Stay the Course

Q3 Investor Letter

Equity markets were mixed during the Q3 with the S&P 500 Index posting a modest 0.4% gain for the period. Year-to-date, the market is up nearly 15%, driven by stronger-than expected earnings as the impact of COVID-19 related shutdowns diminished.

We see strong earnings momentum continuing and look for above-trendline profit growth through CY 2023. A combination of pent-up consumer demand, record household excess savings (over $2 trillion) and robust wage gains should support positive momentum.

At the same time, pricing power has emerged across wide swaths of the economy that have heretofore been fighting deflation for decades. The positive margin implications are underappreciated in our view, and could lead to further upside earnings surprise. 

While supply constraints have stoked inflation fears, we see the current uptick in the CPI measure as transitory. Indeed, the CPI index for services, accounting for 70% of consumer spending, has moved up a more modest 2.7% recently. As supply chain disruption caused by accelerating demand dissipates, we see overall inflation return to a 2.0 - 2.5% band and so see a major upward move in rates as unlikely, particularly given a still-low labor force participation rate.

With earnings growth likely to remain strong for the next 8-10 quarters, we remain constructive on equity markets, particularly in light of a still-modest rate environment. Indeed, the recent uptick in 10-year treasuries notwithstanding, rates at 1.6% implies an equity risk premium of 3.6%. The S&P 500 earnings yield is about 5.0%, suggesting further upside over the next 12-18 months.