Performance figures for each account are calculated using time weighted rate of returns on a daily basis. The Composite returns are calculated based on the asset-weighted monthly composite constituents based on beginning of month asset mix and include the reinvestment of all earnings as of the payment date. Composite returns are as follows:

Market Commentary: What No One Tells You About Stagflation

CIO Rob Edel explores the state of the markets; including inflation and unemployment rates, China’s influence, and the concerns of stagflation, in this edition of our Monthly Market Commentary.

By Rob Edel, Chief Investment Officer

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View the Nicola Wealth Investment Portfolio Returns: September 2021

Highlights this Month

September in Review

Flat equity returns in Canadian markets for Q3 belied an undercurrent of rising volatility and uncertainty as negative returns in September broke a seven-month winning streak. With the S&P/TSX down over 2%, only the energy sector managed positive returns, while high dividend-yielding utilities, real estate and communications sectors lost ground, along with the historically defensive consumer staples sector. It was much the same story for US stocks, with the S&P 500 down nearly 5% in September and energy the only sector managing to stay in the black.

Up until last month, markets were the model of consistency, with the S&P 500 recording 54 record new highs in 2021 but rarely moving up or down more than 1% in a single trading session. Enter September, and investors appear a lot more jittery. Not only has the S&P 500 started to alternate between gains and losses of at least 1%, but a survey conducted by the American Association of Independent Investors found investor sentiment has deteriorated to levels previously seen during the market’s sell-off last September. While the overall market indices have not got anywhere close to correction territory, individual stocks have suffered a bit more, trading well below their 52-week highs. 61% of S&P/TSX stocks and 62% of S&P 500 stocks are in correction territory, trading more than 10% below their recent highs, while 36% of S&P/TSX and 16% of S&P 500 stocks ended September in bear market territory, down over 20%.

A turning point? Or just a well-deserved break?

Did September mark a turning point for the market, or just a well-deserved and long over-due breather? There are certainly plenty of issues for investors to worry about, with a recent Scotiabank client survey listing inflation, monetary tightening, China, earnings, and COVID-19 as worthy concerns for us to explore this month. All five are more than capable of rerailing the current bull market.

Even with these risks, however, investors continue to be drawn to stocks like moths to light. A recent Absolute Strategy Research survey of 216 managers overseeing $4.3 trillion of assets found 72% still believe stocks will outperform bonds over the next 12 months. Perhaps even more telling is a couple of polls conducted by Deutsche Bank Research and Scotiabank. Deutsche Bank’s poll found a majority of respondents (58%) believe we will have a correction of between 5% and 10% before the end of the year. According to Scotiabank, over 80% would be a buyer of that 10% correction.

Let’s dig deeper into some of the issues to determine whether this faith in the markets is deserved. For simplicity, we will combine inflation and earnings under a general “stagflation” theme that has started to get some investor attention lately.  Along with monetary tightening, we add fiscal stimulus to the agenda, given both have been instrumental in propping up markets and economies during the pandemic. With China, there is certainly some overlap with concerns over stagflation given China’s influence on markets and global economic growth, but also some idiosyncratic risks unique to the middle kingdom. A lot to discuss, so let us dive in.

Markets have started discounting the tail risk the pandemic presents.

Firstly, we will deal with the easiest, least concerning issue for investors: COVID-19. While we are wary of underestimating the virus, given its ability to take advantage of weaknesses in complacent mobility restrictions and lagging vaccination levels, markets have started to discount the tail risk the pandemic presents. As shown in a recent Bank of America Fund Manager survey, only 17% of Fund Managers view COVID-19 as the market’s greatest tail risk versus the stated 57% in April of last year. While the pandemic remains unchecked in certain regions, overall case counts in the US look to have peaked and are starting to trend lower.  While new cases continue to move higher in Canada, we expect them to roll over soon. Most experts believe the end of the fourth wave is in sight.  Again, certain regions where vaccination rates are low will continue to see spikes in new cases and hospitalizations but we are no longer watching an end of the world scenario. Wanning vaccine efficacy might prompt health authorities to authorize booster shots, but barring a new mutation able to evade the vaccines entirely, future lockdowns and restrictions to mobility are unlikely.

What has become more concerning for investors is how the global economy transitions to the post-pandemic environment, whether the inflationary pressures we are currently seeing are transitory, and if inflation can provide a headwind to global economic growth and result in a period of stagflation. The evidence is starting to point in this direction, with consumer prices in the US, UK, and Eurozone spiking higher, while purchasing manager indices lose momentum and foreshadow slower economic growth. According to Bloomberg’s News Trends function, usage of the word “stagflation” in stories appearing on Bloomberg terminals has spiked in 2021, particularly in the last two months.

Much of the current stagflation angst can be attributed to the supply and demand challenge presented by the pandemic. The pandemic dramatically altered consumer buying habits, and companies were left with the challenge of quickly adjusting, despite dealing with a shortage of labour and materials. Unlike your typical recession, the problem did not stem from a lack of demand. Demand was stable, and in some cases, surging. The dilemma has been supply. According to Strategas, S&P 500 companies mentioning “shortages” on earnings calls has spiked higher, and a Washington Post article in early October highlighted the unprecedented number of ships waiting to dock at Southern California ports. Given the increase in one-way traffic between the US and Asia, freight rates have skyrocketed, adding to cost pressures.

Investors have rightfully concluded most of this will be transitory.  It may take a while, but supply chain bottlenecks will be handled, and consumer buying habits will eventually gravitate back to pre-pandemic patterns. Bank of America showed more fund managers were buying the transitory story in September than in August, and the percentage who expected higher inflation were balanced with those expecting lower inflation. As Stategas points out, however, inflation is still a concern for investors, even more so than unemployment. While inflation may indeed be transitory, investors shouldn’t become complacent about the risk to markets if it turns out to be more enduring.

A compelling case for high inflation.

Looking at the data, the case for higher inflation is starting to look more compelling. While it could be argued headline CPI numbers have been skewed higher by categories heavily influenced by pandemic-related buying, like used cars, other more unbiased measures have also started to show inflation spiking higher. Taking away the outliers, both on the upside and downside, the Dallas Federal Reserve’s trimmed-mean PCE inflation index and the Cleveland Fed’s 16% trimmed-mean CPI index display a clearer picture of what is happening to prices on average, and both have inflected sharply higher. Interpreting the data can be tricky, however, as the Dallas trimmed index over 12 months is less of a concern than over the past six months.

Taking a different approach, the San Francisco Fed has broken up pricing into cyclical and acyclical baskets of goods. Acyclical goods fell dramatically during the early part of the pandemic, and then quickly recovered, and now look to be rolling over.  This is good news for those in the transitory camp. The price of things, like used cars, have skyrocketed and helped push CPI indices higher, but they don’t rise forever. Eventually, the market will normalize, and prices will come back down. This is transitory inflation at work, and not something central banks can control, especially if it is a supply chain issue.

Unfortunately, the cyclical basket is now starting to move higher, and from an already elevated level, presenting signs inflation could be on the verge of moving beyond the pandemic influenced environment and entering a new cyclically led leg higher. Unlike acyclical inflation, addressing cyclical inflation is well within the central bank wheelhouse. The Atlanta Fed’s sticky-price consumer price index, which includes a basket of goods whose prices have historically changed infrequently, has also moved higher, though it has recently shown signs of moderating.  Unsurprisingly, lower-income consumers have been harder hit by higher prices, as is expected when inflation moves higher.

High prices diminish the benefits of high wages and pandemic fiscal support.

Lower-income consumers have been affected most by food and rent inflation, both of which have moved significantly higher. Food and rent comprise a significant component of a lower-earning consumer’s consumption basket, and higher prices in these areas could diminish the benefit higher wages and pandemic fiscal support have provided to lower-income Americans and Canadians. What received more investor attention last month was the continued increase in commodity prices, which have recently surpassed levels last seen during the China-led commodity supercycle earlier in the decade.

Of particular concern has been rising energy prices, which are soaring across G-7 economies. Coal, which many had correctly written off as an energy source as the World transitions to a low carbon emission future, led the way, followed by oil and natural gas prices. Despite the increased prices, capital expenditure has not increased, particularly for crude oil, as companies have become more financially responsible. Underinvestment in future production might make sense longer-term as alternative energy sources like wind and solar power become cheaper sources of power, but in the short term, it could push the price of commodities like oil, natural gas, and even coal, much higher. Investors appear to have taken note, as energy shares have dramatically outperformed alternative power stocks like solar.

While the current rally in energy prices could be viewed as transitory, given the unexpected demand in power demand is coming partially as a result of strong industrial demand due to higher than expected consumer spending, the transition to greener but less dependable alternative energy sources is also partially responsible given the increased vulnerability from a supply perspective. In the United Kingdom, for example, renewables now supply more than a third of Britain’s energy generation. According to Scotiabank, wind speed and sunshine levels have been lower than normal so far this year, meaning less power generation and thus greater demand and higher prices for fossil fuel-generated power sources. Bottom line, energy and the transition to alternative energy is another factor driving inflation higher, and it might not be that transitory.

Another area where inflation appears less transitory is in the labour market. In early September, the Washington Post stated there were 8.4 million Americans out of work, yet 10 million job openings.  Even with the expiration of supplemental unemployment benefits, workers appear to be slow in returning to the workforce as the US jobs recovery stalled somewhat in September, despite still being 5 million workers short of pre-pandemic levels. And no one knows why. At the same time, more workers are quitting, with the Bureau of Labor Statistics reporting 4.3 million Americans had left their jobs in August, a record 2.9% of the entire workforce. According to a McKinsey survey, employers are experiencing a greater turnover of workers, which they expect to remain elevated, or even increase, over the next six months. This is good news for workers as it is a sign of confidence in the economy, but not so good for corporate profit margins given wage rates have started to inflect higher. Bloomberg journalist, John Authers, indicated that the increase in hourly earnings for non-supervisory workers over the past two years has seen its fastest growth since at least 1983.

Central banks appear committed to starting the tightening process.

As the debate on the durability of inflation and the potential for it to lead to stagflation rages on, central banks appear committed to starting the tightening process. Last month, the Federal Reserve began guiding to a November start date for tapering their $120 billion per month quantitative easing program, with expectations they would be done tapering by the middle of next year. That said, Chairman Powell has made it clear that there was no connection between tapering and raising overnight interest rates, and in fact, a quicker tapering decision could buy the Fed some time in raising rates. Nevertheless, the market is skeptical and implied Fed Funds futures are currently indicating the market believes the first rate hike will happen in Q1 of 2023, while an RBC Capital Markets survey of institutional investors in September showed 45% of respondents see the Fed hiking rates in either Q2 or Q3 of next year.  It is a tough call. The Fed is wary of falling behind the curve, especially if inflation is not transitory. At the same time, they understand the desire of progressive Democrats in Washington to drive economic growth hotter to help increase wage growth for lower-income Americans. Additionally, Chairman Powell’s job is at risk as his mandate is up for renewal in February, and while he still maintains broad bipartisan support in Congress, the betting odds that he will be re-appointed have started to slump. In addition to Powell, several Fed vacancies need to be filled in 2022, presenting President Biden with the opportunity to swing the composition of the Fed towards a dovish monetary policy bias, which could further delay any future rate hikes.

Predictably, global bond yields moved higher last month, driving bond prices and returns lower. Interestingly, credit spreads were mainly unchanged, resulting in decent returns for higher coupon corporate bonds. Stocks were not so lucky, with both US and Canadian equity falling last month as expectations the Fed would soon be tapering gathered steam. Despite this fact, both BMO’s Investment Strategy group and Strategas pointed out that tapering does not necessarily indicate stocks should decline. According to BMO, during the 2013 “Taper Tantrum” the S&P 500 gained nearly 10% during the 12-month tapering period, and a Strategas price graph overlaying YTD performance in 2021 during a similar period in 2013 shows a comparable upwards trajectory.

Not all stocks are created equal, however. Strategas mentions cyclical stocks have historically outperformed in a rising interest rate environment, which according to Scotiabank favours financial, energy, industrials, and materials. Alternatively, the real estate, consumer staples, and utility sectors have historically exhibited a negative correlation to 10-year yields. Rising rates signal economic growth, which is positive for companies in more economically sensitive industries. It is only once central banks have tightened and the economy slows that markets and cyclicals start to come under pressure. Then during the tapering and rising rate cycle, returns are typically driven by earnings growth rather than expanding valuations. Valuations will come under pressure by rising yields, but stronger earnings growth can still push stock prices higher. That has been the case so far in 2021, with both the S&P 500 and the S&P/TSX year-to-date returns being entirely driven by forward earnings growth, with lower valuations detracting from returns.

Along with stimulative monetary policy, fiscal policy has been instrumental in guiding most developed world economies through the pandemic. It may not be pretty, but the ability to spend a seemingly limitless amount of money is typically the solution to most economic problems (in the short term), including a near-complete shutdown of the global economy. As with monetary policy, we are quickly approaching a winding down of the global fiscal impulse, which Goldman Sachs estimates could have turned negative last quarter. The US is leading the way, and Strategas estimates the country could suffer a $1.8 trillion fiscal cliff next year as pandemic spending programs start to expire. Even if President Biden can pass his entire $550 billion infrastructure and $3.5 trillion Social Infrastructure programs (Build Back Better), Strategas estimates fiscal spending stimulus will fall from 11.1% of GDP in 2021 to only 2.7% in 2022, then 0.9% in 2023. Still positive, significantly less than 2020 and 2021. Remember, $550 billion and $3.5 trillion are large stimulus packages, but they are spread over ten years. Even worse, it is becoming increasingly unlikely that Biden will get the entire $3.5 trillion passed, with betting odds favouring closer to $2 trillion.

While $2 trillion might be less than Biden had hoped, along with the $550 billion in infrastructure spending, it would still be an accomplishment for the Biden Administration, and it would help reduce the fiscal cliff somewhat. Getting anything done in Washington these days is near impossible, apparently even when your party controls Congress. The $550 billion infrastructure bill has bipartisan support, so it would appear to be a done deal. For once, Republicans and Democrats agree on something: America needs to invest in its infrastructure.

The agreeance does not seem to extend to social infrastructure, however. Democrats are on their own and will need all of their own 50 seats in the Senate (plus Vice President Harris) to vote in favour to pass the bill. Unfortunately, two moderate Democrats in the Senate, Joe Manchin and Kyrsten Sinema, are not on board. Perhaps they will agree to a smaller amount, or maybe the same annual amount over a shorter period, perhaps five years instead of 10, but not the $3.5 trillion Biden has promised more progressive Democrats. They stand firm. The problem is, so do the progressive Democrats. They believe Democrats have an opportunity to pass a socially transformational bill before they possibly lose control in Congress in next year’s midterm elections and are threatening to withhold support for the not-so bipartisan infrastructure bill if they do not pass the entire $3.5 trillion Social Infrastructure bill.

At the same time, Biden needs to pass a bill to raise the US government debt ceiling, or else the US Treasury could default. The initial deadline was around the middle of October, but the Republicans threw them a bone and agreed to extend it to late December, yet Senate Minority leader Mitch McConnell vows Republicans won’t be so accommodating next time. That being said, Democrats can raise the debt ceiling without Republican support, but the process is more complicated and the Democrats would prefer to focus their energy on passing social infrastructure. We only mention it because, in a dysfunctional Washington, one never knows. Although a default is highly unlikely, the implications for the markets would be troubling, to put it mildly. Overall, even without Infrastructure or Social Infrastructure, fiscal stimulus is still positive, but it was trending in the wrong direction last month.

China’s power demand, impending Evergrande default, and an unprecedented economic overhaul.

Our last market concern to review is China, which lately has been hit by a series of self-inflicted issues.  Similar to the UK and Europe, China is suffering some growing pains in transitioning to a zero-carbon world, which will be more economical in the long term, but more volatile in the short term. Last month, China’s manufacturing purchasing manager’s index dipped below 50 for the first time since the beginning of the pandemic, indicating the manufacturing sector in China was contracting.

The main culprit behind the decline was lower power generation, partially as a result of government-mandated energy efficiency and emission policies, lower coal inventories, and like the UK, lower supply from alternative energy sources like hydro. As Chinese power demand continues to grow, lower coal production has increased China’s vulnerability to power shortages given thermal energy production continues to increase faster than coal production. Therefore, we can add China’s power problems to the growing list of issues that could lead to stagflation.

On top of energy supply, Chinese credit markets were also on edge with the impending default of property developer Evergrande, the world’s most indebted real estate company. With over $300 billion in loans outstanding, markets became concerned that Beijing’s willingness to let Evergrande default could turn into China’s “Lehman” moment and lead to a broader financial crisis and recession.

Real estate is an important component of both the Chinese economy and Chinese household wealth.  According to JP Morgan, annual residential real estate investment comprises 10% of Chinese GDP versus only 4% for the US, and a broader definition of real estate-related activities is closer to 30% of GDP.  Goldman Sachs states that the Chinese property market is likely the world’s largest asset class.

But wait, there’s more! Not only is China suffering a power shortage and a potential real estate correction, but all this is happening while leader XI Jinping is attempting an economic overhaul and overseeing an unprecedented regulatory tightening cycle. Along with increasing the Communist Party’s control, Xi wants to rebalance the Chinese economy away from relying on exports and increase domestic consumption. To do this, he needs to reduce inequality and address what he refers to as “common prosperity”. A noble goal, but not without its drawbacks for investors in Chinese stocks.

All this provides a bit of an issue for investors. At over a 30% weight of the MSCI Emerging market index, China is too big to ignore, especially given the diversification benefits that the Chinese economy could present to global investors as it continues to decouple from the US economy. Yet, given everything going on in China right now, the lack of transparency, and virtually no rule of law to protect investors, it becomes a tough place for investors to venture. According to a Strategas survey, over 70% of investors are either reducing investments in China, have sold entirely, or never had any exposure in the first place. The upside is enticing, however, and the current correction in Chinese stocks could be a great buying opportunity given the size of the domestic Chinese market and its importance to global growth. There are a few thorns, but if one believes China’s centralized authoritarian management of the economy will be able to successfully navigate the re-balancing of the Chinese economy, it could be worth the risk.

If one wants to worry, the market can provide plenty of material.

So, a lot of risks for investors to ponder as they weigh arguments from the bears and bulls. COVID-19 can never be ignored, but we believe the market has started to do so. We hope this is the right call. Stagflation remains the real near-term concern, as inflation continues to test the transitory theory and starts to weigh on global growth. Higher inflation and lower growth present a dilemma for central banks. They are compelled to dial back monetary stimulus as inflation becomes more persistent but fear doing so will negatively impact an already weakening economy. This debate is happening at the same time that fiscal policy is set to normalize as policymakers struggle to add more stimulus.

As for China, let’s hope they know what they’re doing. Even without direct exposure to Chinese stocks and bonds, it will be hard for investors to avoid the fallout if the Chinese economy unravels. We’ll give them the benefit of the doubt for now. If one wants to worry, the market can provide plenty of material. It is hard to sell this market, as from the bull’s perspective, we still see upside to economic growth as the global economy re-opens, and while fiscal and monetary policy may begin to recede, it’s still stimulated and will likely remain so for the immediate future.

Over the long term, the market tends to move in one direction: higher. As Strategas points out, the compound annual return of the S&P 500 over the past 25 years has been 9.0%, but miss the five best return days of the year and your annual return drops to 7.1%. Miss the best 50 trading days, and you are down 1%. It pays to be fully invested, even if you have to endure the odd 10% correction. What is harder to endure is a major cyclical bear market, like the 24-year roundtrip investors suffered from 1929 to 1954, or the 12 years between 2000 to 2012, both markets we hope to avoid. We don’t see a repeat happening soon, but we plan to keep a careful eye on inflation. We believe central banks will do whatever it takes to keep nominal rates low, but higher inflation would severely test their resolve.  Last month marked the 40th anniversary of the peak in 20-year bond yields. September 30, 1981, 10-year US Treasury’s yielded 15.84%. They have been falling ever since.


This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.