Full Steam Ahead?
So far, the economic rebound has largely withstood the twin surges of the Delta variant and inflation. Will that continue?Download PDF
On Sept. 17, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on market action in July, expectations for Fed tapering, opportunities in fixed income, and the effect of the Delta variant on the economy.
In August, we saw equities again move up while bonds dropped under a headwind of higher rates. What insights do you take away the market performance?
In June and July, the narrative was the consumer had money from stimulus, they’re ready to spend, and the economy was expected to move substantially—and it did. But in August, we continued to have supply-chain issues and the Delta variant surge. Plus, the effect of stimulus earlier in the year was waning. As a result, the growth is plateauing, and you’re starting to see reduced expectations for GDP growth.
Even so, the equity markets performed well in August. The S&P 500Index was up over 3% and is up over 21% this year. Russell 1,000 Growth Index was up almost 4% and up over 20% for the year. Amazon, Microsoft, Google, and Apple all outperformed.
I think a lot flows are driving performance, but you still have an accommodative Federal Reserve and an economy that is posting above 5% growth. On the margin, there are some headwinds emerging, but again, liquidity is good, the Fed is supportive, and the economy is doing well.
What else stood out for you in August’s performance?
The NASDAQ hit 15,000 the first time ever. From a historical standpoint, back on March 7, 2000, the NASDAQ hit 5,000. It took 17 more years for the NASDAQ to hit 6,000 and is up 150% since. Also, an amazing decade-long performance can be seen in the PHLX Semiconductor Index (SOX), which is up over 1,000% over the past 10 years. On the flipside, the Energy Select Sector Index is up less than 5%over the past decade.
How did the fixed-income side do in August?
You’re seeing mixed signals as this push-pull between transitory vs. sustainable inflation, effects of potential Fed tapering, and a strong economy vs. the Delta variant are driving forces.
What opportunities do you see in fixed income for the balance of the year?
At this point, it is mostly about coupon clipping. The beauty of credit is there’s a strong backdrop. Companies are generally healthy despite the pandemic-related challenges. You still have this whipiness with inflation and that narrative on the flattening of the curve or steepening of the curve. That seems change every month or two, in my opinion. In an effort to mitigate some of that whipiness, you can stay short on the duration side to defend against inflation threats, but I would stay in credit. As a result, short-duration credit still remains a great way to be defensive against fears of inflation or stagflation.
It looks like the Fed is finally set to announce its long-awaited to intention to taper. So how does this likely play out in capital markets?
In late August, the Fed held their Jackson Hole Economic Symposium. Regarding tapering, Chair Powell’s view was that “substantial further progress” test the Fed laid out earlier had been met for inflation. He went on to say, “There has also been clear progress toward maximum employment.” For those Fed watchers, saying “clear” versus “substantial” is enough to taper, but probably it isn’t enough in his mind to increase rates. I think that’s the market’s base case. Expect the Fed taper announcement either September or November.
Given this, I don’t think everyone should take it for granted that once the Fed begins tapering, rates are going to go up. In fact, if you go back to previous times when the Fed was tapering, the economy ends up having slower growth, and rates end up being lower. From a technical standpoint, there is a buyer that is reducing their purchases, but monetary conditions may tighten and, as a result, you end up having lower rates. What’s different this time is we dumped a truckload of stimulus into the economy relative to previous tapering situations.
Can you address a topic on everyone’s mind: Is the recent rise in inflation transitory or here to stay for the foreseeable future?
I think we’re in a stagflation environment right now. We’ve heard that term thrown around over the decades, but when you think about it, we have inflation surging, but growth isn’t necessarily surging at the same velocity. In this environment, demand is high, and supply is constrained, leading to inflation, but not as robust overall growth.
The Core Personal Consumption Expenditure Index, which is a primary index the Fed uses, is at the highest level in 30 years. It measured3.6% annualized in July. Is this rise in inflation transitory or not? That’s obviously up for debate and something that only time will tell. I looked at the Institute of Supply Management (ISM) August report, and there are some interesting comments coming from various industries. One comment from a transportation company was that “sales were strong, but production is limited due to supply issues with microchips.” Another comment from a food company: “supply-chain functions have been relentlessly challenging, and already constrained labor forces have been further exacerbated by COVID-19 absenteeism plus high prices everywhere were wearing down their employee base.” Another food company said it continues to be unable to hire hourly personnel due to few applicants.
So, the root cause of this inflation element is supply constraints, which is still a sign of the COVID/Delta variant effects.
The August jobs report showed fewer added positions than expected. How should we think about the jobs situation at this point?
As it relates to the most recent jobs report, The Street expected jobless claims to be about 335,000, and they came in at about 310,000. Just to give you some context, a year ago, jobless claims were over 800,000. We’ve seen continuous improvement. That’s a good indicator of the strength of the economy. On the margin, I would expect labor constraints to ease a bit because of the expiring extended unemployment benefits from the CARES Act. At the same time, I think that the supply constraints due to global issues around the Delta variant and COVID will probably go into next year and maybe longer, which partially limits job opportunities.
We’ve said that the Fed’s inflation targets are enough to provide the runway for tapering and maybe even from the standpoint of being able to raise rates. Now the Fed’s focus is on jobs and max employment. I think jobs are going to be what people who are concerned about Fed action certainly want to pay attention to.
What stands out to you now when looking at individual sectors of the market?
In the auto sector, for anybody who has tried recently to buy a used car or new car, I’m sure your eyes might be popping or jaws dropping on some of the used-car prices or markups over MSRP. Essentially, if you had asked these auto makers three months ago, “How do you think things are going to be by the end of summer and into fall?” I think most expected that it would start to loosen up. However, what has happened, this is from a Morgan Stanley analyst, “Our own checks corroborate that the tightness is intensifying at a time that we would have expected shortages to moderate.”
And the theme that you’re hearing now is that the semiconductor shortage is now expected to go into next year. The question is: Will there still be an issue in the second half of next year and even into 2023? Right now, that’s uncertain. Microchip shortages will be in play the rest of this year. It’s now even uncertain if these shortages will be eliminated by next year. That is a shift from the narrative two to three months ago.
I’d like to do a speed round with you. I’ll give you short questions, phrases or even a word, and you give me the shortest answer you can. Ready?
Let’s give it a go.
Will Fed Chair Powell be nominated for a second term?
Yes, I believe he gets nominated.
Biggest secular shift caused by COVID?
Easy. Work from home.
Will there be vaccine availability for ages 5 through 11 by the end of October?
I believe it will be later due to the FDA requesting more information.
Oh, maybe not November. The best answer I have is after October. I hope I’m wrong and it’s sooner.
Will the $3.5 trillion spending bill be passed in October?
I’ll say no.
The next variant to worry about?
I would have given a different answer two days ago, but our latest “Getting Credit” podcast is with Evercore ISI analyst Umer Raffat, and I now firmly say it’s the Delta-plus variant. It is something that hasn’t caught much press yet.
Give me a few more details why.
Right now, it really hasn’t arrived in the States. It’s emerging out of Asia. Umer’s view was that it’s as contagious as Delta and able to evade vaccines better than Delta.
Last question and it’s a changeup: Favorite “Ted Lasso” quote?
Yeah, best show on TV! My favorite quote is: “Be curious, not judgmental.” That comes from one of the series’ best scenes (Season 1, Episode 10) for those who are—or want to be—Lasso fans.
That also sounds like an effective quote in the investing world, for sure. Before we end this interview, can you give us a personal reflection?
A week ago, I dropped off my son at college. He is now a freshman at the University of Wisconsin-Madison, and it’s going to be a great place for him.
As he and I reflected I felt my primary role as his dad has been to be a person who tried to instill discipline and accountability. But now the world’s going to keep him accountable, so he doesn’t need me and the world keeping him accountable. My role is more guidance, advising, and being his champion now. It’s going to be a different relationship, and one I look forward to. I think it will be a much more fulfilling relationship, but my role is going to be different because it needs to be different, because the situation has changed.
I needed to make a change and have embraced it.
One basis point is equal to 0.01%.
Bloomberg Barclays U.S. Aggregate Bond Index is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
Core Personal Consumption Expenditure Index refers to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs, and the PCE Price Index reading are released monthly in the Bureau of Economic Analysis (BEA) Personal Income and Outlays report.
Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.
Energy Select Sector Index provides an effective representation of the energy sector of the S&P 500 Index.
High-Yield is represented by Bloomberg Barclays US Corporate High-Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market.
Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.
Loans are represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. senior secure credit (leveraged loan)market.
The PHLX Semiconductor Sector Index (SOX) is a modified market capitalization-weighted index composed of companies primarily involved in the design, distribution, manufacture, and sale of semiconductors.
Nasdaq (National Association of Securities Dealers Automatic Quotation System) stock market is a global electronic marketplace for buying and trading securities, listing over5000 companies.
The Russell1000 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-value ratios and higher forecasted growth values.
The Russell2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.
The S&P500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
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