Quality will prevail
Quality companies are likely to prevail in a more challenging economic environment highlighted in the October Beige Book report by the US central bank, released Wednesday evening. As such, style and sector selection will likely play an even more significant role in portfolio performance, while allocation to secular trends will likely provide robustness.
After reading the report, the main take-away message is that the operating environment for US companies has become more complex; thus, growth may slow further as companies deal with input and wage cost & supply issues.
Therefore, investors will likely shift portfolios towards quality companies and select sectors with greater prudence. When the economic environment becomes challenging, quality companies are generally able to manage it better. These companies are usually highly profitable and, or less leveraged, with strong brand loyalty, thus often providing better risk-adjusted returns in a more complex combination of growth and inflation.
Regarding inflation risks, we will be looking at the next quarterly US Employment Cost Index (ECI) report due on October 29. If the Beige Book and our GMG US economic outlook are correct, the ECI may come in higher once again. It has climbed for three quarters, moving from 2.4 Q3 2020 to 2.90 Q2 2021 (chart below). If the ECI report comes in at anything over 2.9, it will be at levels not seen since 2008.
We shifted our portfolios towards quality and value stocks several months ago in anticipation of a more challenging economic backdrop, primarily due to our view that price and wage pressures will persist. The Fed’s October Beige Book has confirmed a more challenging business environment; quality & value companies should be overweight in investment portfolios.
US Employment Cost Index (ECI)
The ECI has climbed for three consecutive quarters (next report due October 29, 2021)
Source: FRED. Data as at 20/10/2021. The products or services mentioned are provided as general information only and are not intended to provide investment advice or constitute a direct solicitation on the provisions of investments services. Past performance does not necessarily predict or guarantee future results.
Some key take-away points from the October report include:
- On Growth: Economic growth « downshifted slightly » to a moderate pace in early July through August. The report released in July was more positive. « July Report: The U.S. economy strengthened further from late May to early July, displaying moderate to robust growth.
- Growth Outlook: The October report shows businesses are optimistic but more concerned than before. « Looking ahead, businesses in most Districts remained optimistic about near-term prospects, though there continued to be widespread concern about ongoing supply disruptions and resource shortages. »
- Employment and Wages: The jobs outlooks remain positive, there is rising employment overall. However, labor shortages are having an impact on business activity and leading to higher wages and other incentives (bonuses, more frequent raises, training, flexible hours) being offered by companies; « … all Districts noted extensive labor shortages that were constraining employment and, in many cases, impeding business activity. »
- Prices: The report highlights broad upward price pressures due to “pervasive resource shortages”, thus disruption in economic activity. « Inflation was reported to be steady at an elevated pace, as half of the Districts characterized the pace of price increases as strong, while half described it as moderate. With pervasive resource shortages, input price pressures continued to be widespread. Most Districts noted substantial escalation in the cost of metals and metal-based products, freight and transportation services, and construction materials, with the notable exception of lumber whose cost has retreated from exceptionally high levels.” “… Several Districts indicated that businesses anticipate significant hikes in their selling prices in the months ahead. »
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