{"id":482,"date":"2021-10-14T19:19:06","date_gmt":"2021-10-14T19:19:06","guid":{"rendered":"https:\/\/winthropcm.com\/reports-and-profiles\/?p=482"},"modified":"2021-10-14T19:23:36","modified_gmt":"2021-10-14T19:23:36","slug":"4q-economic-capital-market-outlook-2","status":"publish","type":"post","link":"https:\/\/winthropcm.com\/reports-and-profiles\/4q-economic-capital-market-outlook-2\/","title":{"rendered":"4Q Economic & Capital Market Outlook"},"content":{"rendered":"\n

One World, Two Forms of Capitalism<\/strong><\/h4>\n\n\n\n

Picture this: a world with two different capital market systems. One is a group of countries organized around shared values of pluralism and representative government, connected through a set of established rules that each country agrees to abide by for trade, economic support and financial system integration. This system is intended to operate for the benefit of the group.<\/p>\n\n\n\n

The other system is a group of countries that exist under a more autocratic rule. The rules of law appear erratic and are not well known to their citizens or business leaders. The government dictates the terms for trading with other countries, the financial system is not integrated with the global financial system, and the system is designed for the betterment of the country\u2019s government.<\/p>\n\n\n\n

For many years, we believed that the world was moving toward one capital market system, a system that would operate to the benefit of the entire world. However, over the past five years we have moved firmly into the camp that the world will exist under two capital market systems. The first system reflects the Group of Seven and the World Trade Organization and includes the United States, Canada, Japan and Europe. The second system is a form of capitalism promulgated by China and Russia. We believe China has no intention of ever conforming to the existing world order for trade, intellectual property rights, dispute resolution and financial system integration. They view the rules of that system as unfairly favoring the United States. Instead, they will continue to exist as an independent system and will integrate when it bests suits their needs.<\/p>\n\n\n\n

Over the past year, President Xi Jinping\u2019s hard line Communist party has taken aggressive steps to reign in the technology and business leaders that have, up to this point, operated under the more democratic ways of Hong Kong. Following the pro-democracy protests in China that culminated in Tiananmen Square in 1989, the Communist Party took steps to liberalize and soften its rule of law over its people. There were initiatives to allow entrepreneurs to build businesses and wealth. In fact, since the early 2000\u2019s, China has been one of the recognized world leaders in technology through an intentional, planned initiative supported by research and development and commitment to education.<\/p>\n\n\n\n

However, this period of liberalism has come to a close. China has moved to rein in its business leaders and remind citizens that the Communist Party (and the people) should benefit in this success, which is consistent with the roots of communist China. Censorship and oversight of its people has always been a part of China\u2019s governance. However, this is a new era where a hardline communist government has the keys to the car of some of the largest, most successful technology companies.<\/p>\n\n\n\n

Having large, successful companies in China is important to the Chinese Communist Party in order to compete with the United States and gain the respect of the world. Therefore, we do not believe that China aims to destroy their technology companies. China\u2019s leaders understand that corporate profits can drive the party\u2019s initiatives, grow the middle class, and promote party leaders to influential positions. However, the communist party comes first. China\u2019s leadership has other structural challenges to deal with including its debt laden real estate sector and slowing economic growth. However, for the long-term investor, this is a buying opportunity for China stocks.<\/p>\n\n\n\n

\u00a0The Economy<\/strong><\/h4>\n\n\n\n

The base case for our asset allocation and investment strategies this year was centered on a recovery following the pandemic as consumers take advantage of a reopened economy. Armed with stimulus money from the federal government during the peak of pandemic and employees working remotely, we believed consumers were ready to spend, providing fuel for sustained economic growth.<\/p>\n\n\n\n

We believed that that the vaccine would be effective in controlling the spread of the virus. However, we did not anticipate that large groups of citizens would not want to take the vaccine. The United States is trailing other developed countries in vaccination rates, including Germany, Italy and Japan.<\/p>\n\n\n\n

As a result, the economy is experiencing a reluctant re-opening. However, there is evidence of the economy moving back to \u201cnormal\u201d as restaurants and hotels reopen, students are attending classes in person, and sporting events are back to schedule. On the other hand, business travel is still low, conferences have been cancelled or postponed, and companies are pushing back the time for employees to return to the office.<\/p>\n\n\n\n

Consumer spending edged higher in August, with personal outlays rising 0.8% for the month. The consumer continues to benefit from government assistance handed out during the pandemic. The high level of savings and robust job market will support higher incomes and spending into the fourth quarter.<\/p>\n\n\n\n

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However, the job market hit a wall last month as the September jobs report from the Labor Department showed the slowest pace for the year due to the impact of the Delta variant on economic recovery. The economy created a mere 194,000 jobs in September, down from 366,000 in August. At the same time, the unemployment rate dropped from 5.2% to 4.8% month-over-month, largely explained by the number of people that left the labor market. The labor force participation rate declined to 61.6%. <\/p>\n\n\n\n

\"\"<\/figure><\/div>\n\n\n\n

We are currently experiencing a massive labor shortage, which is affecting manufacturing assembly lines, restaurants, financial services, and hospitality. As a result, businesses are offering higher wages which, in turn, will support the higher inflation thesis. Companies want to ramp up production, open their restaurants, and hire employees to work in their stores, but they can\u2019t find workers.<\/p>\n\n\n\n

The issue lies with labor supply, not demand. Ultimately, the labor shortage will slow revenue growth and crimp profit margins for companies that are unable to build out the infrastructure to meet demand.<\/p>\n\n\n\n

Monetary Policy<\/strong><\/h4>\n\n\n\n

Investors are facing three major issues heading into next year concerning domestic monetary policy and its impact on investment strategy.<\/p>\n\n\n\n

  1. The Impending End to Quantitative Easing<\/strong> – Federal Reserve Chairman, Jerome Powell, has clearly indicated in statements this past month that the Fed will soon begin to reduce it open market purchase program, which has helped to support low interest rates and provide liquidity to the capital markets. The Fed has grown its balance sheet to over $7.5 trillion since it has purchased $120 billion in bonds per month since the pandemic. The Fed is not expected to abruptly end its open market purchase program. Instead, the Fed has indicated that it will begin to \u201ctaper\u201d its purchases, beginning as early as November. Ultimately, this will lead to an elimination of the current purchase program, \u201cQE 4,\u201d and set a path for interest rate increases beginning in early 2023. If the Fed has its way, interest rates will rise. Quantitative easing is a powerful tool to support monetary policy, and we would expect to see the next installment of \u201cQE 5\u201d if the economy stumbles.\u00a0<\/li><\/ol>\n\n\n\n
    1. Inflation is a reality –<\/strong> The Federal Reserve has called this inflation \u201ctransitory\u201d but never provided a clear definition of what transitory means. The Consumer Price Index has increased over 4% in the past year, and consumers are feeling the rise in price. Over the past 15 years, the Fed has struggled to get a sustained rate of inflation at 2%. However, following the pandemic, we are experiencing several one-time events as the result of consumer behavior, government spending programs and trade disputes. These events include supply chain disruptions, rising raw material costs, labor market shortages and a rapid increase in home prices across the United States.\u00a0\u00a0<\/li><\/ol>\n\n\n\n

      We believe inflation will run higher than the Fed\u2019s target of 2% for the next several quarters until the supply chain dislocations and the labor market imbalances normalize.<\/em><\/p>\n\n\n\n

      \"\"<\/figure><\/div>\n\n\n\n

      With the highest level of inflation in ten years and the yield on the ten-year U.S. Treasury note now trading at 1.5%, the current rate of inflation has resulted in negative domestic real interest rates. Investing in the safest security does not keep up with the pace of inflation. The fear of rising interest rates is contributing to heightened volatility in the equity market as concerns of rising raw materials costs, rising labor costs and supply chain disruptions chip away at profit margins. We expect these concerns will likely bleed over into the fourth quarter and next year. <\/p>\n\n\n\n

      \"\"<\/figure><\/div>\n\n\n\n
      1. The Potential Change in the Fed Chairman Seat – <\/strong>Federal Reserve Chairman Powell may be six months away from a forced retirement. A Trump appointee following Janet Yellen, Powell\u2019s initiatives to liberalize and roll back some of the bank oversight rules following the Financial Crisis of 2008 have raised the ire of Elizabeth Warren and other democrats. We do not consider this to be a major risk to the Federal Reserve\u2019s initiative to begin to pull back its aggressive monetary policy initiated during the pandemic, but the impact of a leadership change during the current course to taper is worth consideration. The capital markets prefer stability, and historically, they do not react well to unexpected change.<\/li><\/ol>\n\n\n\n

        China<\/strong><\/h4>\n\n\n\n

        So far this year, the performance of Chinese equities is down -40% after the government had initiated a wave of antitrust and regulatory actions and taken steps to reign in its technology companies. Any investor that has been active in the global financial markets over the past 30 years should not be surprised by the actions of the communist party against Chinese companies this past year. The roots of communist China are authoritarian, not democratic. While there was a wave of liberalism following Tiananmen Square protests in 1989, hardline communists have continued to push back toward traditional communist party values.<\/p>\n\n\n\n

        China operates under a different system of authoritarian capitalism and securities laws than the United States. As a result, the government has a say in the financial decisions of its businesses and can influence the amount of debt a business incurs. It can restrict foreign investment in its companies, does not require consistent auditing of financial statements and does not allow outside parties to inspect the financial statements of its companies. In addition, over the years, securities enforcement has been arbitrary and inconsistent. Due to the lack of transparency, China has always been a difficult place to invest.<\/p>\n\n\n\n

        What changed?<\/em><\/strong><\/p>\n\n\n\n

        Following the Tiananmen Square protests and pro-democracy movement in 1989, the communist party began to take a more tolerant approach toward business. Technology research and development was prioritized by the party. Then, in 1997, Great Britain returned Hong Kong to China in return for terms guaranteeing a 50-year extension of its capitalist system. Great Britain had seized Hong Kong as part of the Opium Wars in the mid-1800s and developed the territory over 100 years as a British colony. As a result, Hong Kong\u2019s government and business developed under the British rules of democracy and capitalism. We liken Beijing to the \u201colder sibling\u201d of Hong Kong \u2013 jealously watching as \u201cmom and dad\u201d allowed the younger sibling to get extra dessert, stay out later, and watch movies that you weren\u2019t allowed to watch.<\/p>\n\n\n\n

        After attempting an extradition law that threatened the foundation of Hong Kong\u2019s democracy, China had lost tolerance for Hong Kong\u2019s democracy, and in June 2020, decisively took control by requiring all election candidates to be approved by the Chinese party. Under the leadership of Xi Jinping, China\u2019s communist party is moving back to the traditional roots of Mao Zedong and the socialist ideology that Chinese citizens benefit together. However, the party not abandoning the businesses that were built. On the contrary, these successful businesses are very important to China and the party\u2019s desired position in the balance of power in the world. According to Forbes, China now has the second highest number of billionaires at 698, behind the United States at 724.   <\/p>\n\n\n\n

        China has been intentional at building out its technology capabilities to compete on a global basis. China now has cutting edge technology and capabilities in conventional areas such as electronics, machinery, automobiles, and high-speed railways. The country is building out its aviation capabilities and is a few years away from manufacturing private aircraft. China is also pushing technological innovations in emerging areas such as new and renewable energy, advanced nuclear energy, next generation telecommunication technologies, artificial intelligence, and robotics. With the new space station, China is making significant gains in its space technology. <\/p>\n\n\n\n

        Equity<\/strong><\/h4>\n\n\n\n

        Despite a rocky September, performance for the third quarter ended with positive returns for the major equity benchmark indices. For the third quarter, both the S&P 500 and Nasdaq increased by 0.40%. The Dow Jones Industrial Average was up 2%. The major equity indices are still showing solid performance for year, with the S&P 500 leading the way at 15% year-to-date. The Technology sector continues to be volatile as the 10-year Treasury rate rises and is underperforming the broad market. With the high concentration of Tech companies in the S&P 500, this sector continues to be a big contributor to the performance of the index.<\/p>\n\n\n\n

        The Covid Delta variant has impacted the re-opening of the economy and dislocated supply chains, which will weigh on earnings estimates as growth and margins are highlighted this quarter. Companies in the Consumer Discretionary, Industrials, and Consumer Staples sectors will be most impacted by the supply chain disruptions. Today, auto companies are struggling to source parts to assemble cars and retail stores cannot get electronics, games and toys into the United States to sell for holiday shopping season. The \u2018just in time\u201d inventory management process pioneered by the Japanese auto industry in the 1970\u2019s and adopted across most manufacturing today illustrates how management has put revenue and profits at risk when companies when the supply chain breaks. <\/p>\n\n\n\n

        There appears to be a severe disconnect between the valuation of many of these stocks and the underlying fundamentals. Ford stock currently trades at $15.12 per share and 18.7 times earnings. However, the company announced at the end of June that it was cutting vehicle production due to the ongoing chip shortage. A recent report published by AlixPartners indicates the global auto industry is on track to lose 77 million vehicles worldwide in 2021 due to the chip shortage, representing 10% of production this year. The shortage will likely carry over into next year. We expect the supply chain disruptions will persist for several years, and at some point, we expect revenue to decline and margins will get pinched at the auto companies.<\/p>\n\n\n\n

        Current earnings estimates for the S&P 500 for the third quarter are about $48.26, marking a 3% increase quarter-over-quarter and a 15% rise from last year\u2019s third quarter. The 12-month earnings estimates for 2021 continue to hover around $200, which still reflects an incredible recovery from last year\u2019s pandemic.<\/p>\n\n\n\n

        Fixed Income<\/strong><\/h4>\n\n\n\n

        Interest rates traded higher over the second quarter as a culmination of economic data and macro narratives shifted. The Fed has announced that it will soon begin the long process of withdrawing its monetary stimulus, supply chain disruptions are weighing on economic growth, China\u2019s largest real estate firm The Evergrande Group is set to default, and equity market volatility is increasing. The signals from the Federal Reserve are enough for rates to drift higher, and the 10-year U.S. Treasury rate increased to above 1.50% near the end of the quarter.  A controlled tapering program will remove the backstop of the Federal Reserve\u2019s balance sheet and set the stage for higher interest rates. However, if the Fed begins to tighten when the economy is begging to slow, they will risk a policy mistake, which could be disruptive for investors. At the same time, the risk of a slowing economy puts a ceiling on how high rates can actually move.<\/p>\n\n\n\n

        \"\"<\/figure><\/div>\n\n\n\n

        The credit markets have been extremely resilient through the recent equity volatility in the third quarter. Despite the VIX rising above 25 and stock prices trading lower, investment grade credit spreads have remained unchanged. High yield spreads have increased by only 5bps during the past two weeks. Typically, we would see a more meaningful widening in spreads as the equity markets decline. However, bond investors are so hungry for yield that they are not selling bonds. We expect the credit sectors will outperform treasuries heading into the end of the year, which would hold especially true if we continue to see interest rates rise. Regardless, the shift in equity volatility solidifies the importance of fixed income in an asset allocation that provides both a non-correlated return stream and dry powder to redeploy into stocks if valuation improves in a market sell off.<\/p>\n\n\n\n

        This report is published solely for informational purposes and is not to be construed as specific tax, legal or investment advice.  Views should not be considered a recommendation to buy or sell nor should they be relied upon as investment advice.  It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.  Information contained in this report is current as of the date of publication and has been obtained from third party sources believed to be reliable.  WCM does not warrant or make any representation regarding the use or results of the information contained herein in terms of its correctness, accuracy, timeliness, reliability, or otherwise, and does not accept any responsibility for any loss or damage that results from its use.  You should assume that Winthrop Capital Management has a financial interest in one or more of the positions discussed.  Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.  Winthrop Capital Management has no obligation to provide recipients hereof with updates or changes to such data.<\/em> <\/em><\/p>\n\n\n\n

         <\/em>\u00a9 2021 Winthrop Capital Management<\/em><\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

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