The ten year was at 2% in Dec. of 2019. During the pandemic, the 10-year yield reached a low of 0.5%. Right now, the ten-year treasury sits at 1.2 %. Keep in mind bond yields are down over 60% in the last four years.
Fed posture: Fed Chairman Powell has communicated very clearly that they are ultimately looking to raise rates before the end of 2023. Although they refuse to give us any specific timeline, they will provide more clarity 3-6 months before their move. Central banks have to properly balance transparency and giving themselves the flexibility to change when the data changes. The one thing that we can say for sure is that they don’t want to wait too long. They must have dry powder when shit starts to hit the fan.
The worst potential outcome is that the economy slides off a cliff, and the federal reserve is still easing. They would have virtually no mechanism to slow things down. We forecast that the fed will raise rates by a quarter of a basis point within the next seven months. The fed’s excuse is they are waiting for the inflation and employment to normalize. In my opinion, this is somewhat of an excuse. It gives them a reason to maintain the status quo. The fed is trying to stay out of the way as much as they can. They will likely wait until the market starts to show some weakness. It ultimately depends on whether or not Joe Biden decides to keep Re-Elect Chairman Powell or not.
OVERALL U.S. ECONOMIC GROWTH
GDP: Next GDP report will be on Dec. 22 at 8:30 am. The previous GDP report was one of the highest numbers we have had in decades. The latest GDP growth figure was 6.6%, up slightly from the previous quarter at 6.3%. Although GDP is relatively unchanged, many are left wondering when the wage, inflation, and supply chain pressures will start to impact GDP+ consumer sentiment. Within the next year, we will likely see GDP return back to pre-pandemic levels. Before 2020, the U.S. economy was growing around 2-3%.
GENERAL MARKET UPDATES
Movement in the bond market: A persistent theme in 2021 is that bond yields continue to move lower. The fed has signaled that they look to be tightening monetary policy soon. While they haven’t given any specific timeline, several investors believe the end of QE could happen a lot sooner rather than later.
Upcoming Fed chairman changes: Fed Chairman Powell’s four-year term will be complete in Feb of 2023. Biden will likely announce his decision whether or not he will replace Jerome Powell, in the next few weeks. Most investors agree that they would rather see a continuation of Chairman Powell’s policies. In many ways, his monetary policy decisions have proven to be incredibly effective. Although former president Trump believed it was unwise for him to continue raising interest rates, that decision arguably saved us from serious catastrophe in 2020. Had we gone into that recessionary period, without dry powder, it would have been difficult to stimulate the economy. The overarching sentiment is that Biden will re-elect Powell fed chairman. Chairman Powell has been heavily criticized at times, but he’s gained much more bipartisan support than some of his predecessors.
Inflation trend peaking: Although the most recent headline inflation numbers are alarming, the evidence suggests that the trend is peaking. The last inflation print was 5.3%, in line with the 5.4% number from the past two quarters. Investors should be careful overreacting to these numbers. We believe that inflation at these levels will be a short-term phenomenon. When you look at the inflation inputs, you’ll notice that a lot of it tracks back to supply chain shortages rather than impacts from monetary policy. Across industries, companies are seeing bottlenecks in their supply chain, partly due to lower labor force participation. Another factor is the Covid restrictions imposed by other countries. U.S. citizens often forget that a lot of the countries are yet to reopen their borders. Most Southeast Asian Countries are just recently starting to reopen their borders.
Biden tax hikes: Democrats are looking to pass a $3.5 trillion bill, and they want to raise taxes to fund the bill. Part of the proposed tax increases includes a 5% increase in capital gains tax(the tax we pay on investment returns). This bill is unlikely to garner full support amongst house members. For the spending Bill to pass, they would need to get the support of every house and senate democrat.
Analyst economic forecast downgrades: Over the past quarter, we’ve seen several bank analysts downgrade their year-end 2021 growth forecast. Goldman Sachs recently lowered their Q4 GDP forecast to a little under 4%. Dallas fed president also lowered his forecast as a result of slower hiring. Let’s not forget famous short-seller Michael J. Burry from the big short. He’s taken a very bearish tone in recent years. His firm is not only short individual equities but also $TLT the 20-year treasury yield index. Although I do believe we are long overdue for a market correction, I remain optimistic in the short term. At least until we start seeing significant moves from the federal reserve. I don’t anticipate we will see that until midway into 2023.
Continued supply chain disruption: Supply chain bottlenecks have been a persistent issue throughout the pandemic. Transport prices have seen astronomical increases over the last year. U.S. citizens often forget that the rest of the world has still been in lockdown. Southeast Asia is now finally reopening. A huge portion of the world’s physical goods are manufactured in this region. Chinese ports are overwhelmed with congestion. Labor shortages have been the icing on the cake globally. People haven’t fully returned to work since the pandemic. Over the next year, I expect this will start to normalize, but it depends heavily on the pace of recovery globally. I think countries will be forced to reopen, despite new coronavirus variants.
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