QUARTERLY MARKET UPDATE as of October 2021
Stocks inched higher again in the third quarter. Large-cap stocks as measured by the S & P 500 gained 0.6%. However, international stocks as measured by the MSCI index declined, moving down 0.4%, and small-cap stocks in the Russell 2000 index dropped by over 4%. Sector performance was equally mixed with six up sectors and six down sectors. The Financials led the way gaining 2.3% while Industrials were off 4.5%.
Longer term interest rates moved lower over the summer and bottomed in early August with the 10-year treasury reaching 1.17%, the falling rates fueled a rally in large-cap tech stocks. This reversed course in September after the Federal Reserve’s open market committee meeting. The 10-year rate subsequently moved back close to the level it started the quarter at 1.5%. The Fed policy meeting concluded with the announcement that it may soon begin the process of slowing its bond purchasing program. The resulting ¼ increase in yield increased stock market volatility in September and pared back the gains for the quarter.
This backdrop heading into the 4th quarter brings us to a cautionary stance, with October historically being a more volatile month for the stock market. There are many fundamental factors to consider. However, the positives still outweigh the negatives.
Growth in the third quarter will be less than expected, a direct result of the surge in the Delta variant of Covid cases. Going forward, as more people will have some form of immunity from either being vaccinated or catching the virus, we see the growth that was subtracted from last quarters rate adding to the next few quarters growth rate. The economy is still opening up. Children are going back to school; balance sheets are very healthy both on the personal and corporate level; and plenty of stimulus money is still on the sidelines waiting to be spent. With interest rates close to historically low levels, earnings and wages increasing, and capital waiting to be deployed, the demand for stocks will remain high.
Headline inflation is at or close to the top of everyone’s chief concern. Supply shortages and wage increases are contributing to a current inflation rate of over 4% year over year, well beyond our normal 2% threshold. There is also uncertainty over the debt ceiling which continues to have partisan disagreements over its suspension. This is a recurring issue that pops up every few years, most recently in 2019. Legislation is being worked on to fund the government into early December when the political theatre will resurface, but we do not believe it will have a lasting impact on the markets.
We expect the current higher level of inflation will settle down, but still be above the Fed’s past target of a 2% annual increase. A resurgence in inflation has historically led to higher interest rates, and while we may see long term rates move up another ¼ percent to 1.75%, there are many factors in play that will keep interest rates from surging higher.
First, the Fed’s dual mandate is to achieve maximum employment and stable prices. We believe the Fed will be more dovish and keep short term rates lower longer, favoring job growth instead of raising rates to combat inflation. As the Fed’s viewpoint is for higher inflation to be transitory, we do not expect to see a rate increase for several quarters at the earliest. The bond buying program will be reduced but not end until next summer. Other central banks around the world also have bond buying programs and policies that favor employment growth over fighting inflation.
Globally, most interest rates are lower, which continues to attract investors to the U.S. The stimulus programs and inability to travel over the last year also created a high savings rate and another source for asset purchases. In addition, the demographics in developed economies is trending towards slower population growth, leading to slower economic growth. Despite the inflation rate exceeding the yields on bonds, the demand for bonds will remain intact as the safe haven asset status attracts investors to U.S. bonds. We also expect the proliferation and adoption of new technology around the world will likely enhance productivity and keep inflation in check over the long run.
Another headline bringing concern is the expected bankruptcy of Evergrande Group, one of the largest property developers in China. This will have an impact on Chinese growth, which is slowing down, and a direct impact on their bond holders, property owners, and manufacturers selling products to the developer. We do not see this leading to a global contagion or an issue of significance for U.S. investors who are not directly impacted. More likely, it will be another source of funds to the safe haven of the U.S. markets.
With bond yields at unattractive levels and plenty of capital waiting to be invested we expect stocks will continue to outperform other asset classes. Sell offs and periodic corrections are always a possibility, especially in October. The optimal asset class still remains stocks, and within stocks, dividend paying stocks with reasonable valuations.