What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, was up less than 1% in Q3.
- The developed markets of Japan was up more than 5%.
- Europe was almost flat, the U.K. up more than 2%.
- Emerging Markets were down about 8% and Asia (Ex-Japan) was down more than 9%.
- Global fixed income returns were mostly flat to positive during the quarter.
Where Do We Stand?
- The third quarter gave us the pullback that was to be expected after 5 consecutive months of positive returns.
- Valuations have moderated a bit but are still well above their 25 year average.
- Current cash levels are trending downwards as I continue to look for opportunities to invest.
- I continue to rebalance your accounts accordingly to ensure targets are within acceptable ranges.
Click play below to listen to the Market Update for 3Q21!
Equity markets were roughly flat over the quarter after a decline in the month of September negated gains achieved during July and August. Concerns over a peak in economic activity, rising inflation, a potential federal debt default and a housing sector crisis in China were to blame. Looking deeper, markets often tend to “look for something wrong” when it’s time for a correction and that is likely what we had this quarter. After five months of unabated positive returns, the markets got tired.
A Breather
The rarity of the markets turning out 6 consecutive positive months in a row is rather high. In fact, data shows that nearly 40% of the time two months of positive returns is followed by a negative month. The reality is that all periods of consecutive performance eventually end. In the last month of the quarter, the S&P 500 was down 4.89%. This is not a correction or a bear market, yet the financial media would have us believe the market was crashing. The S&P 500 finished the quarter at about 4307. This was about 5% lower than it’s recent closing high of about 4537. This is only half of the way to a full correction, but maybe that is enough for now. The markets needed a breather and certainly we have gotten one.
Quality Defense
Economically, the PMI (Purchasing Manager’s Index) is likely to turn lower in 2022. This was inevitable as this index turned violently higher coming out of the pandemic. What this means is we are likely to see lower equity returns next year along with more volatility. To be clear, this is not a harbinger of the end of the bull market. It simply means that the sectors and stocks that have led markets over the past several quarters are not likely to lead going forward. I would expect portfolios that are a bit more defensively (Utilities, Consumer staples) positioned and companies that are of a higher quality (strong balance sheets, consistent earnings) to outperform.
Inflation Pit Stop
Of continued concern is the inflation picture here in the US. Today’s environment is somewhat reminiscent of the 1970’s where prices for basic goods and services increased at an accelerated pace. Recently, prices for necessities such as food, shelter and energy have risen due to both supply constraints (driven by labor and material shortages) and increased demand (driven by pandemic related stimulus). The Federal Reserve would have us believe these higher costs are transitory but the reality is they may not be entirely transitory. Companies have been able to pass along higher costs to their customers in the short term and will likely be remiss to lower their prices. Furthermore, both taxes and labor costs are set to rise as we move forward. Corporate taxes are almost certain to move higher with the Democratically controlled Congress and White House. At the same time, more workers will be returning to the labor force with an expectation of higher wages. Both these items will put a damper on corporate profit margins, one of the drivers of higher stock markets over the past 18 months. These phenomenon will also produce “cover” for companies to keep prices high. While this isn’t something that will completely derail growth in the U.S. it can soften it.
China Stall
Further abroad, the news out of China has been mostly negative. During the quarter China moved to turn private tutoring companies into non-profits. This concerned investors that nationalization of companies could occur in other sectors. They also imposed more regulations on the technology sector by limiting the amount of time children could play computer games. Lastly, the potential default of a very large property developer named Evergrande further weakened equities. While all three of these factors will certainly slow the pace of growth in China, I do not think it is enough to turn earnings growth negative. Earnings are likely to remain robust in China albeit at a slower pace than previously expected.
Bank Turn
In the UK and Europe we saw much the same as the U.S experienced. Central banks there as well as in the US turned hawkish, meaning they are looking to slow their asset purchases and potentially raise interest rates in the coming quarters. While higher rates around the developed world is not a guarantee for lower equity prices, their potential actions could be removing one of the major pillars of higher equity valuations. Granted, with rates so low around the world a return to more normal rate levels would not have the same effect as an unexpected rate increase starting at higher levels. In fact, a return to normal could be construed as a good thing as that means the damage of the pandemic is mostly in the rear view mirror. The result of these actions would be higher bond yields and inherently a continued cooling off of the bond market rally we experienced earlier in the quarter.
Brake Tap
Overall, the equity markets have proven to be rather resilient in the face of all these factors. The latest wave of Covid hospitalizations that took place during the quarter seems to be peaking. Consumers remain in a good place as the high level of savings that has been accumulated over the past several quarters has allowed spending to remain high. These savings in conjunction with good wage growth expected in the coming quarters will help to support markets. The winter season may bring heightened uncertainty around Covid, but vaccinations and further advancements in treatments would likely dampen that effect. Volatility will likely increase as we head into the holiday season and we may hit some speed bumps along the way but the foundation is there for the markets to remain resilient and economies to continue to grow. Much like entering a chicane on a race track. There’s a heightened probability of crashing so you slow down but most cars make it through unscathed.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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