Market Review 3Q 2021
Updated: Jan 27, 2022
The quarter was mixed for fixed income returns. High-frequency data indicates that economic activity is surging, aggregate household balance sheets are healthy, and economic output is expected to beat pre-pandemic levels by year-end 2021. Plans for capital expenditures are strong and high consumer demand are expected to generate higher growth levels in late 2021 into 2022.
By September, fixed income markets experienced multiple concerns including inflation fears, oil price increases, fiscal policy concerns and the Federal Reserve indicating that it may begin tapering in 4Q2021. Supply chain disruptions and continued COVID-19 outbreaks may impede near-term economic growth.
Markets were also roiled by fears of a default on $300 billion of debt by Evergrande Group, the large troubled Chinese property developer. Fear of a Lehman-like failure and a lack of a Chinese government bail-out plan upset the markets.
The FOMC meeting on September 22, 2021 maintained the current Fed Funds target rate of 0%-0.25%. It also confirmed that until there is substantial progress toward the inflation and employment goals, the Fed will continue its $120 B ($80 B Treasuries / $40 B Agency MBS) in monthly asset purchases. The FOMC indicated that reducing its monthly purchases or tapering may soon be warranted.
The FOMC acknowledged that the persistently high COVID-19 cases and supply chain constraints have slowed the economy. It lowered its real GDP forecast from 7% to 5.9% for 2021.
Inflation has now well surpassed the FOMC’s 2% target. Higher inflation is lasting longer than anticipated although the Fed still considers it transitory. The Fed raised its estimates of PCE (Personal Consumption Expenditure) inflation to 4.2% for 2021 and 2.2% for 2022. PCE is the key inflation index used to determine monetary policy, hit its highest level in 30 years.
The FOMC raised its estimate for 4Q2021 unemployment from 4.5% to 4.8% reflecting a modest decline in hiring.
Expectations for rates to begin to rise in 2022 have increased. Fed Chair Powell mentioned that there was support for beginning to taper and end it by mid-2022. The markets expect a November announcement on tapering. Yields are expected to rise slowly to the end of 2021.
Fed Chair Powell, spoke at an ECB event in late September and expressed frustration over the US economic and inflationary challenges. The economy needs to contain the COVID-19 delta variant and vaccinate its population. Supply chain bottlenecks are creating inflationary pressures.
Fiscal Policy and Debt Ceiling
Technically, the US hit its debt ceiling or limit to borrow on August 1, 2021. The Treasury was able to meet its obligations by drawing down from the Treasury General Account (TGA) emergency liquidity fund at the Federal Reserve. Most of those funds were proceeds from debt issuance in 2020 in response to the pandemic. The debt limit needed to be approved before October 18 when the funds would be exhausted.
On October 6, 2021 the Senate agreed to raise the statutory debt ceiling by $480 billion until December 3, 2021 to avoid a default this month. This date coincides with the expiration of the current stopgap government spending bill passed to avert a partial government shutdown.
As Congress continues to negotiate its multi-trillion-dollar healthcare, education, and climate change bill, December will be a contentious time period as it will once again face a government spending bill and debt ceiling issues.
Revised 2Q2021 real GDP grew at a 6.7% Q/Q seasonally adjusted annual rate. Increases were broad based and were partly offset by decreases in inventories, residential fixed investment and government spending. Real output has now surpassed its previous peak in 4Q2019. Weaker inventories weighed heavily on growth, and as businesses restock in upcoming quarters, inventories could be a significant contributor to GDP growth. The September PMI pointed to a slowing pace of economic expansion, although more concentrated in services than in manufacturing. The ISM manufacturing PMI strengthened more than expected to 61.1 from 59.9 in August.
Key contributors to the rise of inflation are supply chain disruptions due to bottlenecks in shipping, finished product shortages, materials shortages, and labor shortages. Auto production and other products have been hampered by shortages in semiconductor chips.
The economy added just 194,000 jobs in September, down from 366,000 jobs added in August. Many workers gave up their job search and exited the labor force in September. The smaller labor pool meant that despite the slowdown in hiring, the unemployment rate fell to 4.8% in September from 5.2% in August.
There were job gains in the leisure and hospitality sectors. Professional services, retail, transportation and warehousing also reported job gains. Employment in public education declined over the month.
The number of unemployed persons fell by 710,000 to 7.7 million. The labor force participation rate remained unchanged at 61.6 % in September and has remained within a narrow range of 61.4 % to 61.7 % since June 2020. In September, there were 6.0 million persons who are not working and currently want a job. Yet there are a record 10.9 million job openings.
Total nonfarm payroll employment increased by 194,000 in September, lower than the monthly job growth rate that has averaged 561,000 this year. Nonfarm employment has increased by 17.4 million since the bottom in April 2020 but is down by 5.0 million, or 3.3 %, from its pre-pandemic level in February 2020.
In early October, weekly jobless claims slowed by 38,000 to 326,000, the largest drop in 3 months. Continuing claims dropped 97,000 to 2.714 million but planned job cuts increased 14% in September.
These mixed labor numbers may be due to early retirement of workers and relocation of workers from urban areas.
The spread of the Delta variant accelerated during the quarter as vaccination rates dropped. New vaccination mandates for federal workers and businesses have shown a modest uptick in vaccinations that had waned. Near-term U.S. GDP expectations were revised downward as major infection outbreaks impacted several states with low vaccination rates.
Corporate profits continue to recover at an impressive pace, already breaking records globally. The gains are very broad by region and industry, and robust growth is expected in 2022. The fastest recovery has been in the worst-hit industries such as leisure, hospitality and travel. Financial sector and industrial companies have been strong.
Sharp increases in oil prices and a weaker U.S. dollar have started to impact certain industries.
The economic environment and abundance of liquidity favor credit sectors that offer some level of yield although credit yield spreads continue to be tight.
Credit markets fluctuated with risk-off and risk-on periods as market sentiment changed during the quarter. Short investment grade corporates generated modest returns while longer duration credit kept pace with Treasuries.
Non-investment grade, high yield fixed income bonds had strong performance as investors continued to stretch for yield opportunities. Returns from securitized and municipal sectors were generally in line with Treasuries.
Global Minimum Tax Rate Agreement
U.S. Treasury Secretary Janet Yellen has made securing a global minimum tax rate a priority. The OECD announced an agreement among 136 countries on October 7, 2021 that sets out a global minimum corporate tax of 15%. This agreement is targeted at preventing companies from shifting profits and revenues globally to favorable low-tax jurisdictions. The agreement is intended to curtail tax avoidance by multinational corporations and raise additional tax revenue for governments. The OECD estimates the new rules would generate additional tax revenue of $150 billion annually. The global minimum tax would apply to companies' foreign earnings, meaning that governments could still establish their own home country corporate tax rates.
The global minimum tax rate agreement seeks to address the challenges posed by companies, particularly technology giants, that register the intellectual property that drives their profits anywhere in the world. As a result, many of those companies established operations in low-tax countries such as Ireland, the Cayman Islands, and Bermuda to reduce their tax bills.
The new agreement, if implemented, would divide existing tax revenues in a way that favors countries where customers are based. The biggest countries, as well as the low-tax jurisdictions, must implement the agreement for it to meaningfully reduce tax avoidance.
The final deal is expected to receive the backing of leaders from the Group of 20 leading economies when they meet in Rome in late October 2021. The countries would have to change their national laws and amend international treaties to put the overhaul into practice. The signatories have set 2023 as a target for implementation which may take longer to attain.
Troubled Chinese Company
Evergrande Group, a Chinese real estate development company, is facing one of the country's largest-ever defaults as it struggles with more than $300 billion of liabilities. Some of its outstanding bonds are denominated in USD. Evergrande is saddled with off balance sheet debt, too, such as debt sold to small investors and wealth management trust loans. Its potential financial demise unsettled global markets that worried about the global impact on financial markets. The fear of a potential debt default dominated the news in September and focused on the extensive, troubled Chinese property sector, banks that lend to them and wealthy investors in real estate bonds.
Evergrande stopped paying its investors, employees and suppliers in September 2021. Investors became concerned about a contagion or Lehman-like global trigger. Since then, Evergrande has hired the independent investment bank, Houlihan Lokey Inc., to handle its debt restructuring. The firm advised on the bankruptcies of Enron and Lehman Brothers.
China has also placed regulatory constraints on technology, cryptocurrencies and other businesses in its move to increase state control of these sectors. High commodity prices, COVID resurgence and property controls have also impeded China’s high growth rate. Continued US-China trade disputes and military posturing around Taiwan have contributed to tensions. intense market focus on Evergrande Group is the apparent unwillingness by the Chinese government to provide a bail-out and concerns that there could be a financial contagion that would impact global markets.
As of October 12, 2021 Evergrande Group has missed its three bond interest payments on its offshore bonds and could formally be declared in default by October 18-19 2021. Fitch Ratings estimates investors could recover less than 10% of sums due if Evergrande goes bankrupt.