Our Thoughts on Third Quarter 2021
Matt Johnson, CFA® - Andy Nugent, CFA®
Market Recap, Portfolio Analysis, and Review
The 3rd quarter saw the Covid-19 Delta variant sweep over the country causing a temporary slowdown in the reopening of the economy. Add to that, the global supply chain is backed up, congress cannot agree on an infrastructure spending bill, and government officials cannot seem to agree on anything. We would think the combination of all these hurdles would cause negative performance in the equities market, however the market looks ahead and earnings remain strong to balance the macro concerns.
After advancing over 5% and 8% in the first two quarters respectively, the third quarter performance was basically even for the S&P 500 and the quarter ended flat erasing gains generated in July and August due to a nearly 5% pullback in September. As we said previously, while it would be terrific to advance more than 5% every quarter, this is not something we expect and when the market dips, we see this as an opportunity to purchase companies we’ve been monitoring.
A big question people are asking is if the jump in inflation we are seeing is here to stay or temporary. We believe it is a little of each.
When thinking about inflation and the amount of stimulus that has occurred over the last year, we would expect prices to increase. When the Government adds trillions of dollars into the economy, supply and demand indicates that each dollar is worth less and you need more of them to purchase a service or good. Basically, the definition of inflation. That said, the reopening story is temporarily exacerbating the situation.
Supply chain issues are a big reason we are seeing increased prices in many areas. There are over 70 ships sitting off the coast of Long Beach and Los Angeles waiting to be unloaded. I was recently up there, and it is a wild sight to see. So many giant cargo ships anchored off the coast. The labor shortage at the ports is causing delays in unloading and a truck driver shortage isn’t helping. Combine the two, and many stores and companies have their inventories sitting on a boat instead of in their stores. It is not just retail, but construction materials, and other industries as well that continue to be affected by the clogged supply chain.
That brings us back to supply and demand. If we have the same or increasing demand and the supply falls, prices rise. These sort of price increases we view as temporary. Hopefully soon, the ports will staff appropriately, the truck driving demand will be filled with new drivers, and business will return to normal. In the end, we should see a normalizing of prices that were hiked over the last number of quarters.
Keep in mind that we are also still suffering from a microchip shortage. Who knows, maybe they are sitting on one of those boats. So many things in today’s world have microchips in them. Many we don’t even think about. One product that continues to make headlines is automobiles. As we mentioned last quarter, the shortage of microchips has caused production of cars to slow and in some cases stop. This obviously causes a lower supply of cars, and therefore higher prices. This is affecting both new and used cars alike. Again, once the supply of microchips is back to fill demand, we will see cars roll off the assembly line and prices likely to come down significantly from their current state.
Not all price increases are due to supply chain issues. Some are fiscal. Oil prices are testing levels not seen in years. During April of 2020, we had excess oil. We had such a surplus that we were struggling to find places to store it. This all changed quickly as the current administration’s policy has halted a great deal of energy projects. This has resulted in the United States becoming net importers of oil. A gallon of gas is over $4 dollars in California. Our thought is that gas prices will remain high at least for the foreseeable future.
Is inflation here to stay? Some of it. But we do expect prices in many areas to return to normal levels over the next year. We had previously expected supply chain issues to be resolved by the end of 2021, but possibly due to the Delta variant, it seems to be taking longer to rectify the situation.
THE US $ and Interest Rates
Interest rates are rising, but compared to the end of first quarter, rates are still low. The 10-year treasury note sits at 1.52% at quarter end. While this is low considering long term numbers, it is up from a yield of just under 1% at the beginning of the year and 1.45% at the end of the second quarter. However, it is lower than the 1.74% yield witnessed at the end of the first quarter. Interest rates continue to tick higher yet, remain very low from a long-term perspective.
It seems unlikely that we would see the US dollar strengthen in these current economic conditions. With all the stimulus spending, it is difficult to see how the dollar could get stronger, yet as US interest rates are relatively
high compared to the rest of the world; we continue to witness strong foreign demand for treasuries which is causing the dollar to remain relatively strong.
As mentioned last quarter, we continue to be very cautious on bond investments as new purchases will continue to have low yields, and if interest rates rise, the price of existing bonds will decline. As such, when we do purchase a bond, we are focusing on short duration instruments with the hopes of rolling that money over into higher yields in the future. We are also utilizing preferred equities as bond proxies to increase yields as dividends received are higher than bond rates and the prices are more stable than common equity.
As of the end of September, unemployment sits at 4.8%. While this number is higher than what was expected, keep in mind that the year started with unemployment at 6.7%. It fell to 5.9% at the end of June and continued to decrease to the point we are today. Even so, we still see jobs going unfilled. Businesses with lower to mid income job openings are using signing bonuses and higher wages to attract workers. This is likely why the average income is up 6% in the last six months, far outpacing the approximate 3% annualized historic norm. With the expiration of enhanced unemployment benefits, it is a bit surprising we still have so many unfilled positions. We would expect the lower unemployment rate trend to continue in the fourth quarter.
Financials – In a quarter that didn’t produce returns for the market, Financials were the best performing sector gaining nearly 2.3%. Higher interest rates are good for Financials. With rates only modestly higher than the previous quarter, the increase here indicates the market expects interest rates to rise as the Fed begins tapering their asset buying. With possible higher rates in the future, it would be a good time to invest here, but only at the right price. Many of the large financial companies are trading above their pre-covid highs. As we are very price conscious, especially with Financials. We will wait for the prices of companies to pull back before investing.
Energy – Energy performed well in the first two quarters and cooled off a bit in the third as it gave back 2.82% despite a solid September where they were up over 9%. The strong performance in 2021, comes on the heal of a dismal 2020 where the sector lost over 1/3rd of its value. Natural gas and Fossil Fuels have gone up in price significantly, so earnings for these companies should continue to grow. Some of the higher prices are due to the supply chain issues, while other are political. We may see energy prices continue to climb and will continue studying the situation. Like with Financials, many of these companies are trading at rich multiples, and we would wait for a pullback in pricing before investing.
Information Technology – After the big 11% performance increase in the 2nd quarter, Information Technology was up a modest 1% in the third quarter. We like that the sector held steady, while growing earnings. It helps bring multiples down and lets earnings catch up with stock price. We are still bullish on the sector long term. We added Global Payments Inc. (GPN) during the third quarter as we believe the FinTech area will continue to do well and GPN has shown its ability to grow both revenue and cash flows.
Consumer Discretionary – This sector was relatively flat on the quarter. Although we do not have a large weighting here, we had a bit of activity in the quarter. We sold Etsy (ETSY) at a profit and took it out of the portfolio because its revenue growth slowed causing us to reevaluate the company.
We added Penn National Gaming (PENN) during the quarter. Online sports wagering is growing and is now legal in 27 states. The industry seems likely to continue to expand at a high rate and PENN appears to be in a position to capture some market share. This is a long-term play that we will keep a close eye on.
Healthcare – Healthcare is another area we think has good opportunity. Like Consumer Staples, many of the companies here pay above average dividends and are trading at reasonable multiples. The sector was up 1% in the third quarter. We sold out of one position, Pfizer (PFE) , as the price exceeded our estimate of its worth. After the sale, the price has pulled back. If the pullback of the stock price continues, we could add it back as it is a quality company paying a nearly 4% dividend.
The third quarter pretty much ended where it started but it was a bit of a bumpy ride to get there. Our hopes for fourth quarter is that the supply chain and employment issues are on their way to getting resolved and that the economy moves towards getting back on track.
We feel that the market is fundamentally in good shape as earnings are good overall. We expect the market to pull back at some point due to a variety of factors and macro-economics and politics will put pressure on some sectors causing volatility. We never time the market but use the downward movements of the market to our advantage and purchase companies at a discount.
As we end most quarterly reviews, we want to remind our clients that we expect the market to pull back at some point. We will not try to time the market but may use volatility to reposition our portfolios. We are in this for the long-term and will ride through any bumps in the road with you. This is an important part of helping to reach your long-term financial goals.
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Andy Nugent, Director of Investments
Sage Capital Advisors, LLC, an SEC Registered Investment Advisor. Sage Capital Advisors is headquartered in Sioux Falls, South Dakota. Advisory services are only offered to clients or prospective clients where representatives of Sage Capital Advisors are properly licensed or exempt from licensure. No advice may be rendered unless a client service agreement is in place.