Weather maps of the continental United States have been in vogue this week on account of a strange pattern in the jet stream (weird climate events, in 2021? Really?). Out west the jet stream dipped into territories south of where it normally flows, bringing an unusual blast of Arctic cold and heavy snows to western and southwestern regions more used to dry heat at this time of year. East of this dip, though, the jet stream bulged up into Canada and produced some record heat conditions in places one normally does not associate with heat – North Dakota, Minnesota and further north still into Ontario.

Fragile Equilibrium

Along the border of the jet stream, in between the extremes of blizzards and scorching heat, lies a somewhat unstable equilibrium, not entirely unlike the present conditions in securities markets. During this past week we seemed to be teetering back and forth between the two narrative forces vying for our attention: the bear case of stagflation and geopolitical dysfunction versus the bulls’ longstanding argument based around unlimited central bank liquidity and global economic recovery.

After a couple down days early in the week investors got to take a look at the published minutes from the latest Fed meeting on monetary policy in September. The minutes didn’t really have anything new to add in terms of substance, but the hot take seemed to be that there was nothing new to worry about in terms of the Fed raising interest rates. So – good enough! Markets recovered smartly and look to be on track for a winning finish to the week.

Peak Stagflation?

A couple days of exuberance does not a trend make, but the recovery in sentiment over the past couple days seems to have been enough to bring out the Pollyanna crowd reading the obituary for stagflation. The actual case for stagflation, as we see it anyway, doesn’t seem particularly stronger or weaker this week than it was last week when markets were in more of a funk. The Consumer Price Index came out this week more or less in line with expectations – headline inflation of 5.4 percent and the ex-food and energy core reading at 4.0 percent (the CPI release was the same day as the FOMC minutes, which goes to show yet again that you just never know exactly which data point is going to move the sentiment needle, and in which direction). Meanwhile China’s producer price index registered at 10.7 percent, a 26-year high and a bit of a concern for what might be felt in China’s export markets down the pike.

Whether or not we are headed towards a repeat of 1970s-style stagflation (which we continue to think is not the most likely outcome), it appears increasingly evident that inflation will be stickier than estimates earlier this year (including those from the Fed) would have had us believe. An optimistic assessment for supply chains getting back to normal is in the 3-6 month range, while the energy shortage looks like it could go on for longer. Meanwhile, even if the Fed does start to taper its bond-buying program before the end of this year, it will still be pumping liquidity into a fixed income market with significant price distortions (as we wrote about with regard to the junk bond market a couple weeks ago). There’s still plenty of time for this fragile equilibrium to come apart.

In case you haven’t heard, the labor market is in a very strange place, both here at home and around the world. If you happened to glance at a British newspaper or magazine any time in the past couple weeks you would have seen long lines at gas (sorry, petrol) stations reminiscent of the oil crisis days of the 1970s. But those lines had more to with the acute shortage of truck (sorry, lorry) drivers delivering supplies to retail outlets than to other factors.

Transportation markets face similar disruptions in the US, with the phenomenon of cargo ships sitting idle in ports, unable to offload their goods because those goods have no one on shore able to get them to warehouses and then off to their final destinations. Unfortunately, not many people expect these problems to be solved by the time the holiday season gets into full gear in a month or so. Presents under the tree this year may come in the form of little pieces of paper with the message “coming sometime next year” rather than the new bike or kitchen appliance or hot toy of the recipient’s dreams.

Fewer Jobs, Fewer Jobless?

This brings us to this morning’s report, the monthly read on the US employment situation courtesy of the Bureau of Labor Statistics. There are two headline numbers analysts pay attention to in the BLS report: the unemployment rate, and the payroll gains in nonfarm employment. Before the report comes out, a poll of economists’ forecasts will set expectations around these two numbers. Going into this morning’s report, the consensus forecast was for payroll gains of 479,000 and an unemployment rate of 5.1 percent.

The actual numbers, then, came as something of a surprise: 194,000 payroll gains (much worse than expected), and an unemployment rate of 4.8 percent (much better than expected). On its face that seems counter-intuitive: if the labor market produced fewer new jobs than expected, why did the unemployment rate fall by so much more than expected? Put another way, where did all those until-now unemployed people go if they didn’t go into a new job?

We’ll circle back to that question. The fact that new payroll gains were lower than expected is actually not entirely surprising. It had to do with the confluence of two factors: the impact of the Covid delta variant, and the timing of back-to-school dynamics. The BLS survey happens in the first half of the month prior to the report’s release; in this instance, that would coincide with the first couple weeks after Labor Day.

One thing that became evident during this period was that increases in post-pandemic rebound sectors like retail, hospitality and entertainment were much lower than expected as the virus impacted the normal course of business for these areas. At the same time, there was a notable drop in employment in local public education – basically, fewer new teachers and school administrators coming back to work. The net effect of these two trends accounted for much of that disparity in payroll gains.

Where Did All the People Go?

But that still doesn’t account for the lower unemployment number, and this brings us back to our opening paragraph about disappearing truck drivers and the like. In order to be considered “unemployed” by the BLS for purposes of that number in its report, a person has to be actively looking for a job. Presumably, a large cohort of the people who would otherwise either have found a job or be knocking on doors and sending out resumes to find one were, instead, willingly not participating in the labor market. The really interesting question will be to see if that number changes significantly next month. The enhanced unemployment benefits originally implemented early in the pandemic finally ran out in late September. The impending termination of those benefits doesn’t seem to have roused too many people to dust off their resumes last month, but perhaps they are doing so now. We’ll find out more about this on November 5, when the next BLS report comes out.

It would be helpful to see more people come back to work, because those dysfunctional supply chains making a mess of the global production, transportation and distribution of goods in high demand won’t be fully worked out until they do. What is becoming clear, though, is that both the pandemic and the fiscal relief efforts put in place to mitigate the effects of the pandemic have produced unintended consequences. We expect there are more unintended consequences to come.

It was a great time to be in private equity, with record levels of new deals and a seemingly bottomless desire by investors for the speculative-grade debt raised by the private equity kingpins to fund their deals. Average yields of around 8.5 percent offered a tasty jolt of purchasing power in a world where headline inflation hovered just around two percent. Nor did the risks associated with debt rated below BBB- seem unduly out of line: the average spread of junk debt to benchmark US Treasuries was around three percent in the middle of the year, more or less in line with historical risk spreads.

That year was 2007, and the good times would not last for long. A year later, as the wheels came off the global financial system, yields on junk bonds spiked into the upper teens, with risk spreads to Treasuries jumping accordingly as panicked investors poured into the safest of asset classes. Anyone lured by the charms of junk bonds in that splendid summer of 2007 paid a heavy price.

Something’s Going to Give

Fast forward to the onset of the fourth quarter of 2021. Private equity volumes have already far surpassed their previous records of 2007, with over $800 billion pouring into more than 10,000 deals so far this year. Where private equity goes, speculative-grade debt follows as sure as the sun rises in the east. Just this week three of the biggest players in the private equity arena – Blackstone Group, Carlyle and Hellman & Friedman – announced a deal for a family-owned medical supply company called Medline that will raise $15 billion in new debt, most likely earning a rating of single-B. The total deal valuation of $34 billion (debt plus equity) makes Medline the biggest single private equity deal since that banner year of 2007.

What are the bondholders going to get out of the deal? Consider the chart below.

Back in 2007, junk bond investors could at least satisfy themselves that they were getting a good deal relative to inflation. Today, for the first time in the history of this asset class, that purchasing power argument doesn’t hold. With inflation having risen over the past several months, the average yield on speculative debt – 4.03 percent according to the ICE BofA High Yield Index shown above – is lower than the latest Personal Consumption Expenditure (PCE) index of 4.3 percent released just this morning.

No Income, and Default Risk Too!

Something is clearly out of whack with this picture. Either inflation is going to drop very soon back to where it has been for most of the past ten-odd years, or current investors in junk bonds are in for some pain as yields rise to compensate for the loss of purchasing power. Which is it going to be?

Now, an observer of the above chart might note that the spread between speculative-grade debt and benchmark Treasuries has been quite stable ever since bond markets in general stabilized following the disruptions of March 2020 when the pandemic hit. Nominal Treasury yields, to be sure, are significantly below inflation at present. But institutions buy US government debt for all sorts of reasons only tangentially related to the earned yield – from foreign exchange reserves stockpiling by central banks to risk mitigation by portfolio managers. Historically, at least, investors have assumed the default risk on benchmark government debt to be zero (let’s hope that continues past the debt ceiling circus playing out now in Congress). The default risk on speculative debt, obviously, is not zero or anything close to it.

In the aftermath of the pandemic, the Fed stepped in to shore up credit markets by, among other things, committing to purchase junk bonds as a buyer of last resort. That explicit commitment ended after markets settled back down. Perhaps junk bond investors today think there is still an implicit commitment by the Fed to not let their holdings go south (there is not, but a person can dream). Perhaps the idea that zero purchasing power is an okay return for higher credit risk is the new normal. To our eyes, that chart says something else, which is that junk bonds are due for a significant repricing.

Fed Chairman Jay Powell is happiest when adjectives like “boring” and “utterly predictable” get appended to his name. He will not have been displeased with the takeaways from this week’s Federal Open Market Committee (FOMC) meeting. This week may have set a new high water mark for frequency of use of the phrase “no surprises” in financial media outlets. All the more remarkable is that this sanguine groupthink happened even as the actual content of the FOMC and its attendant documents (notably the infamous dot-plot tabulating the outlooks of the Committee’s members on economic and interest rate trends) trended notably more hawkish. Well played, Chairman.

Three by Twenty-Three

The most closely-watched dot-plot is the interest rate expectations for the eighteen FOMC participants. For much of the time since the Fed first took action to shore up the economy after the pandemic started, the time line for lifting off the current zero lower bound Fed funds target has been 2023. Now, however, a full half of the FOMC members expect that rates will begin to go up in 2022, and a majority expect there will have been at least three consecutive rate hikes by the end of 2023. That is a more hawkish take than previous projections.

Before anything happens with interest rates, though, the first order of business is doing away with the current program of Fed purchases of $120 billion of Treasuries and mortgage-backed securities each month. Powell expressed confidence that the time is nigh to set a calendar to that winding-down, thus setting clear expectations that this will happen in November (the calendar, that is, with a fixed date for first reductions) with a likely full winding-down of the program by the middle of next year. Here, he stated explicitly that the so-called “substantial further progress” test, meaning the economy’s clear path to average inflation of two percent and full employment, has already been met.

This was the clearest vote of confidence the Fed has yet expressed on the prospects for full economic recovery in the wake of the pandemic. It probably goes a long way to explaining why asset markets have been generally upbeat since the meeting on Wednesday, brushing aside concerns earlier in the week about the Evergrande debt crisis and other troubling data points.

About That Economy…

Behind the general feel-good vibe from the FOMC meeting, though, there are some reasons to hold one’s optimism in check. For one thing, that same Summary of Economic Projections with the interest rate dot-plots also reflected a change in sentiment among FOMC participants about near-term economic growth, which they think will be lower than the previous estimates released in June, and about both headline and core inflation, which they think will be higher. The acceleration of the interest rate hike calendar may reflect a somewhat more heightened level of concern among some of the participants about the potential for inflation to be stickier than the prevailing Fed consensus that it is a temporary phenomenon.

A world in which the central bank has to raise rates, not because of strong economic growth but because of persistently higher inflation that would likely steepen the yield curve well beyond its current shape, summons the dreaded sector of stagflation, that bugaboo of the late 1970s. Right now, the key potential sources of stagflation risk lie in three areas: supply-side problems including sky-high goods transportation costs and dysfunctional supply chains; demand-side problems from the lingering effects of Covid’s delta variant and a slowdown in China; and a shortage of labor. Right now there is still a better case to make that these problems get worked out without triggering 1970s-stye stagflation. But if expectations of higher prices and higher wages fall into a positive-reinforcement spiral, there is more reason to doubt they will simply go away on their own.

The Fed’s problem with stagflation is that it can’t simultaneously solve both sides of its twin mandates of stable prices and full employment. Right now there is not much evidence that this scenario is having any influence on asset prices. High yield bonds, for one, are currently producing average yields in the range of four percent – i.e., not too far off where inflation currently sits. That dynamic is only sustainable if today’s inflation truly is a quickly passing phenomenon. It will behoove us to pay close attention to the frothy market for risky debt – of which there is an abundance at present. It may turn out to be the canary in the coal mine.

The pandemic may have imparted two important lessons for the pundits and prognosticators who populate the world’s financial markets. First, you cannot predict the timing and magnitude of something like a debilitating virus that sweeps across the planet. Second, even if you could predict the event, you couldn’t predict what the market reaction would be. Think about it. Armed ahead of time with the information that the SARS-COV2-19 virus would shut down the global economy in March 2020, would you have predicted that the S&P 500 would end the year up nearly 20 percent? Or that China’s gross domestic product growth in 2020 would be positive, as if the pandemic had never happened?

Don’t Do Stupid Stuff

With year-end just several months away, money managers great and small are focused laser-like on year-end returns. For many of them it is a comfortable place to be. For much of the year it has been easy to coast along on the gentle jet stream provided by generous central banks, rebounding corporate earnings and a bevy of retail investors adding their collective weight to the rivers of capital flowing into all manner of assets, from the solid to the silly. Clients are generally happier when their hard-earned wealth is showing healthy returns.

But, as we noted in our commentary a couple weeks ago, the environment is looking a little twitchier as the fourth quarter approaches. Peak growth, sticky inflation, ongoing supply chain problems, high valuations and potentially disruptive events in China are all clear and present themes. The delta variant, despite a slower growth rate in daily new cases, shows no signs of going away any time soon. The depressingly familiar 2020 refrain of “with an abundance of caution” is making an unwanted reappearance as even some outdoor events slated for the coming weeks pull the plug.

With that same abundance of caution, many investors are deciding to sit tight on their year-to-date gains and not extend themselves further into exposures that could snap back and bite them — but at the same time not do too much de-risking. This perhaps explains why, while equity markets have been registering a higher than usual number of down days recently, the magnitude of the losses has been relatively contained. Right now the S&P 500 is around two percent off the most recent record high reached on September 2. Fear is not the mood of the moment, it’s caution. An abundance of caution.

More Trouble in China

What about those China exposures? It seems that every week we potentially have a new “China risk” story to share, from the clampdown on overseas ADRs to geopolitical risk, the disappearing of China-based financial bloggers and much else besides. In the news this week have been the travails of Evergrande, a large real estate developer and wealth management firm with by some estimates as much as $300 billion in total liabilities amid collapsing sales, on the brink of default. The “great fall of China,” as some wags have named it, could potentially reverberate outside the domestic investors, suppliers and homebuyers who stand to lose a great deal. Among those billions of dollars of Evergrande obligations are the interests of some of the world’s largest institutional investors.

It’s an uncertain situation, to be sure. But again we go back to that lesson learned from 2020: you can’t predict what is going to happen and you couldn’t predict the response even if you had a crystal ball. In this case the first node of the decision tree might be easier to assign a probability to: there is a very high chance that, left to fend for itself, Evergrande goes under and takes all those creditors and vendors along for the fall. But there is also probably a better than average chance that the Beijing financial authorities step in and bail the company out (though on preferential terms that probably will not be to the benefit of those foreign creditors).

Maybe the bail-out comes along with a more general economic stimulus package that puts a new luster on those underperforming China shares weighing down diversified portfolios. In which case, the “first do no harm” approach would be to not sell out low today. For many, exposure to China is a strategic play – a toe in the water or maybe even a whole foot in the expectation that what may be the world’s largest economy by the middle of the decade is simply too important to completely pass up.

Lots of unknowns, in other words. Too many to keep one from doubling down – and too many to keep one from running for the hills. First, do no harm.

Ten years ago, markets got a nasty shock when the normally routine act of raising the debt ceiling got roped into the bitter world of Congressional partisan gamesmanship. Then-president Obama tried and failed to cut a deal with then-House Speaker John Boehner. Standard & Poor’s, unimpressed by the devil-may-care shenanigans playing out in Congress, cut its credit rating on US Treasury obligations from their longstanding triple-A perch. The stock market was even less impressed and plunged nearly 20 percent before the dueling parties finally cobbled together an agreement.

In the wake of this near-disaster the belligerents sobered up, put aside partisan differences and vowed to never again play with fire where it concerns the full faith and credit of the United States government, right? Haha, if only. Ten years after that late-summer debacle in 2011 here we are again. In a sternly worded letter to Congress this week Treasury Secretary Janet Yellen said that the government will run out of money by the middle of October, sooner than expected, and that Congress needs to act pronto. Congressional Republicans united behind Senate Minority Leader Mitch McConnell to say – don’t expect any help from us. To which President Biden’s reply appears to be: I call your bluff and raise the stakes by forcing a vote on the debt ceiling. Go ahead and crater the economy, I double-dog dare you!

We’ve Already Spent the Money

With all the hyped-up performative bloviating about the debt ceiling filling up cable news hours, it’s easy to forget a simple fact: raising the debt ceiling is something we do to pay for things we’ve already spent money on. Raising the debt limit covers past obligations, not future ones. That’s what makes the stakes so high – if the world’s richest country becomes a deadbeat on paying its debts, things can go south very quickly throughout the entire economy. Not to mention the inability for the government to continue funding all the programs out there supporting pandemic relief, Social Security, defense and other critical areas (including the salaries of the people who work in the federal government).

Tough Days for Joe

So how do we keep this clown car from going over the cliff? The legislative environment is looking particularly challenging for the party in power, with razor-thin majorities in the House and Senate. In addition to the matter of resolving the debt ceiling, the Biden administration is trying to figure out how to pass the bipartisan infrastructure deal already approved in the Senate (with 19 Republicans joining the Democrats in a rare show of comity) along with a much larger (for now, anyway) bill packed with a variety of programs dealing with education, child care, climate change and other things the administration likes to call “social infrastructure.” There is a self-imposed deadline of September 26 for figuring out how to get both of these bills passed, but very little seems to have been done to resolve a massive gulf between the expectations of progressives and moderates within the Democratic Party (no support whatsoever is expected from Republicans on the social infrastructure bill, which currently has a price tag of $3.5 trillion and would involves some form of tax increases that are anathema to the GOP).

One way to resolve the debt ceiling problem would be to simply toss it into the social infrastructure bill and pass that through the reconciliation process that would avoid a Republican filibuster. But given the high level of uncertainty around that bill’s ultimate fate, Biden’s decision to keep the debt ceiling separate and require a clean, up-or-down vote on it in Congress (most likely in the form of a continuing resolution to fund the government) is probably the better option. That still leaves open the risk that Republicans stare down the administration’s dare and refuse to budge.

But – assuming that all House and Senate Democrats would vote in favor of the resolution – the Senate Republicans would actually have to use their filibuster weapon in favor of a move that would, with very high likelihood, send financial markets into a tailspin. It’s more likely that heavy pressure from the GOP’s copious network of supporters and donors from the business and financial communities would force them to back down – or at least the ten of them that would be needed to head off a filibuster.

We are of the opinion that a resolution on the debt ceiling, in one form or another, is the more likely outcome (though there are attendant questions about whether it would be just a short-term fix or a more stable resolution that would take the issue off the table for at least a couple years). Even so, though, the uncertainty is not helpful in an environment where there is already enough negative sentiment on other issues, from the persistence of the Covid delta variant to questions about the Fed’s timing for tapering its bond-buying program to the above-trend inflation rates in the US, Europe and China. It would be nice to get the debt ceiling issue fixed sooner rather than later – but we’re not holding our breath.

August is over, which means we can no longer lazily type in “dog days, low volumes, everyone’s on holiday” as the go-to explanation for whatever is going on in asset markets. The kids are going back to school and the smell of pumpkin spice is already wafting through the air, though the air itself is not yet particularly fall-like as climate change extends the feeling of summer further and further into fall’s former territory. It’s time to take a look ahead and see what kind of fall may be in store for investors.

Risk Takers of the World, Unite

We’re starting the post-Labor Day period with the S&P 500 sitting comfortably with a 20 percent year-to-date gain, with the tech-laden Nasdaq Composite nipping at its heels and making up for the big performance gap with value stocks earlier in the year. The vibes of 2H 2020 are in the air: tech and other growth stocks surging right along with new Covid cases. The speculative corners of the market are also doing just fine, thank you – cryptocurrency investors are resolutely ignoring all the regulatory pushback from governments around the world and jaw-jawing their beloved tokens back towards the nosebleed highs of the past spring. The meme stocks beloved of juiced-up trader bros are doing just fine. Any drawdowns in major indexes like the S&P 500 are brief and shallow. BTD (buy the dip) and TINA (there is no alternative) rule the Zeitgeist. It’s a world for risk takers, by risk takers and of risk takers.

When the Denominators Change

Risk takers have had some cover this year to defend themselves against charges of excess. Earnings per share for S&P 500 companies for the second quarter came in at a whopping 92 percent, and are expected to register a 43 percent gain for the year as a whole. That is a pretty forgiving denominator for the price / earnings ratio. The last twelve months price-to-earnings ratio is still high by historical standards at 25, but below the peak of 30 it reached back in April. The next couple of quarters will keep a tailwind behind valuations getting too far out of control.

But the tailwind will not last forever. The market, being a forward-looking creature, will start to pay less attention to valuation based on trailing periods of one-off excess (e.g. the sharp earnings contraction periods in the middle of 2020) and more attention to what profits – and in particular profit margins – are going to look like down the road. One very constant theme in earnings calls with management teams during the Q2 season was margin pressure from inflation. The markets for both labor and raw & intermediate goods are distorted, while the global demand outlook is uncertain with the persistence of the pandemic and the low percentage of vaccinated citizens in much of the world. Earnings valuations have not mattered much in the frenzied speculative chase for riches that has continued for more than a year. But they will matter, and they might start to matter soon.

Elusive Risks Remain

“Risk” in the investment world traditionally has had a fairly specific definition: the likely variability of an asset’s returns around an expected outcome. The greater the variability (which can be up or down) the higher the risk. That kind of risk is measurable via the toolkit of investment professionals – standard deviation, beta, value at risk and all the frills-full derivatives thereof. But these quantitative measures based on probability theory do not work well as insights into the level of measurable risk posed by some of the biggest threats in our world. In our discussions with clients the conversation often comes around to the (in our opinion) four big ones: the 4Cs of cyber, climate, contagion and China (stay tuned for a forthcoming paper which will present our views on the 4Cs in more detail). Neither the timing nor the magnitude of these risks is knowable, but we know they are clear and present. We would perhaps add a fifth: capitulation, which is how we would define an environment where market opinion arrives at a broad consensus that the Fed and other central banks lack the means to fix whatever problem is at hand.

Nothing we have discussed in this paper is necessarily going to have any impact whatsoever on the performance of assets in the fourth quarter. If we had to guess (always a bad idea in this business) we would say that any threat actualizing as a present-day risk would have to pack a fairly sizable wallop to overcome the resolute optimism and complacency prevailing today. We used to speak of a “wall of worry” that stocks had to climb in order to get past investor fears during periods of disruption. Today that idea seems turned on its head – it is rather that the disruption itself has to climb a wall of optimism to make an impact. That wall is still fairly strong, but there may be some emergent cracks in the foundation.

The term “emerging markets” came into being way back in the ancient mists of the 1980s, replacing the clunkier “third world” as a descriptor for countries that, while lacking much of the hard and soft infrastructure of the developed world, had a future of bounteous growth prospects with which to lure investors willing to take a bit more short-term risk in a slice of their portfolios in exchange for higher returns in the long run. The concept really gelled into an investment strategy in the early 1990s with a slew of privatizations and overseas securities listings for previously state-owned companies in China.

Back then three parts of the world stood out as the likely growth engines for emerging markets: Asia, including China and so-called “tiger” economies like Taiwan and South Korea; Latin America, led by resource-rich Brazil and US-adjacent Mexico; and a somewhat vaguer mix of Middle Eastern countries and the embryonic capitalist economies of Eastern Europe, tossed together in a salad called “EMEA” (Europe, Middle East and Africa). Actual on-the-ground conditions in each of these regions (indeed, within the regions themselves) differed greatly. Yet during the 1990s the differences got papered over in favor of a simple story: higher growth than the global average, with some potential bumps along the way towards long-run outperformance.

Define “Long Run”

So how has that trade worked out so far? There’s been plenty of risk. The annualized standard deviation for the MSCI Emerging Markets index over the past ten years is 17.8 percent , while that for the MSCI World Index, comprised of 22 developed-market economies, is 13.9 percent. For all that extra risk, things haven’t exactly worked out over the “long-run” as hoped. The chart below shows the performance of the MSCI Emerging Markets Index versus the S&P 500 over the last 25 years.

The numbers on that chart show comparative cumulative percentage price returns over this 25-year period; specifically, that the cumulative return for the S&P 500 was more than twice that of the emerging markets index, despite the considerably lower risk associated with the large-cap companies that populate the S&P 500. Now, you can see that there have been periods where the emerging markets index did extremely well – most conspicuously in the years from 2002-07 that roughly coincided with a great supercycle in industrial and energy commodities markets. Other than for those having a preternatural gift for timing these rare bursts of outperformance, though, this asset class has been distinctly disappointing.

Time to Call It What It Is

That chart will not give much encouragement to anyone wondering if this asset class will ever be worth investing in. For starters, though, it’s really time to stop calling emerging markets an asset class – at least if you want to stick to that three-regions framework that we described above. Whether or not you should invest in “emerging markets” today really comes down to one thing, and that one thing is China.

The MSCI Emerging Markets index today includes 27 countries. China alone, though, makes up just about 35 percent of the index’s market cap. Add Taiwan (which may or may not become an actual part of China sometime in the next several years) and you’re at 50 percent. Add in South Korea and India, the next two biggest holdings, and you’re almost at 75 percent. Everything else – those other 23 countries – add up to just over one-quarter of the index’s value.

“Emerging markets” in this sense really has no unified meaning. It’s China, which as the world’s second-largest economy is a category unto itself. It’s three other Asian markets, two of which (Taiwan and South Korea) are considered by many metrics to already be developed economies. It’s not much else.

As Goes China

So if you are thinking about an “emerging markets” investment, the thing to consider is not how poorly this investment fared over the past quarter-century. It’s how you think China is going to develop in the next five and ten years – and beyond – and whether that development trajectory is going to translate into value for the common equities of Chinese companies. As you know from some of our recent weekly commentaries, this is a burning question in the market today without a clear answer. The era of Chinese internet behemoths like Alibaba and Didi Chuxing, with their US ADR listings, seems to be in eclipse. Just this week China appeared to indicate that it will place outright bans on companies with large amounts of sensitive customer data from any future overseas listings.

That development does not necessarily bode poorly for the broader Chinese market, though. Sectors like semiconductors, biotechnology and green energy are high priority strategic initiatives for Beijing, and that priority will flow into companies that will be available to foreign investors via listings either on local exchanges or, increasingly, via the comparatively sophisticated financial market infrastructure of Hong Kong. The diversion of planned US ADR listings to the Hong Kong alternative is already well underway.

For our part, the only thing of which we feel certain is that there is a great deal of uncertainty about the co-evolution of China’s markets with those of the US, Europe and non-China Asia Pacific in the years ahead. But we also believe that at least a modest exposure to the country that may actually be the world’s largest economy by the middle of the decade is warranted. The next 25 years – for better or for worse – are unlikely to resemble the last 25 years.

Earlier this week the Fed issued minutes from the most recent Federal Open Market Committee (FOMC) meeting, and the release caused a bit of a kerfuffle in equity markets. By “kerfuffle” of course we mean something that actually triggers a pullback of more than one percent (barely) in the S&P 500 without triggering a Pavlovian buy-the-dip reflex. The consternation, mild though it was, came from the revelation that a majority of Fed officials are of the view that tapering of the $120 billion per month bond-buying program could begin before the end of this year. Previously, the consensus expectation was that the Fed would not start trimming its quantitative easing (QE) operations until sometime next year.

The FOMC minutes were only one part of a generally negative attitude towards risk assets this week. Other factors including a deteriorating Covid environment, China’s continuing crackdown on the tech sector and the Taliban’s swift and complete takeover of Afghanistan took some value off of a variety of assets from small cap stocks to industrial and energy commodities to, unsurprisingly, Chinese and Hong Kong indexes. Some observers pointed out that there is still disagreement among the FOMC’s voting members, with some of the more dovish participants holding to the view that there is still enough economic uncertainty to warrant waiting a bit longer. That raises the question, though, about whether the monthly purchase of bonds is really a remedy suited to the particular economic conditions of the moment. There is a case to make that it is not.

QE’s Origin Story

Quantitative easing first entered the financial lexicon in the aftermath of the financial crisis and recession of 2008-09. The medicine was entirely appropriate for the circumstances of that time. The recession was deep and left households and businesses scarred for many months thereafter. The unemployment rate was still close to 10 percent in July 2010, a full year after the recession technically ended. Consumer demand plunged during this period. Flagging demand –by households and businesses alike – was precisely the problem QE set out to solve. In tandem with the Fed’s other, more traditional policy mechanism of lowering interest rates, the massive scale of bond purchases by the central bank pumped liquidity into the financial system, creating easier conditions for the generation of credit and thus spending power.

Demand Isn’t Today’s Problem

A similar demand-side meltdown looked likely in the immediate wake of the economic shutdown in March 2020 as the pandemic spread across the country. Arguably the Fed’s rapid response to the pandemic crisis, even more aggressive in many ways than after 2008, helped us avoid that outcome. Trillions of fiscal relief dollars and several quarters of economic growth later, though, weak demand is not the problem. Consumer confidence is higher than at any time since 2018 and far above its peak during the 2003-07 growth cycle. Personal consumption expenditures drove the robust Q2 GDP performance.

Today’s big problem is on the other side of the economic equation: supply. Supply chain disruptions have resulted in chronic shortages of a wide variety of goods from semiconductor chips to raw materials. Distribution bottlenecks have produced some of the highest freight and transportation costs in memory. Meanwhile services companies are suffering from a shortage in the supply of labor to fully meet the demand for their services. The Fed’s bond-buying program doesn’t solve any of these problems. If anything, the easy money makes the problems worse by increasing the amount of money thrown at a decreased supply of goods – i.e. the textbook recipe for inflation. In light of this it’s not surprising that a majority of Fed members are ready to get on with it and start tapering QE.

But the Markets!

The fact that there is still disagreement at the Fed for a tapering start date speaks to the problem of communication optics more than it does to economic analysis. Asset markets are tightly wired to everything the Fed says and does (hence the ruffling of feathers this week when the minutes came out). Bond markets went into a full-scale meltdown when former Fed chair Ben Bernanke first uttered the word “taper” in May of 2013. The Powell Fed would like to avoid another such tantrum, and thus has to frame its intentions carefully and with enough sugar-coating to make them digestible to excitable markets.

Next week all eyes will be turned to Jackson Hole, Wyoming, where global central bankers will get together for their annual confab. Expectations are fairly low for any kind of a definitive policy announcement from Powell at Jackson Hole. But he may gently set the stage for the next FOMC meeting in September. If the majority voice gets its way for commencement of tapering within 2021 then that would be the right forum for making the case. It will be a delicate and much-nuanced dance. Given what we know now, we think it would also be the right thing to do.

The second quarter earnings season is about to end, and it’s been a barnstormer. With about 90 percent of all S&P 500 companies having reported, the blended growth rate – comprising the actual reported numbers along with analysts’ estimates for the remaining 10 percent – is a stonking 91 percent. Yes, a big part of that dazzling figure comes from the basis of comparison being the lockdown period of Q2 2020. But even so, the results far outperformed expectations. At the beginning of the second quarter the consensus forecast for earnings growth was 52 percent, so when all is said and done the growth rate will wind up being nearly double that earlier prediction.

Earnings Fatigue

And yet for all those stellar earnings beats (that’s finance-speak for companies that deliver better results than analysts expected) the response from the market has been little more than a yawn. Companies that reported higher than expected earnings saw on average a gain of around half a percent in their share price immediately following the announcement. Those that missed the consensus estimate experienced on average a drop of about two percent.

Why the asymmetry? It seems that the Q2 earnings season got dragged into the emerging “peak growth” narrative that has settled into mainstream thinking. Nobody expects these companies to be plowing ahead with consistently high-double digit earnings growth once the immediate post-lockdown distortions have settled down, so the inclination is simply to treat the current round of numbers as so much noise. Better to focus on what could go wrong than on what has gone right – hence the more punishing reaction to companies missing their target numbers.

All About the Margins

For many analysts and investors the focus going forward is less on earnings growth itself than it is on profitability margins. We’ve all seen the inflation numbers shoot up in the past several months, both at the wholesale level (which companies experience when they purchase raw materials and intermediate goods) and the consumer level. Both wholesale and consumer price indexes are currently at decades-long highs, but there are differences of opinion as to whether this is merely a temporary phenomenon (which is what the Fed, among others, have long been saying) or something more structural.

To the extent that higher prices are here to stay, companies will face decisions about how much of the higher costs they assume at the wholesale level can be passed on down the value chain to consumers. Eating the costs themselves to keep prices low may help maintain selling volumes, but they will be earning fewer cents on each dollar of goods sold. Raising prices, on the other hand, may result in lower demand and loss of market share.

There’s not much in the current quarter’s numbers to give analysts a definitive read on margin prospects. But earnings calls have been dominated by questions about how management teams are experiencing inflation and how they see this playing out in the quarters ahead. We expect that when the third quarter earnings season starts in October, margin performance will be front and center. And with valuations still at historically elevated levels – despite the respite provided by the blowout earnings growth of the second quarter – we also expect that the performance bar will be set high. The earnings fatigue we have seen in the most recent quarter is not likely to dissipate any time soon.