Weekly Summary: October 4 – 8, 2021
- Many indicators point to diminishing effects of Delta variant infections. We assume their containment and/or manageability.
- We believe that energy-related issues will now be the focus in assessing economic growth projections and persistence of inflation rates.
- Winter temperatures should greatly influence stagflation assumptions.
- Global de-carbonization/renewable energy policies should most likely increase the persistence and levels of inflation, at least over the intermediate term.
- Although headline U.S. nonfarm payroll data for September were disappointing, we maintain our view that the underlying components of this report were “reasonably good” enough to keep the Fed on track to begin tapering its asset purchase program in November.
We believe that the upcoming winter temperatures will be determinative in regard to economic growth rates, as well as the levels and persistence of inflation for at least the intermediate term. We expect interest rates to continue their ascent as inflation proves to be more persistent and higher than generally assumed. The latest energy caused disruptions of supply chains and related price increases will make people aware more generally of the costs and sacrifices that might be needed to achieve the world’s desired zero-carbon emissions objectives.
Decreasing Effects from Delta Variant
Many indicators point to a decrease in Delta variant infections. One of the latest such indications was the much better than expected ADP September U.S. employment report released mid-week which showed an increase of 568,000 private jobs. The service sector comprised over 80% of this total, and the leisure and hospitality sector, which is especially sensitive to coronavirus cases, accounted for close to 50% of all service jobs added. These were very encouraging and surprising news items. The latest and still expansionary IHS Markit U.S. Services PMI for September showed its slowest rise in new business in 13 months, which was driven largely by continued labor shortages. Business optimism in services rose to its highest level since June.
An “unprecedented” build-up of back orders accompanied this optimism. The Chief Business Economist of IHS interpreted these survey results as appearing to signify that COVID-19 infections had peaked in September and that the situation for labor supply and demand should improve as we head into Q4. The better-than-expected ISM services PMI confirmed this observation. Otherwise, these latest surveys reflected the same pattern of slowing growth due to labor shortages, supply constraints and disruptions, materials shortages and rising input costs. In its October 6 report, Goldman Sachs agreed that new cases of virus infections appear to have peaked around Labor Day and that Europe (EU) exhibited similar declines. Another encouraging sign that the Delta variant could be managed and contained rather effectively was Merck’s new promising oral drug to treat coronavirus cases, which was revealed last week.
 The IHS Markit India Services PMI is based on data compiled from questionnaires sent to purchasing executives in around 350 private service sector companies. The index tracks variables such as sales, employment, inventories, and prices.
Source – J.P. Morgan US: Survey sector surveys beat expectations (10/5/2021)
Energy as the New Delta
With such good news, we should now expect an imminent pick-up in global economic growth. Unfortunately, as we expressed in last week’s letter, the negative effects of the Delta variant appear to have already been superseded by energy shortages and high energy prices, which are causing supply disruptions. These energy effects most likely will slow economic growth and prompt higher and more persistent inflation. Unlike increased cases of virus infections, which tend to affect service sectors disproportionately, energy related issues tend to be more disruptive to the production and pricing of goods. Energy related disruptions have the potential to prolong the slowing of economic growth, which will then lead to more persistent and higher inflation rates. This combination will increase the risk of stagflation.
China as an Example
As last week’s letter highlighted, energy-related supply disruptions and constraints have increasingly begun to affect China’s output production as it has led to rationing electricity. In fact, China’s September manufacturing PMI dropped by 1.4% to 49.5. This was the first time since the beginning of the COVID-19 infections outbreak that China’s manufacturing sector contracted. According to Citi Research’s October 5 report, this was mainly due to abrupt power cuts and “dual energy control” policies which disrupted production in many energy-consuming sectors. China has also experienced electricity shortages due to both droughts and flooding within the past 12 months. Like many countries, China has de-carbonization policies in place which target peak carbon emissions growth as well as neutral and/or zero carbon emissions.
In the past few weeks, Europe has received heightened media coverage illustrating disruptive effects that the natural gas prices’ surge had on the continent’s rates of production and increasing inflationary pressures. Again, weather has also played a role in exacerbating EU’s energy and related electricity usage constraints and looming disruptions. EU’s wind-generated electricity production was greatly diminished for months by lower than normal wind flows.
Diminished Energy Supplies and Higher Prices
According to J.P. Morgan (JPM) observations on October 4, as the global economies reopened with easy monetary and fiscal policies, along with “chronic” underinvestment in traditional energy supplies, a combination of strong demand for energy – electricity in particular — and reduction of carbon emissions policies in many countries, have led to decreases in energy supplies and elevated prices. Over the past week, oil and natural gas prices surged to multi-year highs and coal prices hit all-time peaks. As natural gas prices were recently trading at the equivalent of 170% of crude oil prices, some natural gas-sourced electricity producers in Asia and EU, switched to oil sources if they were able to do so.
JPM reports from October 5 and 6, revealed that EU natural gas prices rose as much as 450% YTD before surging another 20% in one day. Natural gas prices continued their dramatic ascent the following day before staging a dramatic reversal. This downward reversal of natural gas prices occurred after Russia’s President Putin agreed to increase natural gas supplies to EU. This, along with Senate Minority leader McConnell’s offer to enable an extension of the debt ceiling of the U.S. government to early December, precipitated a dramatic reversal of equities to the upside.
Source – J.P. Morgan US Market Intelligence: Morning Briefing (10/7/2021)
Source – Citi US Economics: The Daily Update (10/7/2021)
Putin to the Rescue – Really?
Putin’s willingness to increase natural gas supplies was accompanied by his admonishment of the EU for its focus on renewable energy sources and its neglect in further development of more traditional energy supplies. He also highlighted EU’s reliance on spot energy prices in lieu of contractually agreed prices with presumably Russia and/or its state-run company Gazprom. Gazprom is the largest supplier of natural gas to EU and Turkey. Along with its offer to supply more natural gas to the EU, Russia was putting pressure on Germany to approve the opening of its recently completed controversial Nord Stream 2 trans-Germany pipeline, so that Gazprom’s natural gas could begin flowing through that pipeline. Many EU and U.S. representatives opposed the construction of this pipeline for fear of increasing EU’s reliance on Russia to help meet its energy needs. Russia has the world’s largest natural gas reserves, while the U.S. has the firth largest.
Natural Gas issues – Less Obvious Repercussions
It is rather easy to assume that insufficient natural gas supplies and surging prices could impact the cost and reliability of electricity and heating supply. But natural gas is also an example of how energy prices and insufficient supplies can very directly affect inflation and inflation expectations. For instance, natural gas is the primary raw material used to produce ammonia. Ammonia in turn, is the main input needed to produce nitrogen fertilizers, which are widely used in crop production. Lower supply and higher prices for fertilizers could reduce food production and/or make such production more expensive. Even though food prices are not part of core inflation measures, we surmise that they would affect inflation expectations if higher food prices were to persist. Higher inflation expectations inevitably lead to higher inflation.
Winter – Cold or Moderate?
What happens next will be greatly dependent on whether the world has a relatively cold or a moderate winter. According to a JPM October 4 report, China is sufficiently concerned that it has instructed its top energy/power companies to secure energy supplies “at all costs.” Judging by the spike up in natural gas prices, the EU has similar concerns. We are of the opinion that colder-than-normal temperatures in a significant portion of the world this winter will result in energy supply deficiencies. These energy shortages will lead to more supply constraints and disruptions and slower global economic growth, as well as more persistent and higher inflation. If temperatures are sufficiently low, these disruptions could perhaps extend through 2022 as countries try to stockpile energy supplies for another potentially cold winter. If that occurs, stagflation concerns could become a dominant theme. But if most countries experience relatively mild winters, we would then expect our “rolling economic recovery” theme to be more prominently on display. The EU and emerging market (EM) countries would experience more predictable economic growth as they continue to reopen.
In its US Weekly Prospects report of October 1, JPM has observed that in the past three weeks, coronavirus infections have increased the fastest in the states with lower average temperatures, even after controlling for vaccination rates. JPM thought this correlation was such that “each 40 degrees lower average temperature in the past three weeks was associated with a doubling of cases over the same time period.” These effects would only accentuate the cold winter effects noted above.
Source – J.P. Morgan US Weekly Prospects Focus: Watching for a winter wave (10/1/2021)
Outstanding Global Weather Forecaster Needed
An outstanding global weather forecaster could help us forecast the upcoming winter season and help us assess the probability of cold or mild winter temperatures around the globe. If cold temperatures arrive relatively early, we could assume that stagflation concerns would become pronounced. Alternatively, arrival of cold temperatures later in the season could stretch limited energy supplies to sufficiently to meet each country’s needs without too many disruptions and at reasonable prices for the remainder of the winter. We expect higher interest rates under either scenario. To the extent that the upcoming period is characterized as one with stagflation, we would expect the USD to continue strengthening in the intermediate term as global economic growth slows relative to the U.S. economy. More selective stock picking would be required in such an environment.
If the upcoming winter season produces relatively mild temperatures accompanied by relatively subdued energy prices, we expect that our original thesis of a “rolling economic recovery” and reopening would materialize. We would then expect that the USD would generally depreciate in the intermediate term as other economies, especially in EU and EM, would show growing economic growth relative to the U.S. Also, we would then expect Value and Cyclical stocks to outperform Growth and Defensive type stocks. Given the relatively high equity valuations in general and as the Fed reins in its easy monetary policies, selective stock picking will become increasingly important.
ESG Costs – How Willing Are We Really?
Environmental, Social, and Governance (ESG) issues have become increasingly the focus of investors and global governments. In particular, many governments now have expressed targeted goals of peak carbon emissions and zero carbon emissions goals as they become more focused on developing cheaper and reliable sources of renewable energy. The recent energy supply disruptions and surging energy prices increasingly make it clear that there is a cost to developing renewable energy alternatives while neglecting further fossil fuel development. Everything else being equal, de-carbonization policies will lead most likely to higher and more persistent levels of inflation. Given the general global policy goals of zero carbon emissions, we would rather err on the side of assuming higher and more persistent inflation. We are also very inclined to assume that climate change will continue to produce very disruptive future weather patterns that will lead to more disruptions in energy supplies and electricity outages. This will inevitably and periodically pressure and disrupt supply chains.
U.S. Jobs and Fed Taper
As indicated in our prior commentaries, we believed that the U.S. employment gains for September would be sufficient for the Fed to announce the tapering of its asset purchase program at its November 2-3 meeting and to actually begin the tapering within the next two weeks after that meeting. The reason that we were confident in this expectation was that the Fed switched from focusing on the headline employment number to relying more on many possible measures of labor market tightness instead. We believe that the Fed does not want to risk any further delays before starting of its tapering. Furthermore, we believe that, as its conviction wanes in characterizing the current inflation as “transitory,” the Fed now thinks it’s “behind the curve” — too slow in reining in its easy monetary policies.
The below consensus September headline nonfarm U.S. payroll growth of 194,000 vs. expected 500,000 was in the words of Fed Chairman Powell “reasonably good” enough to meet the “substantial further progress test for employment” before tapering would begin. Powell made it very clear at his September 22 press conference that the Fed’s focus had shifted to considering various measures of a “tight labor market.” The drop in the unemployment rate to 4.8% from 5.2%, the better-than-expected hourly earnings increase of 0.6% m/m and 4.6% y/y, the upwardly revised payrolls of the prior two months by an additional total of 169,000, all were indications of a tightening labor market. Furthermore, private payrolls increased by 317,000, while government payrolls declined by 123,000. Education related jobs, both public and private, accounted for a 180,000 decline. Moreover, seasonal adjustments to education-related jobs have been rather unpredictable during the pandemic.
Source – J.P. Morgan US: September jobs report certainly was not a knockout (10/8/2021)
We believe that unusually cold and widespread winter temperatures will lead to many disruptions and constraints of supply chains, which will generally slow economic growth and cause inflation to be more persistent and higher. We anticipate that these constraints will be more disruptive to manufacturing sectors than to the service sectors. Labor markets should likewise be less affected. Given this scenario, we would expect that the Fed would begin to rein in its easy monetary policies at a relatively rapid pace. A slowing economy due to supply chain disruptions derived from insufficient and highly priced energy supplies would not be very responsive to continued very easy monetary policies. We reiterate our expectation that the Fed will begin to taper its asset purchase program in November. We view the shortfall in U.S. September job growth as supply driven. Strong continuing labor demand is substantiated by the underlying data.
A generally cold winter would most likely raise stagflation concerns. On balance, we would expect the USD to appreciate in the intermediate term in these conditions. We anticipate also that more moderate temperatures, which could lead to a more suitable environment for EU and EM countries to grow their economies relative to the U.S., would drive the USD to generally depreciate in the intermediate term. Under either scenario, we also anticipate higher interest rates. We continue to favor Value and Cyclical stocks over more Defensive and Big Cap Quality Growth stocks in the intermediate term. We expect market volatility to continue.
Everything else being equal, we assume that the apparent global preferences for the development of renewable energy sources and the relative neglect of more traditional fossil-based energy sources will lead to more supply chain disruptions and more persistent and higher rates of inflation. Such policies, which often target zero-carbon emissions by specific dates, should also blunt the typical market response of increasing production of fossil-based fuels to meet the higher demand that would be reflected in increasing energy prices. More extreme weather conditions, which many people assume to be caused by human-induced climate change, also should be very disruptive periodically. On balance, such disruptions should only add to inflationary pressures. We continue to expect inflation to be higher and more persistent than generally assumed. We prefer to err on the side of the most probable scenarios as we see them.
Charts of Interest
Source – Goldman Sachs The Post-Pandemic Cycle: Summary October 2021
Source – J.P. Morgan US Market Intelligence: Morning Briefing (10/7/2021)
KBW Nasdaq Bank Index (BKX): The KBW Bank Index is designed to track the performance of the leading banks and thrifts that are publicly-traded in the U.S. The Index includes 24 banking stocks representing the large U.S. national money centers, regional banks and thrift institutions.
MSCI EM Value Index: The MSCI Emerging Markets Value Index captures large and mid cap securities exhibiting overall value style characteristics across 27 Emerging Markets (EM) countries.
MSCI EM Index: The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.
NASDAQ: The Nasdaq Composite Index is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.
PCE: Personal Consumption Expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time.
Russell 1000 Growth: The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted and historical growth values.
Russell 1000 Value: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected and historical growth rates.
S&P 500: The S&P 500 Index, or the Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S.
VIX: The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.
Z-Score: A Z-score (also called a standard score) gives an idea of how far from the mean a data point is. It is a measure of how many standard deviations below or above the population mean a raw score is.
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