An Abnormal Return to Normal

Third quarter earnings continued to roll in with S&P 500 earnings-per-share (EPS) tracking about 32% higher year-on-year. Heading into earnings season, expectations were for EPS to rise by about 28% year-on-year. With 115 companies in the S&P 500 having reported, 82% have posted better-than-expected earnings while 12% have missed expectations. This is down slightly from a 84% beat rate the year prior, but the continued earnings strength has helped to ease investors’ fears that price increases and slower growth will weigh on corporate profits.

Democrats have suggested that a deal on an infrastructure spending package may be reached very soon. A vote could come as early as this week with House Speaker Pelosi having set an initial date for a vote on October 31. However, there is no binding date, so it could always be pushed back further. Although exact details are not yet available, President Biden did publicly admit that they are likely not enough votes to raise the corporate tax rate. Betting markets are now pricing an 85% chance that the U.S. corporate tax rate will remain 21% or lower. It is unclear if Democrats will try to raise the funds elsewhere, but no change to the corporate tax rate would potentially remove an expected earnings hit to 2022 corporate earnings-per-share.

Back to top

Supply chain issues are popping up everywhere, people are worried about being able to find Christmas gifts, higher gas, food, and home prices are causing people to worry about inflation for the first time in a long, long time, and the Fed is talking about initial steps to remove its economic life support. These topics dominate our client conversations, and each present a risk to growth with third quarter real U.S. GDP expected to fall from an annualized rate of 6.1% in the second quarter of 2021 to an annualized rate of just 2.8% in the third quarter of 2021. However, what investors are seeing is the patient finally leaving the hospital after being in critical care for much of 2020. These first steps may be wobbly, uncomfortable, and nerve-wracking for those watching, but they also mark an important milestone that the economy (and life) is returning to normal.

While discussions of supply chain issues, weakening global growth, and inflation have clouded the outlook, we think it is important that we acknowledge that they are all tied together and a result of a rapid normalization. Advanced economies, like the United States, received vaccines first and consumer spending surged with real consumer spending jumping 16.2% year-on-year in the second quarter of this year (see figure 1). This spending contributed about 7-8 percentage points to real GDP in the first and second quarters of 2021 as consumers left their homes, visited family, and took vacations for the first time in years. This reopening surge was supported by a massive jump in the personal savings rate following COVID-induced lockdowns and massive fiscal support from Congress. By March 2021, the personal savings rate in the U.S. was 26.6%. Prior to this pandemic, the highest savings rate in the U.S. was 17.0% in May 1975. However, since March, the personal savings rate has dropped to 9.4% as of August (see figure 2). This implies that the initial surge in spending post-lockdowns is unlikely to repeat as consumer behavioral patterns return to normal as personal savings come back down to Earth.

This line chart shows the U.S. personal consumption expenditures (Year-on-Year percent change) from 1948 to 2021 Year-To-Date.

This line chart shows U.S. personal savings rate (in percent) from 1959 to 2021 Year-To-Date.

One result of that spending is that imports of goods and services skyrocketed in the second quarter of 2021 – up 36% from the year prior (see figure 3). While a jump in imports post-recession is not unusual, the global economy is still grappling with a lack of vaccines in some emerging markets and continued social-distancing protocols which is exacerbating supply chain issues. For example, during the lockdown consumers demanded home electronics as workers created home offices and upgraded their home entertainment, which diverted semiconductor chips away from auto manufacturers. Then consumers wanted vehicles as they moved away from city centers and wished to avoid public transit, which created a further squeeze on auto inventories and weighed on auto sales as supply could not meet demand. In the third quarter, auto sales are running at an annualized rate that is about 3.6 million units below the pace witnessed in the second quarter of 2021 (see figure 4). This dynamic will likely weigh on the 3Q 2021 real U.S. GDP print with supply constraints possibly dragging down consumer spending’s contribution to GDP to below one percentage point for the quarter.

This line chart shows the U.S. imports of goods and services (Year-on-Year Percent Change) from 1993 to 2021 Year-To-Date.

This line chart shows the U.S. auto sales (seasonally adjusted annualized rate, millions of units) from 2015 to 2021 Year-To-Date.

Aside from driving up imports, this demand amid constrained supply has driven up prices with domestic U.S. manufacturers also reporting a surge in order backlogs and higher input costs (see figure 5 and our Weekly Market Update | Inflation is Here - Will It Stay for Dinner for more insights). Essentially, we are experiencing the aftershocks of the earthquake that was COVID. The global pandemic shutdown production, closed borders, and forced workers out of the labor force. Now, we are trying to ramp up production, open borders, and bring workers back into the U.S. labor force with 2.8 million more jobs available than the number of unemployed. While supply remains visibly constrained, just 4.0% of small businesses are saying that poor sales are their number one problem. Combined with a still elevated savings rate, demand does not appear to be primary issue. As such, we think these problems should recede as natural immunity and vaccinations reduce the virus’ lethality and governments end restrictions and open borders and international travel.

Institute for Supply Management manufacturing backlog of orders versus prices paid from 2012 to 2021 Year-To-Date. Recent data on order backlogs and prices paid by manufacturers suggest that both may be starting to ease.

Normalization Likely Means Less Policy Support

This path to normalization also means that monetary and fiscal policy will likely start to normalize along with the economy. On November 3rd, investors will likely hear the Federal Reserve announce that they intend to start tapering their bond purchases with a goal to end bond purchases altogether by mid-2022. Although this may concern some investors, this is what should happen when the economy signals that extremely accommodative monetary policy may no longer be warranted with the unemployment rate back down to 4.8%. Importantly, there is still further improvement needed in the labor market with the number of employed still about 5 million below where it was in February 2020, but the U.S. economy has been adding back an average of 550,000 jobs over the past three months. We are not sure that pace can be maintained, but if it can, then it would take about nine months to close the remaining employment gap. This is conveniently close to mid-year 2022, which is when the Fed has stated its tapering will likely be finished.

Although fears of persistent inflation have pulled forward expectations of a rate hike with the forward-curve structure now pricing in two rate hikes in 2022 and three mores in 2023 (see figure 6), Citi Research’s base case remains that the Fed will hike just one time in late 2022. We think that the Fed will remain more dovish than markets think as long as wage inflation pressures don’t worsen significantly. Although the odds of a policy misstep do seem a bit elevated, which could eventually cause more market volatility than currently anticipated, we continue to expect U.S. stocks to continue to climb the wall of worry during what is typically a seasonally strong period for equity markets.

This line chart shows the number of Fed rate hikes expected by December 2022. Investors are moving up their timeline for rate hikes due to inflation expectations.

Back to top

Back to top