Perception about the economy changed during the latter part of the third quarter. The quarter began on a positive note with the virus waning, and businesses and industries were reopening, adding jobs, and looking for employees. Around two million workers were added to payrolls in June and July and the economy was gaining strength, building on the 12% growth of GDP during the first half of the year. Even the Federal Reserve (Fed) at their meeting in July expressed that progress toward their goals of an average inflation of 2% and maximum employment for a sustained period were closer to being achieved. Citing progress toward their goals, the Fed at their September meeting stated that “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” It seems they will likely announce at their November meeting that a taper in bond purchases will begin. In addition, they also appeared to signal a move up in the time table to raise short term rates – Federal Funds Rate – into 2022 rather than 2023. If the Fed is positive on the economy, what are the changes that concern us? First, the highly contagious Delta variant of the virus, while down from the highest levels of cases, remains a significant headwind to a full reopening of the economy that had begun early this year. The other concern is that the current level of inflation may not be as transitory as the Fed believes.
Looking back to the Great Recession of 2008/9, the recovery of the economy was impressive. The aggressive monetary policy – near zero interest rates – used by the Fed achieved full employment without triggering inflation. Currently, monetary policy is aggressive as we continue to recover from the 2020 recession, but unlike after the Great Recession, inflation has become an issue. Consumer spending – 70% of GDP – is aiding the recovery; however, the labor market is still weak and full employment has not been achieved. Growth is primarily the result of the massive stimulus dollars provided by the government. This economic expansion is occurring in an environment of supply shortages – autos, housing, raw materials etc. – as well as a shortage of labor to produce goods and services. This supply shortage is causing prices to rise as demand is greater than supply. In addition, the labor shortage will result in the price of labor (wages) increasing. Both are inflationary, but are they transitory as the Fed thinks?
The current inflation rate as measured by the Consumer Price Index (CPI) is 5.3% and if we subtract out food and energy – the so-called core rate – is 4.0%, both above the Fed’s targets. Some inflation is transitory. Shortages in the supply chain of products like auto technology are transitory, but inflation caused by rising wages is different. Historically you cannot have sustained inflation without wage pressure and that is the current concern. Businesses cannot find enough labor. According to the JOLTS report, there are 11 million job openings, but in August businesses added only 235,000 employees to their payrolls. Businesses are having to raise wages to find labor, and higher wages means higher costs to produce goods and services which businesses pass on to the consumer as higher prices – inflation. Higher wages also mean more income for consumers to spend on goods and services which increases the demand by businesses for even more labor resulting in higher wages and prices. The concern is that inflation caused by higher wages may not be transitory.
Many economists think that inflation is becoming embedded. If true, it creates a dilemma for the Fed. The Fed is primarily an inflation fighter, and their main weapon is higher interest rates. If the Fed is to achieve their goal of maximum employment for an extended time, they need to keep monetary policy accommodative. The Fed believes a large amount of current inflation is transitory and that a gradual move to a less accommodative policy will allow for growth and be adequate to keep inflation in check. Hopefully, they are right. We do expect the virus to wane as more people get vaccinated or recover from the virus with antibodies. These should help alleviate the labor shortage and wage pressure allowing the economy to expand without igniting more inflation. Stay positive and healthy.
“USA, USA, USA” – this was the chant heard at Whistling Straits Golf Course in Wisconsin as the US emphatically beat the European team 19-9 to bring the Ryder Cup back to the US side of the Atlantic. This US vs. Europe (and the rest of the world – ROW) also played out in a similar fashion in the equity market during the third quarter as domestic equities once again bested their international counterparts. A variety of factors contributed to this most recent trend, including a slowdown and crackdown in China which spilled over to other emerging markets and China’s large trading partner, Germany. In addition, a stronger US dollar during the quarter created a headwind for international shares. Of course, this trend of US vs. ROW is not a new one. Unlike the Ryder Cup where Europe has won 9 of the last 13 competitions, the US has dominated for the last 10+ years in the financial markets. As a result, the valuation disparity between the US and ROW has become significant, perhaps creating a window for some outperformance in the future. In addition to this dynamic between US and International markets, we see a similar theme in the disparity between large-cap valuations and sentiment and small/mid-cap equities. Small and mid-cap companies look relatively attractive compared to their larger brethren that get most of the headlines. Time will tell if these valuation gaps close. For now, let’s examine what happened in the past three months.
After closing at record highs in June, the S&P 500 continued higher at breakneck pace through July and August, with brief pullbacks. However, the US large-cap index encountered some resistance around 4,500 in early September and is set to record its first down month since January 2021. However, for the quarter, the S&P 500 Index closed marginally higher, up 0.6%, including dividends and now sits 15.9% higher for the YTD period. Despite a solid rally late in September, small-cap stocks (as measured by the S&P 600) underperformed their larger peers ending down -2.9% for the quarter but are still higher by 20.0% on the year. As discussed above, International stocks lagged for the three month period with Developed International Markets losing -0.3% for the quarter (as measured by the EAFE Index). Emerging Markets (EM) fared worse, falling -8.0% for the quarter (using the MSCI Emerging Market Index). For the first nine months of the year, Developed markets are up 8.8% and Emerging markets are down -1.2%, respectively. Putting the US and International markets together, the MSCI All-Country World Index (ACWI) was slightly negative for the quarter, -1.0% and is 11.5% higher for the year-to-date period.
The sector performance was decidedly non-cyclical for the first two months of the quarter as Communication Services, Utilities, Real Estate, Technology and Healthcare led the way. The tone shifted in September, however, and as rates moved higher, Energy and Financials moved into the top spots. In the end, seven of eleven S&P 500 sectors were positive for the three-month period, with six beating the overall market return for the S&P 500. Financials rallied late to take the top spot for the quarter, up nearly 3%. Utilities, Communication Services, Healthcare and Technology rounded out the top five, rising between 1% and 2%, each. Despite the rally in September, the bottom four sectors were mostly cyclical, including Consumer Staples, Energy, Materials and Industrials. Staples were down less than -1% while the other three were lower by -2% to -4% for the quarter. In the middle, Real Estate and Consumer Discretionary were flat to up 1%. Through three-quarters of the year, all eleven sectors were positive, with just four outperforming the broader market. Energy remained at the top, up over 43%, but Financials, Real Estate and Communications Services were up nicely between 22% and 29%. Consumer Staples and Utilities occupied the bottom two spots YTD, rising approximately 5% and 4%, respectively.
As discussed in my quarterly letter, there are no shortage of variables out there for the investors to digest and evaluate as we enter the fourth quarter of 2021. Perhaps the most important ones for equity investors are earnings and interest rates. As we have discussed in these pages before, strong earnings results in the past three quarters have been a significant driver of positive equity returns. We are starting to see some challenges from companies dealing with increased inflation and supply disruptions that could crimp earnings growth in the coming period(s). Rising interest rates, while perhaps a positive signal for future growth, could weigh on valuations for certain parts of the equity market, particularly those with earnings prospects further out in the future. We will be watching both of these variables carefully as we move into the final quarter of the year.
As mentioned in the Economic Outlook section, the Federal Reserve appears ready to remove some of the accommodation provided since the onset of the coronavirus pandemic. The expectation is for a reduction of $15 billion of the $120 billion per month of Treasury bonds and Mortgage-backed securities they are buying. This suggests the program ends in the middle of 2022 though they will most likely continue to reinvest proceeds of the existing portfolio for some time. Additionally, measures of inflation remain stubbornly high. All else equal, this should allow for rates to drift higher.
While the yield curve was very little changed point to point for the quarter, this belies the volatility that occurred during the three month period. For example, the 10-Year Treasury yield touched a low of 1.12% in July and August before finishing relatively unchanged for the period. Overall, the 10- Year Treasury Note moved up by 2 basis points in the quarter to 1.49% and is higher by 58 on the year equating to negative returns of -0.31% and -4.40%. The 2-Year Treasury Note ended the quarter at 0.28%, only 1 basis point higher on the quarter and 16 more than the beginning of the year resulting in returns of 0.09% and negative -0.01%, respectively. Here again, though, we saw intra-quarter moves with the 2-Year rate touching a low of 0.16% in early August before rebounding. We expect inflation to moderate, but will not be as transitory as the Fed expects. Therefore, we are cautious on government bonds.
Corporate bond spreads remain near all-time lows leading to continued outperformance relative to other fixed income investments. The total return of ICE BofA 1-10 Year Corporate Index was 0.06% and -0.28% for the quarter and year, respectively. Similar to Treasuries, longer-dated bonds outperformed shorter ones and those of lower credit quality performed the best as investors continue to reach for yield. High-yield bonds continue to be the biggest beneficiary of the benign environment – outperforming investment grade bonds by 65 basis points for the quarter. Higher energy prices are one reason for this dynamic as the sector makes up a large part of the high yield index. We remain overweight corporate bonds, but are focused on companies with strong balance sheets given the narrowness of credit spreads
At these very low rates, municipal bonds were little changed on the quarter. The Bloomberg 5-Year Municipal Index had a total return of 0.13%. The return for the year is 0.30%. The ratio of Municipal yields to Treasury yields improved to 76% with a lift on municipal yields at the end of the quarter. Local municipalities are beneficiaries of the programs being passed at the federal level. This is providing a windfall for budgets and reducing the need for increases in debt issuance for local projects. Additionally, investors are focused on looming tax increases keeping demand for these instruments high. We continue to favor this sector for those in the higher tax brackets.
|QTD 2021 Total Return1||YTD 2021 Total Return2||52 Week Total Return3|
|MSCI Emerging Markets||-8.03%||-1.16%||18.52%|
|Barclays Int. Gov’t/Credit||0.02%||-0.87%||-0.40%|
|Barclays Aggregate Bond||0.05%||-1.55%||-0.90%|
|Barclays 5-Year Municipal||0.13%||0.30%||1.08%|