Q3 - October 2021
Quarterly Commentary
We held more cash during the quarter, as we have been concerned with how the market would respond to a shift in Fed policy, and we expect some disappointing news when earnings season comes around given the continued supply chain issues and pricing pressures. This proved to be helpful during the 3rd quarter as volatility perked up and the indices drifted lower in September. As a reminder, we sell a stock if we determine that it is fully valued, our reason for owning it has passed, or if it is inconsistent with our macro-outlook. On that last point, prior market cycles have taught us that some stocks simply do better or worse in certain environments.
Other than CEOs flying to space and troubling news about China’s real estate companies, inflation has been the most discussed topic in the markets for the past several months. Consumers are seeing it in the checkout line and at the gas station, and businesses are seeing it in the cost of labor and in the price of goods that they order to make their products. The word “inflation” was said 63 times on the restaurant distributor US Food’s second quarter earnings call in July. It was mentioned just 5 and 6 times on their second quarter calls in 2018 and 2019. While the price of many things is elevated, the surprise factor is what is most noteworthy. As the chart below illustrates, no one expected inflation to be this high. Fed Chairman Powell has pointed to the “supply-side constraints” ¹ as the source of the inflation, which his team believes will be transitory. Since the Fed did not see this coming, the market has grown skeptical that the word transitory might mean, for a while or even longer. Regardless, the Fed now feels compelled to act, and they have signaled that they will begin to pull back on their monetary stimulus.
What does that mean for the markets? The Fed’s first step will simply be to slow the pace of growth of its balance sheet (they buy securities to lower interest rates, which increases the value of certain assets). Their balance sheet has expanded by $4.1 trillion dollars in a year and a half, and it will continue to grow even into the new year. To put this round of stimulus into context, in response to the Great Recession a decade ago, the Fed increased its balance sheet by $3.5 trillion dollars over a six-year period. You can see the effects of their recent effort when you look at the housing market. Today, the 30-year mortgage rate is below 2.9%, down from 3.7% at the end of 2019, and the average existing home goes for $363,000, up more than 30% over that same time. While the pandemic may have reprioritized our own space and homes have become more of a personal sanctuary, the Fed’s stimulus has had a direct effect on this market and many others like it. Rates went down and prices went up. To be clear, we do not expect rates and prices to necessarily go back to their prior levels. In theory, the Fed’s goal is to step in during times of stress and step out as natural supply and demand forces return. While many parts of the economy are still far from normal, in aggregate the US economy surpassed its pre-pandemic level in the second quarter, a first among the major countries. The market’s concern is how smooth this transition will be.
How have we positioned the portfolios? In general, we are avoiding areas of the markets that we feel are over extended, and we are focused on companies or parts of the economy that will benefit from a further recovery. That statement might sound a bit broad, so I will narrow it down some by saying that we have de-emphasized or reduced positions most dependent on low or falling rates. At the same time, we see areas of the economy that are still recovering or companies that are continuing to grow, AND importantly are attractively valued.
Tyler Pullen, CFA
Portfolio Manager
¹ Policy Panel discussion before virtual ECB Forum on Central Banking on Sept 29, 2021
² Cross Country Healthcare’s 2nd Quarter, 2021 Earnings Press Release, August 4, 2021
Past performance does not guarantee future results. Market conditions can vary widely over time and can result in a loss of portfolio value. In accordance with the rules of the Securities and Exchange Commission, we notify you that a copy of our ADV, Part 2A filing with the SEC is available to you upon request.