Runway for Cyclicals and Q3 Themes

By TRG Advisors on October 3, 2021

The third quarter ended last week with more market volatility and significant company sentiment around struggling ability to absorb persistent pricing pressures driven by supply chain issues. Growth names meaningfully underperformed value last week on better economic data, higher inflation readings and higher bond yields.¹ The 10-year bond yield in September rose 42 bps which helped the financial services sector, which is a big part of the value benchmark. Last week several companies lowered guidance due to the supply chain complications and we expect this will be the theme during Q3 and Q4 earnings reports. Pricing power and cost controls will be extremely important for companies to offset the higher input costs. A lot of this is already known with several sectors and stocks down 10-20% from their highs. Guidance will be key, as usual. Supply chain issues are transitory but the timing is unknown on resolution. As a result we have extra cash on hand to buy any dips in the market.

Following seven consecutive months of the S&P 500 in positive territory and without a 5% correction for 227 straight days, the index broke both those streaks last week. According to Sundial Capital, only ten streaks of greater than 200 days without a 5% correction have occurred in history (since 1928), and post-correction, the index was up 9/10 times with a median gain of +2.4% in two months. Additionally, the VIX indicator suggests peak volatility is in the rearview for 2021 and various indicators suggest an oversold market. Even as the S&P 500 sold-off, other market indices with smaller market caps, broader exposures and lower relative valuations stood resilient.² This suggests a solid risk/reward scenario for investors in Q4, especially in the re-open and recovery themes. Market discounts for a natural slowdown in growth of the recovery, which has hampered Q3 performance of sectors like financials and industrials, provide opportunities.

Importantly, many companies have indicated that demand has remained well above trend which is good news. A lot of this is directly related to an above trend growth in GDP and higher inflation. Specifically, the consumer remains strong with higher wages, better jobs (if they want them), a 9.4% savings rate and real pent up demand. Retail Sales is now 10% above pandemic levels. We expect the services side of the economy to be the driver to above trend growth this year and next. On the manufacturing side, Durable Goods are stronger than expected and the Industrial Production new orders component are now up 15 consecutive months above 60. This is important as it is a leading indicator for earnings.

Q4 typically provides strong seasonal tailwinds for cyclicals and specifically retailers. A rising rate environment favors value over growth, companies with strong balance sheets and secular growth strategies. Impacts from COVID in Q4 remains uncertain, though progress continues to give us optimism.

Market participants and The Fed have spent the past months navigating inflation and trying to determine what is transitory vs. what is not. While a significant share of the supply chain cost pressures are probably transitory (i.e. higher freight costs, commodity shortages from high demand), others such as wages and rental costs are stickier.³ As consumer demand stays hot and costs remain high, The Fed has shifted its timing of tapering its monthly bond purchases to November/December. Importantly, they don’t expect to raise interest rates until mid 2022 or early 2023.

Inflation will be key to watch going forward. The core PCE rose 6.1% y/y in August, well above the Fed’s 2% target rate. Again, we believe much of the inflation is not transitory but will be focused on all data points on this subject.

Meanwhile, in the world’s second-largest economy, Beijing saught to reign in corporate power across many industries, from education to casinos. As they limit corporate power they also slow down economic growth. Risks to the Chinese property sector, energy shortages and an unexpected contraction in China factory activity in September contribute to a cautious outlook for the region.

1. Yields Higher, Spreads Wider. Despite seemingly big news Friday of a preventative Covid pill developed by Merck, Treasury yields closed lower – likely driven by the Fed’s intervention. High yield and Investment Grade sold off on the week, with spreads widening 12 and 3 basis points respectively. Municipals also sold off for a second straight week (3-5 bps on the front, 8-10 in intermediate/long), but due to inflows in 71 of the past 72 weeks, have lagged Treasuries’ broader move higher.
2. Divisive Politics in Washington. A lot of negativity surrounding the current political environment is contributing to mixed economic sentiment. There’s anger within party lines, with the bipartisan infrastructure bill stuck in the House, as progressives and moderates argue over spending capacity and progress on other bills. The debt ceiling looms and the issue will likely continue to be kicked down the road and contribute to more market uncertainty. The path to additional fiscal stimulus is bumpy to say the least, at a time when easy monetary stimulus is set to tighten and demand for infrastructure and labor is high in many sectors like energy, transportation, education and health care.
3. Energy Prices Soaring. OPEC+ and its ability to increase energy capacity and supply will be the most significant factor for oil and natural gas markets in the coming months, with limited ability to increase capacity in domestic markets due to capital allocated towards new energy infrastructure projects that don’t yet yield the necessary supply for winter demand. Coal plants have been shut down around the globe, as countries push forward a green agenda and curb greenhouse gas emissions. Regions around the world, led by Asia and the EU, have low reserves and are at severe risk of power outages. The low supply is likely to strain the energy grid and household wallets this winter.
4. The Week Ahead. Tuesday: Final PMI Services and PMI Composite, Non-Manufacturing ISM report. Wednesday: ADP Employment Survey. Friday: Nonfarm Payrolls and Hourly Earnings.

Returns for Selected Indices ⁴

¹Chart: FactSet
²Chart: FactSet
³Chart: FactSet
⁴Source: Bloomberg