— 2021 Q3 UPDATE —

Summary:

The vast quantity of market moving headlines in Q3 of 2021 was enough to make just about anyone’s head spin.  This most likely had an impact of investor psychology which led to negative returns in the Dow Jones Industrial Average, Russell 2000, & NASDAQ indices, while the S&P 500 posted a modest positive return.  With certain market wide valuation metrics such as the Shiller Price to Earnings Ratio (also known as the Cyclically Adjusted P/E Ratio or CAPE Ratio) at its highest levels since the dot-com bubble, the combination of perceived risk factors potentially caused market participants to rethink the amount of risky assets they held in their portfolios during Q3.^[1]

Read on for our full Q3 market update…

Shiller P/E Ratio for the S&P 500:

Source: www.multpl.com

According to multpl.com, the Shiller P/E Ratio is “Price earnings ratio based on average inflation-adjusted earnings from the previous 10 years, known as the cyclically Adjusted P/E ratio (CAPE Ratio), Shiller P/E Ratio, or P/E 10.”

Some of the market risks and events that potentially impacted markets in Q3 were global supply chain issues, the Delta Variant of Covid-19, labor market shortages, the transitory vs. secular inflation debate, a congressional debt ceiling battle, the Evergrande default, anticipation of when the Federal Reserve would begin tapering their bond purchases, large increases in reverse repurchase agreements between market participants and the Fed, and the list goes on ad nauseum. 

As investors in the financial markets, it is vital to look at each of these events and decide whether it is a signal of something that will impact markets in a material way or if it is simply noise that will sway market participants emotions in the short term.  This quarterly update, like all before it, will attempt to distill the few signals hidden in the plethora of noise that can distract investors at best and at worst lead to wealth destroying decisions.

This market update is going to explore the following topics:

• Returns from Major Indices
• Supply Chain Issues & Inflation
• Labor Market Conditions & Inflation
• Conclusion

Returns:

Supply Chain Issues & Inflation:

Before March of 2020, the global supply chain was probably not something the average citizen or even the average investor gave consistent mental energy towards.  In an era of hyper-optimization, the “just-in-time” supply chain, where material is moved just before it is needed in the manufacturing process, just seemed to work like magic.^[2]  This is usually how complicated systems look from the outside looking in.  We specifically refer to the global supply chain as a complicated system rather than a complex system because complex systems typically have two properties that complicated systems do not have, emergence and anti-fragility.  In relations to systems, emergence can be thought of as happening when the sum of the system cannot be explained by looking at the individual parts.  For example, one could not derive a traffic jam by looking at individual cars on the freeway, the same way that if a scientist looked at billions of individual human cells under a microscope, they would not be able to explain how life suddenly emerges.  Traffic jams, just like life, emerge as more than the sum of their parts because they are complex systems with interactions and feedback loops that cannot be predicted by looking at the individual parts in isolation.  The second aspect of complex systems is the concept of anti-fragility, which is explained in great depths in the book Antifragile: Things that Gain from Disorder (Taleb, 2012). Taleb explains how a complicated system can be resilient in the face of volatility/disorder, but a complex system becomes stronger with a certain degree of volatility/disorder (Taleb’s 500+ page book gives a much better explanation on the topic).

This dichotomous nature of complicated systems and complex systems is vital to understanding the global supply chain and the current problems it is facing.  The global supply chain is a complicated system which is a system that can be resilient but ultimately functions better the less disorder there is.  Part of the problem with the hyper-optimized “just-in-time” supply chain is that optimization reduces resiliency which makes a system more susceptible to disruptions from increasingly smaller amounts of volatility the more optimized it is.  The reason there is a tradeoff is because optimization definitionally reduces the amount of slack and redundancy in the system to achieve higher efficiency, but removing the slack and redundancy increases the fragility of the system when volatility is present.

Rewinding to March of 2020, global supply chains went from hyper-efficient systems to extremely strained with unprecedented amounts of disorder due to lockdowns of different countries and states at different times.  Those lockdowns caused shortages and bottlenecks of numerous products in 2020, which was widely expected.^[3]  However, what was unexpected was similar supply chain issues would continue to rear their ugly neck all the way into Q3 of 2021 after the lockdowns were broadly lifted.  The natural linear thinking about this situation is that there were shortages due to lockdowns, therefore, the shortages should end once the lockdowns are ended.  However, by understanding what type of system the global supply chain is, it would have been easier to predict the extreme difficulty of getting such a complicated global system that has been fine tuned for optimization to restart and work properly after a theoretical wrench was thrown in the engine, multiple times!  Ideally, viewing the supply chain as a complicated system that is negatively affected by disorder can give insight surrounding the potential timeline the supply chain may need to self-correct, which may be much longer than the consensus view.   

Now that a mental model has been developed for analyzing the supply chain, it is vital to understand what the real economic consequences of the current supply chain bottlenecks have been.  According to the graphs below, the supply chain bottlenecks have caused global freight rate to rise dramatically.

Composite Index showing the freight rate of a 40-foot container:

Source: Drewry Supply Chain Advisors

Freight prices to and from major destinations:

Source: Drewry Supply Chain Advisors

Along with freight costs rising dramatically, the supply chain bottlenecks have been a major catalyst for precipitous increases in commodity prices because supply is struggling to catch up with the global demand (for our purposes, the global demand increase can be thought of as a different issue from the supply constraints).  The graphs and figures below highlight some of the dramatic increases in major commodity prices.

According to Trading Economics, the Baltic Dry Index “provides a benchmark for the price of moving the major raw materials by sea.”

Source: Trading Economics

YTD % Increase of Major Commodity Prices as of 9/30/2021:

Source: Trading Economics

One of the main issues with such large increases in commodity prices is that most commodities are major inputs to products and services throughout all different sectors of the global economy.  Since commodities affect all different sectors of the global economy, the increase in prices will inevitably affect different types of businesses (and in turn their customers) differently.  Below are two simple scenarios that illustrate how these commodity price increases may ripple through the economy depending on which type of business is using the commodity.

Scenario #1: Increases in commodity prices are passed onto consumers through more expensive goods/services from companies with pricing power.

Scenario #2: Increases in commodity prices are absorbed by companies that do not display pricing power which reduces profit margins. 

In the first scenario, the increased input prices are passed onto the consumer which reduces the purchasing power of consumers and increases profit margins for the business.  This might slowly reduce demand for these goods and services as consumer purchasing power decreases relative to the increases in prices.  This could be a self-correcting cycle which the Federal Reserve assumes will come to fruition which is one of the reasons they believe inflation is “transitory”.^[4]  However, prices tend to be sticky once they have risen so without continued government stimulus or continued rising wages, this situation could end inflating goods and services while keeping real growth is low due to decreasing demand relative to increasing input costs.  This could lead to stagflation which widens the wealth gap even further due to fixed wage earners suffering more from an inflationary environment relative to financial asset holders.  This scenario could also widen the competitive gap between companies with pricing power over their products against companies without those same competitive advantages, which tend to be smaller companies without scale or brand recognition.  These types of companies are the focus of the second scenario.

In the second scenario, increased input prices are absorbed by companies which do not display pricing power which reduces their profit margins.  This scenario would most likely lead to bankruptcies for companies with slim profit margins, highly indebted companies, and companies which are heavily reliant on underlying commodity prices.  This could reduce the size of the labor force due to bankruptcies and/or companies laying off workers to keep profit margins slim.  This outcome would most likely hurt workers and depending on the magnitude of the situation could cause a large reduction in consumer demand from an increase in unemployment.  This situation is simply the underbelly of the first situation which leads to companies with better pricing power continuing their ability to expand operations at the expense of companies without the competitive advantage.

The most realistic situation is that a combination of both scenarios happen which could lead to the strongest companies becoming stronger, the wealthiest becoming wealthier, and the consumers without financial assets or high-skilled jobs finding themselves in a worse financial situation than they were in before the inflationary pressures. 

These two scenarios would be considered transitory inflation because they would essentially resolve once the supply chain is functioning properly.  However, the timeline of when these resolutions will happen is uncertain and the longer the global supply chain bottlenecks continue the less sanguine investors will be about hearing the word transitory.

Labor Market Conditions & Inflation:

The supply chain bottlenecks are only one side of the coin when it comes to the inflationary spike.  The other side of the coin is coming labor market shortages and high consumer demand.  These two factors would normally be at odds with each other because consumer demand has historically been lower when unemployment is higher, a phenomenon that partially led to the idea of the Phillips Curve (which is the inverse relationship between inflation and unemployment).^[5]  However, since the birth of quantitative easing, the Phillips curve relationship has all but broken down and the economy is feeling the brunt of that breakdown as we are lifted out of a recessionary period with high unemployment combined with an inflationary spike.^[6]

There are a few different theories as to why there are labor market shortages, and these different theories essentially resides in two different camps.  Some theories are behavioral theories such as “people fear catching Covid-19 at work” or “people have realized the value of spending time with family after working from home” which are difficult to analyze but most likely have some explanatory power.^[7]  Then there are some theories that are economic in nature and are likely the foundation for the behavioral theories to even exist.  For example, if someone does not want to work because they want to spend time with family or fear getting sick, but they must work to feed their family, then they will most likely work.  Therefore, the economic analysis of what is providing the foundation for the option of whether they decide to work will be the focus of this analysis.

Analysis:

While the unemployment rate for September was down from June levels of 5.9% to 4.8%, the unemployment rate only tells one part of the labor market story.  As of July 21^st, 2021, there were approximately 10.9M job openings in the United States with approximately 8M unemployed persons, which shows that there is a clear disconnection between the jobs that are open and the types of jobs people are willing to take. 

Source: FRED

Another aspect of the labor force story that does not receive enough focus is the labor force participation rate.  The labor force participation rate provides more context for the unemployment rate because if a person drops out of the labor force, they will not be counted towards the unemployment rate which artificially lowers it.  The downtrend in labor force participation is a long-term trend.  From January 1^st, 2000, to September 1^st, 2021, the potential civilian labor force in the United States grew by 50.357 million people, which was a 23.82% growth [8].  Meanwhile, in the same time period, the actual civilian labor force only grew by 19.087 million people.  Therefore, the current labor force participation rate of 61.6% cannot be attributed entirely to the post Covid-19 economy but there are some aspects of the post Covid-19 economy that have played a significant role in rapidly reducing the labor force participation rate.

Source: FRED

The first factor that is causing people to have more flexibility in the jobs they choose or have the ability whether to work at all is the wealth effect in the United States.  Between direct government transfer payments, the rise of retail investors, booming alternative markets such as cryptocurrencies and NFTs (Non-fungible tokens), and rising asset prices in almost all traditional markets, the average American has higher inflation adjusted savings and net worth than ever.

Source: FRED

Source: FRED

While the long-term trends in the labor force have been heading towards a lower labor force participation rate, which is due to factors that are outside the scope of this quarterly update, this boom in savings sheds some light onto why people can reject the idea of returning to work in the short term.  This ability for workers to force employers to give higher wages may seem like a positive in the short term, it will unfortunately hurt those same employees in the long term through the same mechanism that higher commodity prices will hurt consumers.  Wages, like commodities, are input costs for companies.  Companies with superior pricing power will be able to pass on a larger percentage of these input costs to consumers, which will be the same people making those higher wages, which will effectively negate their new earning power.  The wage growth aspect of inflation is the side of inflation that the Fed and financial markets have the least control over, and it is the one with the greatest feedback loop.  Therefore, if the wealth effect continues to give fixed wage earners the ability to reject work in the hopes for higher wages which gets passed back onto those same people as higher inflation when they are consumers, this could have a detrimental feedback loop that leads towards secular inflationary factors rather than the potential shorter-term supply-demand market based inflationary factors. 

Overall, it can be helpful to mentally separate the supply chain bottlenecks from the developments in the labor force for the purpose of analysis, but all aspects of the global economic system are intertwined together.  Which means there may be some aspect of the supply chain bottlenecks that are happening because of labor shortages and visa-versa.  However, analyzing the two events separately can allow for more clarity on the likelihood of each coming to fruition and the subsequent potential ramifications. 

Conclusion:

Here at K2 Financial Partners, our main mission is to help you reach your financial goals.  We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are coming to the forefront.  Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns.  At the end of the day, we are here to help you!

Sources:

• multpl.com
  
• Just-in-Time Supply Chain: What Is It? (thebalancesmb.com)
  
• 10 Products in Short Supply Due to the Coronavirus | Kiplinger
  
• Pent-up demand, shortages fuel U.S. inflation | Reuters
  
• Phillips Curve - Econlib
  
• What’s the Phillips Curve & Why Has It Flattened? | St. Louis Fed (stlouisfed.org)
  
• The Other Reason the Labor Force Is Shrunken: Fear of Covid-19 - WSJ
  
• S. Bureau of Labor Statistics (bls.gov)
  
• Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
  
•   Taleb, N. N. (2012). Antifragile. Penguin.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss.