Cooling inflation in Q3, additional focus on employment and consumer demand

Matt Kelley, BridgeTower Media Newswires

Estimates for economic growth fell dramatically throughout the third quarter as COVID cases spiked and consumer demand waned. GDPNow, the Atlanta Fed’s model for estimating GDP, began the quarter forecasting over 6% annualized growth for the third quarter, and is now estimating only 1.3%. As a comparison, second quarter GDP growth was 6.7% annualized.

Inflation cooled this quarter, after peaking in June with a CPI reading of 0.9% month-over-month, coming in at 0.5% and 0.3% respectively for July and August. CPI less food and energy was up only 0.1% for August. Much of the reduction had to do with slowing consumer demand for services related to travel, likely attributable to the recent flare up in COVID cases. Airline fares, vehicle rentals and lodging away from home all posted large, negative drops for the month of August. Additionally, used vehicles, which had been a large driver of past CPI readings, also showed signs of slowing, down 1.4% for the month of August after increasing more than 30% over the second quarter.

Growth in consumer spending also slowed through the quarter, possibly due to a combination of the spike in COVID cases and the expiration of additional unemployment benefits. According to the Atlanta Fed’s GDPNow estimate, the forecast for third quarter consumer spending has dropped from almost 4% at the start of the quarter down to ~1%. Retail sales have fallen through the third quarter, with July and August readings of -1.8% and 0.7% respectively (September data not yet available at the time of this writing). Looking at payment card transactions from the Bureau of Economic Analysis, estimates for retail and food service spending (excluding non-store data) looks to be fairly muted for the month of September after posting strong numbers over the Labor Day holiday. Spending on restaurants, bars and accommodations away from home is still well below levels seen before the crisis.

The global supply chain is one area of the market that still needs sorting, given the record surge in demand for goods. U.S. demand for goods has increased more than 20% from levels seen before the pandemic, as consumers shifted away from in-person service spending. Couple this with the shortage in workers required to maintain the supply chain, and we have a bottleneck. Consumers are currently seeing highs in both shipping costs and delivery times. For this to work itself out, we will need to see continued increases in global vaccination and/or acquired immunity, coupled with a shift in demand back to services. 

Unemployment continued to improve throughout the third quarter, despite coming in below expectations at 4.8% for September. There were silver-linings, including both the reduction in permanent job losers and long-term unemployed, down 236,000 and 496,000 respectively. Additionally, the number of persons employed part-time for economic reasons, while unchanged for August and September at 4.5 million, is at the same level seen pre-crisis in February 2020. The leisure and hospitality sector was the biggest contributor to job gains, and has recovered 80% of losses caused by the pandemic. Bridging the remaining gap in employment may be difficult as we are still seeing a record number of job openings despite the recent surge in consumer demand. 51% of small businesses have reported a job they were unable to fill in the current period, which is a record and more than double the 48-year average of 22%. Wage pressures are also mounting as 12% of small business owners reported labor costs as their top business problem and a net 42% of owners reported raising compensation, both record readings over the last 48 years.

The Fed is still considering inflation to be a transitory phenomenon and continues to focus on employment growth and consumer demand, as they kept both rates and monthly asset purchases unchanged after the September meeting. In his statement, Fed Chair Powell stated, “so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” This would signal that the tapering of monthly asset purchases may begin sometime this quarter. Looking at the treasury futures market, estimates for the first rate hike are unchanged, still signaling late 2022 or early 2023.

The 10-year treasury rate started the quarter at 1.48% and ended it essentially unchanged at 1.49%, despite a relatively volatile 3-month period. Interest rates fell moderately in June and August to under 1.2%, then spiked sharply late in September following Fed comments that it will likely begin tapering by the end of the year. As such, bonds were relatively flat for the quarter as positive returns from June and August were erased in the last few days of September following the rate spike. The Bloomberg Aggregate Bond Index posted a 0.05% gain for the quarter. The bond market continues to confirm the transitory inflation narrative, with the 5-year breakeven inflation rate continuing to hover around the 2.5% level throughout the quarter. 

—————

Equities and bond market updates

The S&P returned 0.58% in the third quarter after losing almost 5% in a volatile September.  After a relatively muted start to the year, September saw more consecutive daily 1% moves than we have seen going back to June 2020. Equities continued higher in July and August, in light of stronger than expected corporate earnings and continued Fed support. However, investor sentiment shifted in September — reversing the style and sector trends we saw earlier in the quarter — as rising interest rates, hawkish comments from the Fed and economic concerns in China, led to steep sell-offs.

Growth outperformed value during the quarter and large companies outperformed small. Amid rising COVID cases and uncertainty of future economic growth, most of the large cap growth companies’ outperformance came during July and August as investors continued their rotation to less cyclical companies and sectors. In September, this trend reversed as news of potential Fed tapering and rising interest rates led to a devaluation of growth and technology companies.

From a sector standpoint, Financials, which underperformed for most of the quarter, ended the quarter with the highest returns, thanks to rising interest rates late in September. Healthcare and technology companies also performed well, however most of the gains in these sectors came from the beginning of the quarter, as COVID cases spiked dramatically and investors shifted to more defensive areas. Industrials and materials were the biggest underperformers during the quarter. Industrials, which tends to be a very cyclical sector, suffered in the beginning of the quarter amid inflation concerns and supply chain issues. Materials, on the other hand, declined later in the quarter amid economic concerns in China, following the Evergrande debt crisis. 

Both investment grade and high yield corporate bond spreads were little changed this quarter, and continue to be near historically low levels, shrugging off the volatility seen in the equity markets. Investment grade bonds ended the quarter completely flat, following a sell-off in September, which was driven by the increase in rates. The investment grade corporate bond market has a longer maturity profile than the high yield market, as well as the broader fixed income market, as companies have continue to issue and refinance debt at low levels for longer periods. This higher duration, resulted in a sharper sell-off in September. High yield bonds fared slightly better over the quarter, posting a slight positive gain, as their higher coupon payments help to mute the effect of rising rates.

—————

Conclusion

Many question marks remain in our recovery from the global pandemic. For consumer spending to fully recover, we need to see demand shift back to services from goods. This will also help to shore up the issues we are seeing with the global supply chain bottleneck. One of the main indicators for future demand for services will be vaccine rollout and acquired immunity, something that is interrupting the global supply chain. Until then, we should continue to see volatile economic data in the coming months correlated with COVID trends. For investors, now is the perfect time to take the opportunity to revisit portfolio exposures and ensure they are consistent with long-term objectives.

—————

Matt Kelley is a portfolio strategy manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.