The Economy

As we approach the end of the third quarter, we are stepping back to look at a few primary variables in the economy and investment markets. We have prioritized and outlined our thoughts and investment initiatives.

1. The Delta Variant – In spite of the re-opening, economic growth is slowing. The spread of the Covid variant has negatively impacted the re-opening of the economy. As a result, business travel and conferences are slow. Workers returning to the office has been postponed or delayed. Stocks of Disney, Carnival Cruise, and Delta are trading off their highs. The Delta variant has changed the calculus of reopening the economy. In the absence of another round of federal assistance, we expect more small businesses including restaurants, dry cleaners, gyms and nail salons will close.
2. Monetary Policy – In its statement last week, the Federal Reserve indicated that it may begin reducing its bond purchase program as early as November. The aggressive monetary support is coming to an end; however, the Fed indicated that it does not intend to push short term interest rates, which are currently trading at zero, higher until 2023.
3. Inflation – Inflation, measured by Core-CPI is running over 4%. The Fed has long desired for inflation to exceed two percent. Following the pandemic, supply chain disruptions, raw material shortages, trade conflicts and dislocations in the economy have collided to push inflation above the Fed’s target. The Fed is calling the heightened inflation “transitory.” We expect it will take the better of two years for the rate of inflation to adjust back to the Fed’s target.
4. China – China has been aggressive over this past year at increasing regulation at targeted companies and industries that it believes are out of line with the party’s priorities. Companies operating in a number of industries, including education, gaming, digital media, and retail, have been targeted by the government. The theme of the targeted crack down is the communist party’s version of “China First,” which means the company should be aligned with the communist party, and not western values.
   • China will let its largest real estate developer, China Evergrande, Group fail. This will be the largest bankruptcy in modern China’s history.
5. Valuation – Stock prices are trading at 33 times earnings measured by the S&P 500.

Equity

The stock indices sold off hard on Monday to start the week, but they ended the week positive as the S&P rallied to finish up 0.50%. For the year, the S&P is up 18.62%, the Nasdaq is up 16.65%, and the Dow Jones is up 13.69%. Cryptocurrencies were unable to make up their losses as China announced that Bitcoin transactions were illegal, sending BTC down over -10%. Both Nike and Costco reported earnings last week, giving us insight into potential supply chain issues across both of the consumer sectors.

Nike Inc [NKE]
Nike reported earnings of $1.16, beating estimates by 4 cents. Revenue was up 16% year-over-year, but it missed estimates by $220 million. Direct sales were $4.7 billion and up 28%, while digital sales were up 29%. The sales performance was led by a 43% increase in North America. Gross margin expanded 170 basis points from last year, and cash grew to $13.7 billion from the prior quarter. The stock experiences a tough sell off, as shares were lower by over-6% due to the revenue miss on global supply chain issues. Shares are up 6% for the year, which is underperforming the consumer discretionary sector by -9%. Although the short-term outlook may be concerning due to supply chain issues, we continue to believe in the company’s long-term drivers, as Nike’s innovation and demand trends are still very strong.

Costco Wholesale Corp [COST]
Costco reported earnings of $3.90, beating estimates by 36 cents. Revenue was $62.69 billion, up 17% year-over-year and beat estimates by $1.23 billion. The company reported comp sales growth of 15% in the U.S. and 20% in Canada, with e-commerce sales rising 11% during the quarter. Membership fees were 37% higher than the prior quarter. The stock was up over 3% on its strong results. Costco is now up 24% year to date, and up 44% over the last 12 months. The stock is outperforming the staples sector by 20% this year.

Fixed Income

A central bank taper is coming and, the indication of higher rates is not far behind. Interest rates reversed their recent return to declines. The 10-year U.S. Treasury increased 15bps during the week to 1.45%. Now, the focus shifts to whether the Fed is about to begin pulling back on stimulus just as the economic recovery is beginning to slow. Supply chains are beginning to become locked up again. The economy is not opening as quickly as originally expected. The reality we are facing is that a premature tightening in monetary policy could choke off the economy before it truly becomes strong enough to sustain itself.

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