Making sense of the markets this week: July 19, 2021

Each week, Cut the Crap Investing founder Dale Roberts shares financial headlines and offers context for Canadian investors. 

Why inflation might stick around a while

America’s finance chiefs don’t think inflation will go away overnight.

It’s all part of a “transitory for longer” argument or framing that is making the rounds in financial circles. And perhaps we’re spinning in circles on the transitory inflation debate. And, yes, “transitory for longer” is an oxymoron. 

From that CNN post… 

“Chief financial officers, on average, expect higher-than-normal cost increases to persist for eight to 10 months, according to a Duke University survey released Wednesday.

“Some worry inflation will linger longer. About one in four CFOs expect elevated costs to last through most of 2022.”

In the Duke survey, the vast majority of executives admitted they have passed along cost hikes to customers; any supply chain hits end up on the consumer’s bill. And business bosses believe that will continue well into 2022. (Duke’s survey also confirmed the business optimism we reported in last week’s column.)

A recent U.S. report showed broad-based inflation levels at a 13-year high, increasing by 5.4% year over year. The core index, which excludes food and energy, rose 4.5% year over year, the biggest increase since November 1991.

Labour shortages in the U.S. are also pitching in on increased costs to businesses—they have to increase wages to attract workers. Once again, those costs are often passed along to the consumer. That is called wage-push inflation, and it’s one of many isolated forces pushing on the inflation front. They can add up over time, creating more structural or long-lasting inflation that could be hard to unwind. 

So, transitory for longer might be more than the phrase of the week—but how much longer is anyone’s guess. But it appears likely that higher levels of inflation will be with us at least well into 2022. 

Let’s not forget the biggest risk is still the pandemic. It’s not over. And barriers to full vaccination could blunt or delay any economic recovery, and the global vaccination rate is still only in the 25% range. 

This week, bonds considered inflation and then had second thoughts:

The bond market momentarily perked up and then went back to deciding yup, it's transitory. pic.twitter.com/rddO75K4yg

— Lisa Abramowicz (@lisaabramowicz1) July 13, 2021

It’s earnings season again, and here’s what to expect

We’re going to see some eye-popping numbers on earnings and revenue growth in many cases—but remember we have that base effect as we’re comparing to very depressed levels from the pandemic. 

The initial reports are very encouraging. That said, this is expected to be the earnings peak. Not that earnings will reach a peak level, but the rate of growth will top out. Most estimates suggest we’ll continue to see earnings growth over the next few quarters, but it will be hard to match the current quarter.

Analysts estimate earnings increased 64% in this, the second quarter of 2021. That’s the highest level of growth in more than a decade. Look for the earnings growth rate chart in that link. 

The chart from FactSet offers that growth for the last quarter of 2020 was 3.8%; the first quarter of 2021 delivered 52.5%; and 64% in this quarter, potentially topping out. 

• Q4 – 3.8%
• Q1- 52.5%
• Q2 – 64% 

From that Wall Street Journal article… 

“[F]orecasts have drifted higher in recent months, helped by an unusually large number of companies advising investors that they expect earnings to come in higher than analysts had been estimating.

“‘The reason for that is simple: The speed and robustness of the recovery is greater today than everyone anticipated three months ago,’ said Hal Reynolds, chief investment officer at Los Angeles Capital Management.”

Pepsi gets a pop

The restaurant industry is ramping back up, and we will see the spin-off effect for food and beverage suppliers. From Seeking Alpha… 

• PepsiCo Q2 Non-GAAP EPS of $1.72 beats by $0.19; GAAP EPS of $1.70 beats by $0.18
• Revenue of $19.22B (+20.5% Y/Y) beats by $1.27B
• Organic growth of 12.8% vs. consensus of +7.59%

Pepsi beat on revenue and earnings, and the stock saw a nice pop upon the earnings release. 

I’m happy to own this “boring,” usually slow-growth consumer discretionary stock. It’s a very diverse global food and beverage company that owns many strong brands. It also pays a solid dividend near 2.8%. It typically grows the dividend at an annual 7% rate. 

And its dividend growth history is impressive. Pepsi is one of the U.S. dividend aristocrats.

BlackRock on very solid ground

Also in my portfolio, BlackRock reported very impressive numbers and eyes an astounding $10-trillion level in assets under management. That AUM number increased by an incredible 30% in the quarter, aided greatly by market gains, of course. 

Many of the major U.S. banks reported very good numbers, but the markets mostly shrugged that off. Bank of America was hit by lower interest rate concerns. The market makers can be quite picky at times. 

Morgan Stanley beat expectations thanks to stock trading and investment banking. 

But what about revenue increases? 

Here’s a more than interesting tweet from Lance Roberts (no relation), chief strategist at RIA Advisors. 

Thought this was interesting.#Earnings are expected to hit $151 #reported this quarter

Q4-2020 = 94.13
Q1-2021 = 128.20
Q2-2021 = 151.17 est.

But here is revenue

Q4-2020 = 367.48
Q1-2021 = 364.05
Q2-2021 = 360.81

Anyone notice an issue relating to #Price/Sales

— Lance Roberts (@LanceRoberts) July 13, 2021

We see earnings growth for the market, but not the matching revenue growth. And perhaps that is part of the higher-level and longer-term framing of the U.S. stock market’s earnings and revenue story. 

We’re back to that earning valuation “thing.” Much of the returns for U.S. stocks are courtesy of prices being bid up. It is not fully supported by operating earnings and sales increases. 

North of the border

Total earnings for companies in the S&P/TSX Composite Index are estimated to rise by 98% year-over-year compared to 65.4% for the S&P 500 index, according to Refinitiv data. The main drivers of Canadian earnings will be industrials, energy and consumer stocks. I would throw tech stocks into the mix as well. 

I’ll be following up with more earnings reports next week and beyond. 

Mid-year outlook from BlackRock

It’s always a good idea to check in with some of the smartest folks in the room, who offer a truly global perspective. We should not take any opinion as gospel, but I’m always happy to throw BlackRock’s opinions into the state of markets hopper. BlackRock is the largest asset manager on the planet, and the team recently offered their mid-year review. You can download the full report on that link. 

Here are the report’s leading themes or observations: 

This comment stands out in regards to the policy response in the economic fight against the pandemic:

“The post-global financial crisis (GFC) playbook won’t work, in our view, as the historic monetary-fiscal collaboration to bridge the pandemic should lead to a higher inflation regime. This means we don’t expect another decade-long bull market in stocks and bonds.

“A restart is not a traditional business cycle recovery—you can only turn the lights back on once, so to speak. Fiscal stimulus and easy monetary policy have provided a bridge through the pandemic. We have estimated the U.S. has seen more than four times the stimulus compared with the GFC for less than one-quarter the shock.” 

In that report, BlackRock is looking beyond the economic restart. 

The response to the GFC (Great Financial Crisis) perpetuated that low-growth disinflationary environment. That is all we investors of today have known. And the slowing-inflation environment has been very good for stocks and bonds—a.k.a., the traditional balanced portfolio. 

“We see the post-pandemic world as a very different one compared with the post-GFC landscape of deleveraging, sluggish growth, low inflation and constant policy support. That support helped herald a decade-long bull market in both risk assets and bonds.”

Playing off of the “new normal” terminology of the COVID world, BlackRock sees the post-restart economy and markets could potentially create the new nominal. 

There is a wonderful schematic in their presentation that lays out the potential pathways through the pandemic restart and on to the other side of the pandemic. 

What’s their take on portfolio positioning? It’s consistent with many of the themes put forth in this column. And it largely comes back to an all-weather portfolio that’s ready for inflation, just in case. They are also cautious of U.S. stocks. They like more equity exposure to Europe, Japan and emerging markets. 

As are many, I’m still a fan of Canadian stocks as well. 

On the bond front they do suggest some exposure to inflation-linked offerings. 

“We are taking advantage of the pullback in U.S. inflation breakevens to return to an overweight on Treasury Inflation-Protected Securities (TIPS). We find TIPS particularly attractive relative to inflation bets in the euro area where the outlook for inflation remains sluggish. We also like other inflation-linked exposures, such as commodities and real assets. We prefer TIPS to nominal U.S. Treasuries.”

BlackRock prefers more equity exposure over bonds, and suggests that stocks are not terribly overvalued given the low bond yields of the day. 

We might say that we take a core balanced portfolio approach that you’d find in the Best all-in-one ETFs for 2021 and then pay more attention to inflation. 

That’s what I’ve offered in this balanced portfolio. 

Bank of Canada: inflation to run hot, hot, hot

On Tuesday, July 13, the Bank of Canada announced the overnight rate will stay put for now, at 0.25%. That low rate affects the bond markets and borrowing costs. And the overnight rate is a tool that can be lowered to stimulate the economy. 

Tiff Macklem, Governor of the Bank of Canada, is raising his expectations for inflation, but has lowered growth expectations for the Canadian economy in 2021. The third quarter may deliver our peak growth. 

The third wave of COVID infections and lockdowns suppressed economic activity creating a downward revision for economic growth this year to 6% from 6.5%. Macklem’s team sees growth surging to an annual rate of 7.3% in the third quarter. 

The central bank then shifted some of their growth projections to 2022. We’re now looking at 4.6% compared to the previous estimate of 3.7%. 

That is two very strong years of back-to-back growth. 

Given the widespread confidence in economic recovery, the bank will also ease up on its quantitative easing (QE) program. That is, they will ease upon or taper their bond-buying practice; it’s being adjusted to a target pace of $2 billion per week, down from $3 billion.

A few weeks ago we looked at QE and the taper tantrum that stock markets might throw. 

“‘With cases falling, rapid progress on vaccinations and easing containment measures, the governing council is increasingly confident that growth will rebound strongly as the economy once again reopens, and this time growth will be more durable,’ bank Governor Tiff Macklem said in a news conference.”

The bank also raised its own inflation expectations. Bank analysts now see inflation to remain above 3% for the remainder of 2021. They see another slight increase in 2023 before inflation settles back to that 2% target range in 2024. But Macklem acknowledged inflation is expected to remain above target (2%) for several years. 

Recently, inflation in Canada has been warming up, with an annual rate of 3.6% in May and 3.4% in April. 

The bank will keep an eye on employment. They seek to stimulate or enable a very inclusive labour market recovery, having stated it may be their most important end goal. 

In this space we’ve often discussed how the pandemic picked on the weak, both physically and economically. Macklem pointed to a Statistics Canada report that showed the economy added 230,700 jobs in June. We need another 550,000 jobs to return to pre-pandemic employment levels. 

That might be possible as more restrictions are lifted across the country. In Ontario, on July 16, most everything opened, including indoor dining. 

In a research note, BMO’s Doug Porter offered… 

“We expect the tapering process to continue apace, with the bank winding down its QE by early next year. This will set the stage for rate hikes, likely within the next 12 months of the end of QE, with a good chance of sooner rather than later.” 

Following that Bank of Canada announcement, the markets were well behaved; there was no taper tantrum. 

Dale Roberts is a proponent of low-fee investing who blogs at cutthecrapinvesting.com. Find him on Twitter @67Dodge. 

About Dale Roberts

Dale Roberts is a former investment advisor and proponent of low-fee investing. He created the Cut The Crap Investing blog in 2018. Find him on Twitter for market updates and commentary, every day.

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