Research Bulletin – Sept. 28, 2021
Laffer Tengler Investments – Research Bulletin
Nancy Tengler, Chief Investment Officer
The Outlook for Equities – Nancy Tengler, Sr. Portfolio Manager & Chief Investment Officer
Warning signs the market needs to recalibrate: In the face of rising corporate taxes, increasing regulation, supply chain disruptions and higher wage costs, Wall Street strategists continue to hike earnings estimates for 2022. The average estimate now stands at $222 which is $5 higher than estimates in August. Federal Express (FDX) reported lower than expected earnings for their Fiscal Q2 despite strong revenues due to higher labor costs and “resulting inefficiencies”. Add to that margins for the S&P 500 companies have hit another new high at 17.0%. When margins decline, stocks tend to follow.
If Washington has its way, the marginal pressure on earnings and margins is more likely to be down than up.
Washington has a way of crashing the best parties: The inside the beltway crowd should really get out more. Take our friends at the Fed, for example. Since the Great Financial Crisis the Fed’s focus on 2% inflation has been met with abject failure. They kept money super-easy for a decade, constantly befuddled as to why inflation didn’t manifest despite uber easy Fed policy. Clearly former Chair Yellen was not an Amazon Prime member. Her stated surprise that inflation was MIA harkened back to the photo of President George H.W. Bush, apparently surprised to discover the wonderful world of bar-coding. While that may have been unfair, the mantra of out-of-touch stuck. Fast forward to today’s Fed. We have been hearing all year that the Fed’s viewed inflation as “transitory”. What was initially understood as a few months quickly became a few quarters and may eventually become a few years. Transitory=temporary=brief duration according to Merriam-Webster, but not apparently to the Fed.
Add to the fact that inflation eluded the Fed for 10 years and has now materially exceeded the Fed’s target, forcing them to raise their target twice already in 2021. And, despite that, they are still targeting a level well below the year over year rate as expressed by the CPI (below). The headline number is 5.3% and the core is hovering around 4.0% year over year in August. Supply chain disruptions remain acute—Costco (COST) recently announced shortages in toilet paper and paper towels in line with or exceeding early COVID deficiencies—and Federal Express (FDX) missed earnings due to supply chain disruptions slowing shipping volumes and wage pressures negatively impacting the bottom line.
Inflation may indeed alleviate at some point in 2022 but as we have argued it will be with us for some time. Energy costs are up, rents are rising, wages are increasing and inflation expectations
(which are a key barometer of future inflation) are at recent highs (though the Fed seems to think otherwise—see below).
Growth is slowing but we are not in the stagflation camp.
Today we added a view of the equally weighted S&P 500 (SPX). It is no secret that five stocks represent about 25% of the cap-weighted SPX. We thought it was high time to add a view of the equally weighted index. The chart below explains. The index may feel toppy to some investors, but the average stock has experienced a healthy correction.
Bonds & Fixed Income – Jason Weaver, CFA, Head Trader & Portfolio Manager
Since the first notion of trouble with China Evergrande Group reared its head, the financial media, and the sell side investment banks have rushed, though an incessant number of articles and research reports, to insist that it was NOT going to become a systemic event for world markets, the Chinese government and monetary authorities had things well under control and would be resolved quickly and with little losses in the end (aside from its own equity and bondholders.) History tells us though that when opinion is universally one-sided on an event, unexpected effects can emerge that elicit a very disruptive reaction in the case that things do not turn out as planned. While ~$300B in defaulted debt is certainly not a global crisis in and of itself, the potential fallout from the failure of one of China’s largest property development firms could be.
Enter Kenneth Rogoff, author of “This Time is Different”, and a scholar of financial crises and debt bubbles. Rogoff believes the way forward for China to be very clouded by Evergrande’s failure (as well as a long list of other economic errors that have taken place there under the CCP’s leadership.) China is already in the midst of a slowdown and is extremely dependent on the housing sector to drive growth (why real estate has often been the target for prior stimulus efforts.) Currently, real estate-related enterprises drive nearly 29% of Chinese GDP as estimated vs the US at 15% (at the 2007 peak!.) Per-capita housing investments are roughly equal to those in most EU nations, while per capita income is only a quarter. True, Chinese leaders have been aiming to halve their reliance on real estate for some time, but gradually. However, finding themselves in the midst of the current slowdown and the problems with the sector, pricing pressure is likely to only amplify the slowdown, possibly reaching other parts of the economy such as construction work, and resource extraction. If perhaps GDP growth (not accounting for the property sector slowdown) declines in the next year from 6% to 4%, adding in the real estate woes may take it down to 2-3% which could prove to be devastating. Moreover, this could have a material impact on commodity exporters such as Australia as well as the EMEA region which could produce reductions in aggregate demand globally, a giant butterfly effect with unforeseen potential to drive even more market volatility.
Convertible Securities – Stan Rogers, Sr. Portfolio Manager
News / Earnings of Note:
Despite optimism for a meaningful pickup in new issuance, the calendar was relatively quiet. There were 7 issues in the primary market for total proceeds of $2.7 billion. The downdraft in the equity market may have caused some issuance to be shelved temporarily.
The convertible portfolio held up quite well during the equity market weakness, as the defensive characteristics helped support on the downside, and we have eked out a small positive gain month-to-date versus negative returns in the broader equity markets.
Equity Hedging – David Jeffress, Portfolio Manager
On Monday, 09/20/2021, the S&P 500 Index fell as much as 118 points (or approximately 2.60%). During this period, the most recent addition to our put option positions, the 270 strike price contracts expiring on 10/15, increased in value to 0.14. As we have said before, the options we buy each quarter are not intended to hedge a 2% drop in equities, nor would we consider selling these positions for such a modest gain. However, the gain we saw in this contract relative to the brief sell-off we witnessed was reassuring nonetheless as it gives us confidence that we have the appropriate hedge in place should the market experience a more precipitous decline.
We have spent the last few weeks preparing the accounts for the next round of hedging and we anticipate making the first purchases for the fourth quarter this week.