Supply Chain Reactions
Large supply-chain bottlenecks and labor shortages continue as demand grows. What does this mean for consumers and the economy?Download PDF
On Nov. 15, 2021, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on October market action, the Fed’s tapering, effects of the broken supply chains, spending trends within sectors, and opportunities in fixed income.
What did the market action in October tell you?
October was very good month. S&P 500 Index was up 7%, and the Russell 1000 Growth Index went up by more than 8%. To me, it was a post-Delta variant rebound for equities. Fixed income was flat, as measured by the Bloomberg Barclays US Aggregate Bond index.
Overall, the corporate story is still very good. Over half of the S&P 500 companies have now reported earnings and they’re up 40% year-over-year. This growth is widespread with energy-sector earnings up significantly more. When you look at the next 12 months, estimates are in the 220 range on the forward earnings per share of the S&P. So, that means a price-earnings ratio of around 20 at current levels. Given where Treasury rates are, that’s not an absurdly high level. It might be higher than most people would want, but earnings have backed it up.
Let’s talk margins.
Margins are above where they’ve been for much of the past decade. Now, that may be tough to maintain given cost pressures induced by broken supply chains, the cost of labor, etc. But right now, company earnings are very good, margins are very good, and valuation of the S&P is not absurd on a go-forward basis. Again, we’re now opening up post-Delta, and I also think the Federal Reserve (Fed) is still being accommodative.
The Fed recently announced its tapering program but emphasized that the need for higher interest rates would be determined separately. How is the market digesting the Fed’s messaging?
In a nutshell, I think the Fed has offered no hawkish surprises, which is critical for the market. The market knows liquidity has been important for the economy, and now with demand where it is, there’s probably a large swath of folks who believe the economy can be self-sustaining. We’ll see. It’ll probably take a year or two to find out if that’s the case.
As for tapering, the Fed has been purchasing about $120 billion in bonds per month, and that’s expected to decline at rate of a $15 billion per month. So, in theory, November will be down to $105 billion, December will be $90 billion, January $75 billion, and so on. That would be a nine-month process to get to where there’s no more quantitative easing (QE).
There is a debate whether the tapering will take as long as nine months. Citi, which is pretty aggressive, believes the tapering will occur at a rate of $30 billion per month, and there may not be any time between the end of tapering and the hiking of interest-rate. Citi now forecasts three rate hikes in 2022.
To me, the reality is that if there’s any economic hiccup, the Fed may pause on tapering, and they may extend out rate hikes. But right now, base case is a nine-month tapering ends the middle of next year, and then rate hikes begin toward the end of next year. So far, market has been okay with that.
Broken supply chains continue to be a threat to the economy. What are you seeing?
Ships are coming in loaded with cargo, and they cannot get it offloaded. According to an Evercore Wealth Management survey, 97% of the company respondents said supply-chain constraints are an issue. And the pain is being felt across sectors.
For consumer-based companies, the biggest constraints are shipping and port logistics, followed by ground transportation, and finally availability of components or products. Those were the three largest challenges. Behind those was labor.
When you look through to the real estate sector, the biggest supply constraint was labor availability and then raw material availability. That’s really about home construction, etc. Inventories are actually marginally better there.
For industrial companies, the number-one area of constraint within the supply chain was, by far, shipping logistics, including the clogged ports, followed by labor availability.
There are other factors at play that have created this bottleneck. Even when the container ships are unloaded, it’s difficult to find space to store the containers. In Southern California, there is about two billion square feet of warehousing, and that’s overflowing. This means only about a third of a container ship’s cargo can find storage space right now.
To make matters worse, there is a significant shortage of truckers—80,000, according to the American Trucking Associations. At this point the math is simply, if supply cannot keep up with demand, this results in inflation and a sub-optimal economy.
The fix will be complicated. Last month, the ports of Los Angeles and Long Beach, under pressure from the Biden administration, opened up 24 hours day. The ports have also started fining ships for containers that aren’t being offloaded. But as noted earlier, there’s no place to put the containers and not enough truckers to haul them away. So, this bottleneck is through the logistics stack.
Of course, some of this could have been avoided or at least eased. Over the past decade, the federal government has invested about $11 billion in East and Gulf Coast ports, but only $1 billion on the West Coast. We are certainly seeing that lack of investment affect West Coast logistics.
Going forward, do you see companies blaming the broken supply chain for underperformance?
It’s possible. You just have to judge how much of an earnings or poor guidance is really caused by the current supply-chain environment or was it just an excuse for bad performance.
Are the supply-chain issues changing consumer behavior?
Absolutely. You’re seeing consumers buying things earlier, doing their holiday shopping sooner, and certain industries making pivots such as the auto industry’s original equipment manufacturers (OEMs),which are incentivizing folks to order cars earlier and online. You’re seeing consumer behavior change, you’re seeing company behavior change, and you’re also seeing higher prices because the demand is high and supply is short. We’re getting inflation, and, for some companies, their margins are screaming.
How is all this playing out in different sectors?
According to Bank of America credit-card data, spending in October was up more than 16% year-over-year and up over 20% from two years ago. Drilling down into the sectors, lodging spending relative to two years ago was up 16%; restaurants up 20%; gas up 20%. Airline spending, which had been a negative for well over a year-and-a-half, is now down only 2% from two years ago. Among other things, you are starting to see holiday travel come into play.
I would say a sector that stood out to me was entertainment spending. That’s where you do see the patterns of behavior varying based, I think, on state COVID regulations. Compared to two years ago, Texas was up 20% in entertainment spending in October, Georgia up 50% and North Carolina up a whopping 70%. So, residents there are getting out and about.
But in New York, entertainment spending was up only 5% from two years ago. Illinois and California up 6%. Pennsylvania, down 3%. Those are blue states. The red states with generally more lax COVID regulations and perhaps attitudes are seeing far greater spending.
Given all that we’ve discussed, what opportunities do you see in fixed income?
I’ll reiterate what I’ve said for most of this year. The inflation picture is uncertain, very uncertain. The interest-rate picture is very uncertain. The Fed’s now tapering. There are expectations for a liftoff in interest rates. At the same time, companies are doing well, and the economy is solid. So, the strong credit story continues. To me, short-duration credit still feels very good. Over the past month in fixed income, the strongest performer was floating-rate loans. Over the past three months, the strongest performer was floating-rate loans. And year-to-date within fixed income, strongest performer was floating-rate loans.
Okay, let’s do a speed round. Short questions, short answers. Number one: On a scale of one to 10, how will supply-chain bottlenecks affect holiday shopping?
Eight. The effect will be the early ordering of presents.
Will the holidays bring another COVID surge in the U.S.?
I’m going to say no. I’ll go with the data that points to another possible surge in the winter, so that would be Q1 of next year.
Will inflation in the fourth quarter of 2022 be higher or lower than today?
I’m going to say lower. I think prices will be higher in December of next year relative to this year, but the rate of growth will be lower.
Will the Fed drop "transitory" as adjective when describing inflation, and if so, when?
I think they will drop “transitory” sometime next year, but they may replace it with another word that is more cyclically based. I do not believe that the Fed believes this is a secular inflation story. I’m of a similar opinion.
Rate hikes in 2022. How many?
I'll say one.
One hundred container ships are now anchored outside the ports of Los Angeles and Long Beach. Will that number move higher or lower?
Two holiday-related questions to wrap up the speed round. Fresh or canned cranberries for Thanksgiving?
I'm not a cranberry guy. Sorry.
Stuffing: Inside or outside the turkey?
Inside, hands down.
Finally, do you have a personal reflection to share with us for the holidays?
Yes. This one is on stress. I think it’s something that affects a lot of us. I think it’s important to remember that stress is a choice we make. So many times, people say, “My boss is stressing me out, the holidays are stressing me out, work is stressing me out,” but they aren’t stressing you out. You are allowing yourself to be stressed out. It’s a choice to be stressed, not something that has to be done. I have really tried to keep that in mind.
As we head into holiday season, there’s plenty of opportunity to be stressed. But I think it’s important to find something—whether it’s walking, running, reading, breathing, meditating or whatever—to help you relieve stress. It’s your choice.
Bloomberg Barclays US 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.
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