Mixed Messages

Friday Reflection | August 6, 2021

Few children’s stories are more iconic than Goldilocks and the Three Bears. This 19th century British fairy tale has been retold countless times, and the simplicity of the imagery has allowed the message to be durable across generations. Author Christopher Booker characterized the structure of this classic tale as the “dialectical three”, where the first path is wrong in one way, the second in another or opposite way, and only the third, in the middle, is just right. Booker goes on to say: “This idea that the way forward lies in finding an exact middle path between opposites is of extraordinary importance in storytelling.¹

Storytelling is central to how prices are calculated in financial markets. Part of asset pricing is the analysis of historical data, profit and loss statements, and financial information released by the company for the prior quarter or fiscal year. This data is then used to create financial models and expectations of how the future may unfold for a specific company, commodity, cryptocurrency, or the broad economy. These future expectations are a version of storytelling, creating an imagined future that is used to inform current behavior and action.

The prevailing story in the markets for the past year has been one of economic recovery, pandemic progress, and Fed support. The story has supported price growth, but hinges on a “just right” middle path to keep those three pillars in balance.

Investing carries the expectation that future earnings will be stronger than current earnings, so investors are constantly looking for data that reflects durable economic momentum. Considerable progress has been made since the pandemic brought the global economy to a halt last spring, but recent surges in the Delta variant have renewed investor concerns about slowing economic growth.

This week, indoor mask mandates were reinstated in the Bay Area and the entire state of Louisiana, and masks are being strongly advised in New York City.² These renewed restrictions are in response to data showing the rolling seven-day average of new Covid-19 cases in the US hit a six-month high this week.³ Many in-person events including the New York Auto Show have been cancelled in the past few days, and large companies are delaying their return-to-office plans.

Amazon had planned to bring employees back in early September, but has announced it will delay that milestone until at least January 2022. Wells Fargo and Blackrock both announced similar delays of their staggered return to corporate offices, pushing the timeline out to October while citing rising Covid-19 cases.⁴ For some investors, the fear of lockdown 2.0 is disrupting the recovery narrative and reinstating the uncertainty that existed most of last year

While investors don’t want negative economic reports, there is also concern about the recovery progressing too quickly. For workers and employers, a faster pace of recovery is a good thing. For investors and markets, it’s more complicated (at least in the short term). Current low interest rates support higher stock and bond prices, and investors worry that the Fed may push them up prematurely and cause a market decline. The current level of monetary support (Fed is purchasing $120 billion of bonds per month to support the market) could also be removed or reduced sooner than otherwise anticipated if economic reports run ‘too hot’.

The July jobs report was released this morning and exceeded expectations – the US economy added 943,000 new jobs and the official unemployment rate declined to 5.4%.⁵ This should be good news, but it is being met with mixed reactions among investors. It is important to note that the July survey was conducted in the middle of the month. That was before some local governments reinstated mask mandates and other restrictions, and before many employers announced they would require employees to wear masks, be vaccinated, or get regularly tested. This resurgence may cause a dip in job seekers in the near term, particularly among unvaccinated workers or parents who are wary that schools will follow companies in delaying their re-opening plans.⁶

Corporate earnings have also been running hot. Second-quarter S&P 500 earnings per share are on track to be up 83% from a year ago and companies have been beating estimates by 16% on average, according to data from Credit Suisse. Investors expected companies to increase earnings from the depressed landscape a year ago, while much of the economy was shut down. The rate at which they have exceeded analyst estimates has impressed investors. Considering this progress in the face of ongoing challenges around Covid-19, supply chain bottlenecks, and inflation concerns argue that the market doesn’t need the level of emergency support that the Fed is providing. That worries investors.

From a technical perspective, the recent environment – a growing economy, but with low bond yields – has favored stocks and offered Goldilocks returns for investors this year. It is unrealistic to assume the Fed will be able to please all investors as it navigates the reduction of current monetary support, and therefore market volatility is to be expected. That doesn’t mean that reducing support is the wrong move, just that the transition period to a more sustainable policy environment may be bumpy.

In our view, the ‘just right’ approach is to maintain a long-term view of markets in our stewardship of client portfolios. History shows us that there is always reason for concern, and yet markets and global economies have continued to grow and compound returns for the holders of patient capital. Investors who maintain a long view can ignore much of the short-term noise, whether pandemic disruptions, political shifts, or simply fairy tale trespassers eating your porridge.

References

¹ Booker, Christopher. The Seven Basic Plots: Why We Tell Stories. London: Continuum, 2004. Print.

² Louisiana and San Francisco Area to Reinstate Indoor Mask Mandates WSJ

³ Trends in Number of COVID-19 Cases and Deaths in the US Reported to CDC, by State/Territory CDC.gov

⁴ Amazon, Wells Fargo, BlackRock Push Back Their Return to Offices Barrons

⁵ U.S. Economy Added 943,000 Jobs in July, Unemployment Rate Fell to 5.4%. Robust job growth last month reflects a strong labor market ahead of the Delta variant threat WSJ

⁶ Return to Work? Not With Child Care Still in Limbo, Some Parents Say. New York Times