As the final quarter of 2021 commences, markets are on edge, with inflation, supply chain issues, and monetary policy raising concerns.
The September/October seasonal time frame has often been the most volatile period in the stock market, and the past month was no exception. After setting record highs throughout the summer, the S&P 500® index declined nearly 5% in September, wiping out nearly all the gains achieved during the summer rally.
Growth stocks, dominated by the very large information/technology stocks, were especially weak in September due to fears of rising interest rates, possible government scrutiny, and concerns over relatively high valuations. The broader stock market was inevitably pulled lower due to the very large weighting of the information/technology sector.
Bond yields, which have been expected to rise for months due to mounting inflation, finally moved up in September. Longer-maturity Treasury yields reversed course again, rising about 20 basis points for the month. Consequently, fixed-income returns were modestly negative during the month, but essentially flat for the quarter.
Commodities continued to register impressive gains during September, as they have all year. The S&P GSCI Index, which is a representative broad basket of commodities used throughout the world, was up nearly 6% in September, and is now up about 36% through the 3rd quarter. Oil and natural gas have been a key driver to this surge, with oil prices up nearly 10% in September alone.
Are these edgy markets a precursor to more volatility and potential weakness? Following are two key dimensions to our outlook.
Inflation and changing Fed policy and politics
A key long-term support to the overall stock and bond markets has been Federal Reserve (Fed) policy, which has not only pinned short-term rates at effectively 0% but has also provided for the purchase of massive quantities of bonds in the open market. This has kept long-term bond yields very low, and real (inflation-adjusted) yields decidedly negative. It has also provided much of the fuel for the stock market’s advance.
The Fed has indicated over many months that the significant rise in inflation is due predominantly to unusual supply bottlenecks caused by the COVID-19 pandemic. It has characterized this dynamic as being transitory, and that inflation pressures will eventually recede back to its 2% target.
However, persistent inflation, and now wage pressures, are entering into the debate amongst key Fed officials. The Fed has indicated that it will likely begin winding down its asset purchase program this year. The effect of this tapering has been a concern for some time, although it should not be a surprise to the market given that it has been on investors’ radar for a number of years.
Politics has now entered into Fed dynamics. First, two influential Fed bank presidents are resigning, partly due to the negative optics of personal market trading. Fed bank presidents are important in setting monetary policy, so the uncertainty of these vacancies is relevant.
Second, Fed Chair Jerome Powell’s term is concluding soon, and politics are emerging which are modestly diminishing the prospects for his reappointment. The market has embraced Powell’s leadership, so his departure would not be a welcome development.
In summary, although a modest change in policy is coming – and politics may increase uncertainly over Fed leadership – monetary support for the economy and for markets will continue.
“Economics 101” – supply/demand dynamics and profits
Consumer demand has been incredibly resilient during the pandemic. The labor market continues to be very tight. This situation is a double-edged sword for the economy. On one hand, income and wages are meaningfully increasing, which is bolstering demand for goods and services, particularly as the economy continues to reopen.
On the other hand, however, the pandemic and long demographic trends are hindering the supply of labor to such an extent that some businesses are being significantly impacted, thus hindering growth.
Meanwhile, the pandemic’s depressing effect on supply chains continues, leading to problematic shortages in a number of materials and goods. Geo-political issues, especially with respect to China, also have hindered the sourcing of supplies.
The consequence of this disequilibrium in supply and demand is rising prices. Up to now, rising prices have not been a major issue for corporate earnings, which have been bolstered by a major snap-back in sales. As sales growth moderates and cost pressures persist, corporate earnings, which have continued to surpass expectations, may be affected.
Third quarter corporate earnings results, due for release in the coming weeks, will be an important dynamic (as always) in the direction of the market. There have been hints that earnings in certain industries and companies may be affected by rising costs, which could lead to further market weakness.
Our view of the markets has not changed significantly since the end of the 2nd quarter. However, risks have been rising along with market returns throughout the year.
Overall, the key supports to the economy and markets remain in place. However, costs pressures, monetary policy uncertainty, and fiscal policy politics represent new, and potentially negative dynamics, for investors to consider.
With interest rates remaining stubbornly at levels that are well below reported or expected inflation, fixed-income returns will continue to be lackluster at best. But rapidly rising interest rates and bond yields do not seem imminent.
We remain moderately overweight in equities. But in such a high valuation market – with inflation signals flashing warning signs, Fed policy potentially in transition, and growth likely peaking – we continue to believe this is not a time for aggressive positioning.
Security selection, focusing on quality, durability, and solid fundamentals regardless of sector is important, particularly in a choppy, somewhat leaderless market environment.
Outside the U.S. equity market, the developed markets, particularly Asia (outside of China) and Europe, appear to be in a better position than the emerging markets. Emerging markets will remain challenged by the surprising insinuation of the Chinese government in their economies, rising interest rates, a stronger dollar, and geo-political tensions.