The Table Has Been Set

Third quarter earnings season kicks off with Financials taking centerstage.

S&P 500 earnings-per-share (EPS) are expected to rise by about 28% year-on-year while Bank earnings are expected to rise by about 23% year-on-year. Investors will likely be watching bank earnings to see how rising interest rates may be impacting net interest margins. Technology earnings will also be watched closely with EPS expected to rise by about 28%. Investors will also be listening to company comments on rising input costs and whether companies have sufficient pricing power to pass on these rising costs to consumers or if the costs will cut into profit margins.

World leaders struck a landmark deal on a global minimum tax rate for multinational corporations.

The Organisation for Economic Cooperation and Development (OECD) announced that 136 countries and jurisdictions, including China, agreed to a deal that would ensure that big companies pay a minimum rate of 15%. The countries that joined the deal account for more than 90% of the global economy. The agreement will likely become law in 2022 and go into effect by 2023.

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Investors were pleased to hear that Congress may have reached a short-term deal to lift the debt ceiling by $480 billion in order to allow the U.S. Treasury to maintain government operations until at least early December. Thus far, the extension has been approved by the Senate, but still awaits passage in the House with a vote possible on October 12. While likely to pass and provide a short-term reprieve, kicking the can down the road may still set the table for an awkward Thanksgiving dinner between Republicans and Democrats if Democrats do not make any additional progress on the debt ceiling or federal spending by then (a continuing resolution that is funding the federal government will expire on December 3). It is unclear to us whether the additional time will simply be used as more time for both parties to point fingers or if it will be used productively, but we strongly suspect that “no immediate crisis” may mean “no immediate action.” However, at the very least, the near-term risk of a government default appears likely to be temporarily averted and market volatility may begin to ease some after weeks of wild swings in the Dow Jones Industrial Average (see figure 1) and third quarter earnings season kicks off. Aside from giving Democrats more time to work out procedural details, the delay may also allow the Treasury Department more time to bolster “extraordinary measures” should the debt ceiling debate go unresolved by December 3. In theory, bolstering these measures could allow the Treasury to fund government operations into the first quarter of 2022, pushing the “hard” debt ceiling back significantly from the original date of October 18.

This line chart shows the Dow Jones industrial average from September 1st to October 6th 2021. Washington, D.C. in-fighting has led to increased market volatility.

Did the September Jobs Report Set the Table for a Fed Taper?

We think it probably did. The September employment report came in weaker-than-expected with just 194,000 jobs being added during the month (versus a consensus estimate of 500,000 jobs). However, much of the weakness can be attributed to a sharp decline in state and local government employment with local government education employment falling by 144,000 and state government education falling by 17,000. According to the Labor Department, pandemic-related staffing fluctuations have distorted the normal seasonal hiring and layoff patterns. In fact, prior to seasonal adjustment, the sector added 718,000 jobs in September. Excluding government jobs, private payrolls rose by a much better 317,000 jobs (see figure 2).

This bar chart shows the monthly change from January to September, in 2021 U.S. Nonfarm Payrolls (Thousands). The September Employment Report was likely good enough for the Fed to move forward with tapering.

Importantly, even with August and September payrolls coming in weaker-than-expected, monthly job gains have averaged 561,000 per month in 2021. That is a very solid recovery pace with the unemployment rate falling to 4.8% in the latest report. There are also signs that the more modest pace in hiring seems to be more of a result of worker shortages than a lack of demand with job openings in the U.S. still near a record high. In fact, there is currently 2.8 million more job openings than there are unemployed (see figure 3). While a positive dynamic, this could continue to put upward pressure on wages in pandemic-distorted sectors of the labor market. A prime example is the leisure and hospitality sector where wages are now up 10.8% year-on-year as the demand for workers outstrips the supply (see figure 4). Transportation and warehousing wages are also up 6.0% year-on-year and education and health services wages are up 5.8% year-on-year.

This line chart compares the number of U.S. unemployed versus the number of U.S. job openings (Thousands) from 2001 to 2021. There are 2.8 million more job openings than unemployed.

This line chart shows the year-over-year (in thousands) average hourly earnings of leisure & hospitality workers.

This likely bolsters the Fed’s case that sufficient progress has been made within the U.S. labor market to move forward with a tapering of its bond purchases. An announcement seems highly likely to occur at the November 2-3 Federal Open Market Committee (FOMC) meeting; however, we would encourage investors to keep an eye on third-quarter growth with the widely-followed Atlanta Fed’s GDPNowcast tracking at just 1.3% currently (see figure 5).

This bar chart shows nonfarm payrolls versus Atlanta fed GDP Nowcast Tracker for 3Q 2021. Growth trackers have been signaling slower growth.

Such a low rate of growth seems out of step with the type of growth that national business surveys like the ISM manufacturing and services indices are pointing to, but with third quarter real gross domestic product (GDP) set to be released on October 28 the report could be yet another hurdle for the Fed to overcome before making their official announcement. Though it is encouraging that there are plenty of signs that suggest that the recent slowing in growth is a result of supply chain issues and not a slowing in demand. The National Federation of Independent Business’ Small Business Economic Trends report supports this with just 4.0% of small businesses saying that poor sales are their single most important problem (see figure 6). Quality of labor remains a much larger issue with a record high 28.0% saying it is their biggest problem. Unsurprisingly, the cost of labor is also becoming a larger problem as the shortage of qualified workers persists (see figure 7). Assuming supply chains issues eventually ease, this should lead to a stronger fourth quarter real GDP print.

This line chart shows the percentage of small businesses reporting poor sales as the top problem from 1990 to 2021.

This line chart shows the percentage of small businesses reporting reporting quality and cost of labor as the top problem from 1990 to 2021. Returns were more modest when the Fed’s balance sheet was no longer expanding, but were largely still positive.

What Does a Less Accommodative Fed Mean for Markets?

Despite the prospect for near-term volatility as investors look for clarity, if we use the 2013 “taper tantrum” as a playbook, the U.S. stock market held up quite well over the longer-term – returning an average of 12.2% over the next four years as the economy continued grow while the Fed stopped expanding its balance sheet and eventually went on to raise interest rates nine times between the end of 2015 and the end of 2018 (see figure 8). Returns were indeed negative in 2018, but we would argue that rising U.S. – China trade tensions likely played a crucial role. As figure 9 shows, on average, the S&P 500 returned an additional 35.6% over the next two years following the first Fed rate hike in a monetary policy tightening cycle before experiencing a 20% plus bear market. With the first Fed rate hike unlikely to occur before the end of 2022, history suggests that a bear market remains some ways off.

This line chart shows the S&P 500 annual return versus federal reserve balance sheet from 2011 to 2021. Returns were more modest when the Fed’s balance sheet was no longer expanding, but were largely still positive.

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