The Mini Taper Tantrum

September was a difficult month for investors as the market experienced its first 5% pullback since October 2020 – one of the longest winning streaks in history.  The pullback was inevitable as bull markets often experience 5-10% pullbacks multiple times in a year.  Pullbacks are healthy as excesses are corrected and capital can flow to new opportunities with better risk-adjusted returns.  The reasons for each pullback vary but this pullback could be described as a Mini Taper Tantrum.

The term “taper tantrum” was coined to describe the market’s negative reaction in May 2013 to the Fed’s proposed reduction in their purchases of Treasuries and Mortgage-Backed Securities – a monetary policy instrument used to create liquidity in the financial system and to maintain low interest rates in response to the Great Financial Crisis of 2008.  The Fed has been actively engaged in similar purchases since March 2020 and these purchases inevitably must decline as the markets and economy recovers.

Akin to May 2013, the markets in September experienced a sharp pullback and higher volatility as the market priced in the expectation the Fed would soon announce a tapering of their purchases.  There were other contributing factors, such as the failure of the Chinese real estate firm Evergrande and haggling in Congress over the debt ceiling, that further encouraged investors to take profits.

Ultimately, the markets in 2013 resumed their upward climb and the S&P 500 finished up a stunning +32.4%.  The S&P 500 finished September up 15.9% for the year, which is a great year by itself.  The lesson to remember is that pullbacks are normal in bull markets and from our seat we do not see an end to this cycle just yet.

Market Update

The U.S markets retreated from August’s record highs in September.  The S&P 500, the Nasdaq and the Dow all fell 4-5%.  Driving the decline was the material increase in the US 10 Year Treasury bond (“UST10”) yield that surged from 1.22% to 1.49%, which is still below the YTD high of 1.74% set in March. This surge has continued thus far in October as the market prices in the effect of the Fed potentially decreasing their purchases.  Equity prices are not always positively correlated to interest rates; however, the initial tightening of monetary policy often creates short term volatility and that is exactly what happened. 

Fixed income indices were largely negative. The Bloomberg Barclays U.S. Aggregate Bond Index and Investment Grade Bond Index declined -0.9% and  -1.1%, respectively, in sympathy with Treasuries.  The riskier U.S. High Yield Bond Index finished flat likely supported by investors seeking yield and credit risk while shunning convexity risk, which is a bond’s sensitivity to changes in interest rates.  High interest rates are bad for bonds with long duration due to convexity.

Commodities surged in concert with higher inflation expectations.  The Bloomberg Commodities Index rose a sharp 5.0% during September.  Leading the way once again were large upward moves in natural gas and oil (20.9% and 10.3%, respectively) due to continuing supply issues amidst growing demand.  In contrast, agriculture, oil and precious metals were generally lower.  Confoundingly, gold ended the month -3.2% lower, which is a bit surprising as gold is normally considered a hedge for inflation.  The worst performing commodity was once again iron ore (-23.4%) in reaction to Chinese growth and import quota concerns.

No Deceleration Yet

We have been in the camp of expecting higher inflation for longer since last Spring.  Our thesis rested on a key data point.  U.S. retail inventory to sales is a metric tracked by the U.S. Census Bureau.  As the chart below shows, this ratio is 24% below pre-Pandemic normal levels.  The data point reflects what we as shoppers already know:   it is hard to find product in stock.  Everything seems to be on back order.

A key driver of this inventory shortage is the well-publicized ongoing disruptions in the supply chain that is preventing shelves from re-stocking.  As of last week, there were over 100 cargo vessels waiting to unload containers of goods at the Ports of Los Angeles and Long Beach – the two primary ports for receiving goods from Asia, according to MarineTraffic.com.

Equally as problematic – at least as far as correcting the inventory imbalance - has been the resiliency of consumer spending in the face of lower fiscal stimulus and the spike in Delta-variant cases. Consumer spending, which drives retail sales, has remained at what we believe are unsustainable levels.  As the graph below shows, Personal Consumption Expenditures in August set yet another all-time high.  We expect to see some decline in this figure and were surprised it did not happen in August.  So long as consumer spending remains high, factories will have to work harder and longer to recover to pre-Pandemic levels.  This is a very bullish sign for the economy, but it also means that inflation will remain higher for longer and how that ultimately drives the Fed’s timing and degree of tightening monetary policy is the central issue for markets moving forward.

Outlook

We remain confident in our statement from last month: “We continue to be bullish on equities and commodities considering the current environment of negative real interest rates, elevated inflation and a roaring hot economy”.  Having experienced a Mini Taper Tantrum, some of the froth has been taken out of the market leaving interesting new stock-picking opportunities.  That is not to say that we won’t experience periodic bouts of volatility in the future, but the market feels much healthier now that inflation expectations and interest rates have moved up.  Corporate earnings season is ahead and will likely show broad economic strength.  We expect that some companies will have a difficult time managing through supply chain issues and higher inputs costs, which furthers our resolve that we are in a classic stock-pickers market amidst the continuing bull market.

Conclusion

It is normal for bull markets to experience pullbacks.  They are healthy, necessary and usually offer great buying opportunities.  The significant imbalance between excessive demand and supply constraints has created an unusual economic environment that is generating excellent investment opportunities if you know where to look and have a flexible mandate.

Disclosures

INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS OR INVESTMENT STRATEGIES. BLOOMBERG IS THE SOURCE OF MARKET DATA. INVESTMENTS INVOLVE RISK AND ARE NOT GUARANTEED. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.