INDIVIDUALS & FAMILIES INSTITUTIONS TEAM ABOUT VIEWPOINT CONTACT T: 626.792.2228 LOG IN MARKET COMMENTARY Quarterly Insights: October 2021 Clifford Swan October 15, 2021 The U.S. economy continues its recovery from early 2020. However, economic indicators point to a slowing rate of growth. Estimates for annual GDP growth for 2021 have come down from 6-8% to around 5.5%. Currently, intense negotiations for additional fiscal stimulus are occurring in our country’s capital and we expect that a substantial stimulus package is forthcoming. Without this additional stimulus, economic growth would likely slow further, risking a recession. Concerns about an economic slowdown next year will persist until signs of a self-sustaining recovery are in place. The fact that interest rates have been range bound is evidence of this concern. Price inflation for both businesses and consumers has increased since last quarter. Central Bank officials have acknowledged that inflationary conditions may be with us for a while longer. The Consumer Price Index (CPI), a measure of inflation, is running at about 5%. The yield on 10-year U.S. Treasury bonds is around 1.5%. Accordingly, the “real yield,” or the yield after inflation, is approximately -3.5%. Bond investors usually demand a premium return to inflation to preserve purchasing power. If inflation persists around the current levels, there will be upward pressure on interest rates. On the other hand, the Federal Reserve is still buying $120 billion in fixed income securities per month and owns approximately 55% of all outstanding 10-to-20-year U.S. Treasury securities. You might say that the Fed has cornered the market for longer dated Treasury bonds, putting them in a strong position to influence interest rates. The Fed recently promised to slow their rate of market purchases of bonds (tapering) beginning near the end of the year. The reduced participation of a very large buyer of U.S. Treasury bonds could also put upward pressure on interest rates. Economic policies in China are evolving. For one, the Chinese government appears focused on reducing speculative investment activity. Restricting lending to leveraged real estate company Evergrande is evidence of this. Additionally, Chinese authorities introduced plans to significantly reduce China’s carbon footprint. For the last two decades, the global economy has relied on the Chinese growth engine to drive industrial output. China became the largest consumer of raw materials and the largest producer of refined products. As a low-cost producer, China exported deflation, keeping a lid on inflation in developed economies. This may change as China becomes more internally focused on “cleaning up” their manufacturing footprint, and their costs of production will likely increase. Moreover, the high growth rate of China’s economy could slow to a rate closer to other developed economies. Back here in the U.S., stock prices reflect very bullish corporate earnings estimates which assume strong economic conditions going forward. The S&P 500 Index is currently priced at a 22x price-to-earnings ratio. This is high, by historical standards, but could prove reasonable if earnings growth matches expectations. We are careful not to extrapolate current positive trends, especially for corporate profit margins. The companies that we speak with are experiencing rapidly increasing costs to do business. The supply of labor is short (for now). Supply chain issues are causing shortages of key input materials and inventories. Energy costs are increasing. Yet, earnings estimates are factoring in record corporate profit margins. Earnings drive stock price returns over the long term. If corporate profit margins come under pressure (we expect this), then investment returns should moderate as well. We identified four key trend changes in this letter: inflation is rising, interest rates in the U.S. may have bottomed, economic growth in China may be slowing, and the level of earnings in corporate America could be peaking. Another important change is our government’s increasing role in the economy and financial markets. During periods of significant change, portfolio diversification can be a powerful tool to both reduce risk and stabilize investment returns. Your investment counselor would be happy to talk with you about what diversification strategy is most appropriate for you. The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance. RELATED ARTICLES QUARTERLY INSIGHTS: OCTOBER 2021 Clifford Swan LONG DAY’S JOURNEY INTO NIGHT Kevin J. Cavanaugh Let's take the next step together STAY CONNECTED First Name Last Name Email 177 East Colorado Blvd. Suite 550 Pasadena, CA 91105 T: 626.792.2228 F: 626.792.2670 E: info@cliffordswan.com Privacy Policy Disclaimer Form CRS