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Key Points for the Week

  • Earnings season is off to a strong start, and 30% of companies in the S&P 500 report this week. Earnings are expected to grow 32.7% and will likely grow more than 32.7% as companies usually beat expectations.
  • U.S. industrial production slid 1.3% last month as the shortage of semiconductors pushed auto production down 7.2%.
  • Chinese GDP (Gross Domestic Product) increased only 4.9%. Energy shortages in China forced production halts that limited economic growth.

MESSI (Moderating Expansion with Sticky Supply-driven Inflation) is a type of inflation that occurs when “strong, but cooling demand is met by constrained, but accelerating supply, leading to transitory, yet sticky inflation.” The coronavirus pandemic may have produced just the right circumstances, according to Gregory Daco of Oxford Economics.

Initially, extreme health conditions, severe social distancing measures, and unprecedented fiscal transfers to households supported a surge in spending on goods. With domestic and international supply struggling to rebound quickly and inventories being run down, prices for goods surged. Later, as the health situation improved, the re-opening of the economy led to greater demand for services which also ran into the tight supply conditions, leading to higher service sector inflation.

Gregory Daco, Oxford Economics

The recent rapid rise of inflation has many people concerned that we may experience runaway inflation, which occurs when prices rise rapidly, or stagflation, which occurs when economic growth slows while inflation rises. Daco doesn’t believe either will prove to be the case:

It’s not runaway inflation, and it’s certainly not stagflation…In the debate between transitory and runaway inflation, we have repeatedly said that the truth lies somewhere in the middle, with inflation likely to be ‘sticky but not oppressive.’

Gregory Daco, Oxford Economics

The baseline view from Oxford Economics is that higher inflation will persist into the first half of 2022 before falling back to about two percent by the end of next year. We remain convinced that inflation will run at 4-6% over the next several years, which is more pessimistic than Oxford Economics.

Time will tell.

This Week in the Markets

Thirty percent of the S&P 500 will report third quarter earnings this week. Based on earnings already in and analyst expectations, earnings are expected to grow 32.7% compared to last year as corporations continue to bounce back from a COVID-led earnings decline.

The most significant challenge for markets and the economy remains the supply shortages that are pressuring prices higher. U.S. industrial production shrank 1.3%. The monthly decline was larger than any seen from 2017 to 2019. Auto manufacturing dropped 7.2% last month, largely due to a shortage of semiconductor chips and other supply difficulties.

Energy shortages in China have contributed to a slower global recovery. Limited blackouts have curtailed production. Chinese industrial production grew only 3.1% during the last 12 months, a 2.2% decline from last month’s report. China’s economy continues to grow rapidly compared to the U.S., but its growth trend hasn’t been as strong post-COVID.

On balance, investors decided the news was good enough for equity markets to rise sharply. The S&P 500 jumped and reached a new all-time high. The global MSCI ACWI also added. The Bloomberg U.S. Aggregate Bond Index gave back slightly as concerns about increased inflation remain a risk for bond investors. The aforementioned third quarter earnings reports and third quarter U.S. gross domestic product headline economic data released this week.

Earnings Season

Once again, earnings season is off to a hot start. More S&P 500 companies than normal are beating estimates, and by wide margins.

Overall, of the companies reporting, 84% have beaten estimates versus the long-term average of 76%, and the average earnings beat is 13.4% above estimates compared to an average of 8.4%. Earnings strength is broad-based across several sectors, led by information technology, health care, financials, and communication services.

We are still in the early stages of earnings season with only 23% of companies reporting so far, but this week should be interesting with another 164, or 30% of companies in the S&P 500, reporting.

The growth in earnings has helped push equity markets even higher, causing the S&P 500 index to surpass its previous record high. Market jumps without increased earnings can push valuations up. Valuations have moderated in recent quarters as earnings have risen faster than the stock prices. Even with the earnings gains, valuations remain higher than normal. The forward 12-month price-to-earnings ratio for the S&P 500 is 21, which is higher than the five-year average of 18.3 and the 10-year average of 16.4.

An interesting comparison is to analyze companies in the S&P 500 that generate most of their revenue overseas with those that generate the majority of their revenues in the United States. Given the disparity in economic recoveries, one might think that companies with more revenue coming from the U.S. would be doing better, but that’s not the case. The third-quarter earnings growth rate is 44.3% for companies that generate more than 50% of their revenue outside the U.S. and 26.3% for domestic-focused companies.

We will be monitoring earnings releases over the next few weeks. Some of the largest tech companies will report next. While the information technology sector has performed well, there have been some notable misses in the sector. Future quarters will also begin to face tougher comparisons, and the outlook, as well as the numbers, are likely to make the next few weeks extra interesting.

Did you Know? This Week in History

October 27, 1904: New York City Subway Opens

On October 27, 1904, New York City Mayor George McClellan took the controls on the inaugural run of the city’s innovative new rapid transit system: the subway.

While London boasts the world’s oldest underground train network (opened in 1863) and Boston built the first subway in the United States in 1897, the New York City subway soon became the largest American system. The first line, operated by the Interborough Rapid Transit Company (IRT), traveled 9.1 miles through 28 stations. Running from City Hall in lower Manhattan to Grand Central Terminal in midtown, and then heading west along 42nd Street to Times Square, the line finished by zipping north, all the way to 145th Street and Broadway in Harlem. On opening day, Mayor McClellan so enjoyed his stint as engineer that he stayed at the controls all the way from City Hall to 103rd Street.

That evening, the subway opened to the general public, and more than 100,000 people paid a nickel to take their first ride under Manhattan. IRT service expanded to the Bronx in 1905, to Brooklyn in 1908 and to Queens in 1915. Since 1968, the subway has been controlled by the Metropolitan Transport Authority (MTA). The system now has 26 lines and 472 stations in operation; the longest line, the 8th Avenue “A” Express train, stretches more than 32 miles, from the northern tip of Manhattan to the far southeast corner of Queens.

Every day, some 4.5 million passengers take the subway in New York. With the exception of the PATH train connecting New York with New Jersey and some parts of Chicago’s elevated train system, New York’s subway is the only rapid transit system in the world that runs 24 hours a day, seven days a week.

Weekly Focus

The great do not stay great, nor do the small stay small.

Bertolt Brecht, Playwright

The human imagination cannot be programmed by a computer. Our imagination is our greatest hope for survival.

Keith Haring, Artist