The U.S. and European economies slowed in September as supply-chain bottlenecks and worries over the COVID-19 Delta variant weighed on businesses, adding to signs the global economy has experienced a soft patch amid an uneven recovery.
Manufacturing and services businesses in both the U.S. and Eurozone reported slower growth in activity in September, although the pullback was more pronounced in Europe. In addition, the Delta variant, which caused a summer surge in coronavirus cases in many parts of the U.S., weighed on activity at service-sector businesses.
Still, the U.S. economy has shown signs of resilience, with retail sales rebounding in August. Weekly filings for unemployment claims, a proxy for layoffs, have also remained near pandemic lows. Gauges of business activity in the 19-nation Eurozone recorded sharply slower growth in September in both manufacturing and services. The slowdown that began in August, after activity in July hit a 21-year high, extended into September when widening vaccination campaigns allowed public health restrictions to be rolled back and economies to rev up.
Purchasing managers' surveys in both the U.S. and Eurozone pointed to some bright spots, as they anticipated a pickup in demand and an easing of the pandemic. While overall business activity at U.S. manufacturers slowed slightly in September amid supply-chain issues, new orders and hiring increased. Meanwhile, the surveys signaled faster growth in Europe than the region normally experienced before the pandemic, suggesting a solid if slowing recovery.
The most important development in the U.S. economy in the last month has been the continued spread of the Delta variant. As a result, Americans have generally become more cautious. That said, most states seem unwilling to impose the same sort of restrictions that locked down the economy in the spring of 2020. Most individuals seem to be going about their daily routines, albeit perhaps not with the same vigor as they did earlier in the summer when the pandemic appeared to be winding down. In short, significant retrenchment in consumer spending does not appear likely unless the new case count shoots markedly higher from its current level. Real GDP in the United States should grow 6.0% in 2021, which, if realized, would mark the strongest year of U.S. economic growth since 1984.
Given strong economic fundamentals—supportive macroeconomic policy and solid household and business balance sheets—the economic expansion should remain intact. In that regard, real GDP is expected to grow by 4.5% in 2022. This above-trend real GDP growth should lead to solid growth in payrolls in the coming months, so that the unemployment rate, which currently stands at 5.2%, should trend lower in 2022. With the economy growing at a solid clip and unemployment gradually abating, inflationary pressures have increased. Supply chain disruptions and labor shortages in certain industries have also contributed to the imbalance between consumer and business demand for goods and services and the availability for that demand to be met by the economy. This imbalance is likely to persist until the middle of 2022 which should contribute to a gradual lowering of inflation to somewhere between 2%-2.5% in the quarters ahead.
Supported by strong corporate earnings and dovish comments from the Federal Reserve, U.S. equities generated solid gains in July and August. However, these gains were largely given back in September, as the S&P 500 dropped 4.7% during this month. September produced the first pullback of five percent from a peak since October 2020 as markets responded to concerns about the slowing rate of economic growth, the rise in Delta cases, the Evergrande real estate crisis in China, and the potential outcome of political gamesmanship in Washington. September’s result was the first negative S&P 500 monthly return since January 2021.
Overseas, equity markets posted a negative quarter. In Europe, the period started with gains amid positive second-quarter earnings and the ongoing economic recovery from the pandemic. As the quarter progressed, however, inflation worries emerged due to supply chain bottlenecks and rising energy prices. In Japan, the equity market was range-bound through July and August before rising in September. For the quarter, the MSCI Japan index gained 4.6%. In a surprise decision, prime minister Suga announced his intention to resign without contesting the Liberal Democratic Party (LDP) leadership election. Fumio Kishida was ultimately elected as LDP party leader and became Japan’s 100th prime minister. As a result, emerging market stocks fell sharply during the third quarter. The MSCI Emerging Markets index lost 8.1%.
Broad bond market indexes generated mixed results during the third quarter, with U.S. issues posting an essentially flat return while international bonds lost 1.6%. Bond yields ended the quarter not far from where they began, but this understates the volatility experienced during Q3. Yields initially fell as the rapid economic recovery appeared to be moderating. However, as the market’s focus turned to rising inflation and the prospect of the withdrawal of monetary policy support, yields rose. The 10-year Treasury note started the quarter at 1.45% and closed as low as 1.19% in early August only to end the quarter at 1.52%. Among U.S. corporates, high yield issues rose 0.89%, while investment-grade credit was little changed.
Global equities rallied to new highs early in the third quarter, driven by strong economic and corporate earnings growth, particularly in the U.S. and Europe. In the near term, we expect growth to remain strong and monetary policy to be accommodative. This creates a supportive fundamental backdrop for equities. In the U.S., the economy is likely to sustain above-trend growth into 2022. However, the easiest gains may have already been realized as the recovery phase of the business cycle matures. The possibility of a more complete economic recovery is supported by greater vaccine access for children and early indications that the Delta variant threat may be fading. The Federal Reserve appears poised to start tapering its asset purchases in late 2021, although a rate hike is unlikely until late 2022 or 2023. Inflation is a risk to our generally positive outlook for U.S. stocks. The outcome of heated fiscal policy debates in Washington D.C. also has the potential to impact markets.
Developed international equities appear relatively attractive, supported by solid growth expectations and lower valuations. Signs that the Delta variant may not derail progress could mean a rotation back to cyclical this fall. Cyclical stocks, which tend to dominate international stock indexes, often perform best when the outlook improves. In Europe, growth slowed through the third quarter but looks to be on track for a return to an above-trend level during the fourth quarter and into 2022. Vaccination rates are high, and the region has more catch-up potential than some other major economies. Europe is also expected to receive more fiscal support than other regions, with the EU’s pandemic recovery fund only beginning to disburse stimulus. In Japan, the economy should benefit from rising vaccination rates and political leadership changes that may result in more fiscal stimulus. Japanese equities are slightly more expensive than other regions such as the U.K. and Europe, however. In the U.K., GDP remains below its pre-pandemic peak. Therefore, there appears to be plenty of potential for strong economic catch-up as borders fully reopen and activity normalizes.
Emerging market economies are benefiting from a stronger than expected first half and a lower tolerance for renewed restrictions on activity. EM stocks have been poor performers since the announced development of vaccines, but there are some encouraging signs. Initially, this asset class was held back by a slow vaccine rollout. And of late, developing market stocks have come under pressure from a slowing Chinese economy and regulatory concerns surrounding Chinese tech companies. Other Chinese industries were dramatically impacted by recent regulatory changes (e.g. the for-profit education sector). But most in the headlines of late has been the likely default on the debt of China’s largest real estate developer, Evergrande. While the potential demise of a large and important company is stressful for the market, its size is small in comparison to the entire Chinese economy. Our view is that the Evergrande debacle will be handled by the markets and probably quietly behind the scenes, the Chinese government. Currently, however, the vaccine rollout across emerging nations has accelerated and it appears that Chinese regulatory policy may be largely priced in. Risks to the outlook are on the downside and include a delayed exit from the pandemic and a difficult transition from recovery related, ultra-accommodative government policies.
For fixed-income investors, government bonds are expensive, and yields may come under upward pressure as output gaps close and central banks look to taper back asset purchases. Although the Fed is not expected to raise short-term rates until late 2022 or 2023, longer-term Treasury yields will probably rise given market expectations for inflation and economic growth. A 10-year U.S. Treasury yield approaching 1.75% in the coming months would not be surprising. If yields rise, total returns for bond investments likely will be driven by coupon income rather than price appreciation. Investment grade and high yield corporate bonds are expensive on a spread basis, but profits are strong and default rates are low. High-quality core bonds should continue to serve as ballast in equity-heavy portfolios.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading at the 11th percentile from January 1957 to October 11, 2021.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers an August 2021 reading at the 97th percentile from January 1979 to August 2021.
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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