Stocks went on a run for the first two months of Q3, overcoming both growing inflation worries and rising Delta variant infections. Contrary to the narrative of a slowing economic expansion, the market was propelled by strong corporate earnings, the absence of compelling investment alternatives to stocks, and a “buy on the dip” investor mentality.
But as the summer faded to fall, investors turned more cautious as they began navigating the season’s rocky reputation amid persistently high levels of COVID-19 cases. The nagging knowledge of how long the market has gone without a significant retreat topped with the fiscal and tax policy discussions in Washington set an appropriate tone as September turned volatile. Stocks retraced their earlier gains as seasonal weakness was exacerbated by the mounting financial difficulties of a large debt-laden property developer in China and rising bond yields.
Stocks steadied briefly following a Federal Reserve announcement that its bond buying would continue, with tapering of monthly purchases likely beginning in November and extending into mid-2022. However, a surge in bond yields in the closing week of the quarter unsettled investors and led to steep declines in tech and other high-growth stocks as higher interest rates threatened the value of future cash flow, resulting in lower current stock valuations.
In the end, September erased the gains built over the previous two months, leaving major indices largely flat for the third quarter as many now wonder if the post-COVID recovery is coming to an end.
ECONOMIC CONDITIONS: MODERATING EXPECTATIONS
U.S. – We May Have Peaked
GDP: The degree to which economic growth may have slowed in the third quarter won’t be known until October’s release of the Q3 Gross Domestic Product (GDP) report. However, according to the Federal Reserve Bank of Atlanta, which tracks economic data in real time, their model is indicating a 3.2% annualized real rate of GDP growth in the third quarter, a sharp retreat from its model’s prediction of 5.3% on September 1. 
The Federal Open Market Committee’s economic projections issued in September also reflect a more cautious view of the economy in the near-term. GDP growth projections for 2021 were revised lower from June estimates, from 7.0% to 5.9%, while inflation estimates jumped from 3.4% to 4.2%. 
UNEMPLOYMENT: Labor markets improved over the course of the last three months to the degree that employers were having difficulty finding workers. The Federal Reserve Bank ascribed a range of reasons for the worker shortage, including increased turnover, early retirements, childcare needs, challenges in negotiating job offers, and enhanced unemployment benefits. 
One consequence of this labor shortage has been an acceleration in wage gains, which may hold the potential for lower future corporate profits (if companies find that they are unable to pass on the higher cost) and higher inflation, as increased wages raise the costs of products and services.
HOUSING: Home sales continued to be constrained by low inventory. The average prices of single-family houses with mortgages guaranteed by Fannie Mae and Freddie Mac in the United States advanced 1.4 percent from a month earlier in July 2021, the least since February and following a revised 1.7 percent gain in June.
INTERNATIONAL: Mixed Signals
The outlook for economic growth in European Union (EU) countries grew more positive with widening vaccinations, an improving health situation, and the easing of lockdown measures. The European Commission expects that output will return to pre-crisis levels by the fourth quarter of 2021. GDP growth estimates were lifted to 4.8% for 2021, while 2022 growth is expected to be 4.5%. Inflation estimates were raised to 2.2% for 2021 and 1.6% in 2022. 
The economic momentum that the United Kingdom enjoyed in the second quarter appears to be abating, owing to a resurgence in COVID-19 infections, staff shortages, kinks in the global supply chain, and continuing trade tensions with the EU. Nevertheless, the U.K. economy is projected to post a 6.6% growth rate for 2021 and a 5.5% expansion in 2022.10 After recording two successive quarters of strong economic growth, China’s economy is showing signs of slowing down. Flooding, higher input prices, and a surge in COVID-19 infections have all weighed heavily. A regulatory crackdown on a number of industries did nothing to improve conditions on the ground. It’s estimated that China will end the year with a GDP growth rate of 8.5%, with a drop-off in 2022 to 5.5%. 
Despite a rise in the pace of vaccinations, the Bank of Japan pared its economic growth estimate to 3.8% from 4.0% for its fiscal year ending in March 2022, though it raised its estimate for the following year to 2.7%, from 2.4%. Encouragingly, Japan announced in late September that it would be lifting the coronavirus state of emergency that was in place since April 2021. Additionally, it’s unclear what the impact may be of the decision by Prime Minister Suga not to seek reelection, but it has created an overhang of political uncertainty. 
EQUITIES: Emerging Market Uncertainty
U.S. EQUITIES: U.S. equities notched up a small positive return in Q3. Investors saw another quarter of exceptional corporate earnings growth. Second-quarter earnings exceeded Wall Street estimates for 87% of the companies comprising the S&P 500 index. Foreseeing continued strength in earnings growth, market analysts have increased earnings estimates, anticipating that the earnings growth rate will come in at 27.9% for the third quarter. If these estimates are realized, this would represent the third highest year-over-year earnings growth rate in over a decade.1,2 The strong earnings lifted U.S. stocks in August when the Federal Reserve (Fed) also seemed to strike a dovish tone when it confirmed its hesitance to tighten policy too fast. However, growth and inflation concerns late in the quarter meant U.S. equities retraced their steps in September and finished the quarter up just 0.58%.
DEVELOPED INTERNATIONAL EQUITIES: The quarter started with gains amid a positive Q2 earnings season and ongoing economic recovery from the pandemic. As the period progressed, worries emerged over inflation due to supply chain bottlenecks and rising energy prices. The MSCI- EAFE Index, which tracks developed overseas markets, dropped 2.70% in Q3.
EMERGING MARKETS: Emerging market (EM) equities declined in Q3 with several factors at play: continued concern over supply chain disruptions, a sell-off in Chinese stocks, and worries over rising food and energy prices. Regulatory actions in China were the initial trigger for the market weakness, and the threat of default by Chinese real estate behemoth Evergrande added to the swoon. At quarter end, the FTSE Emerging Market index dropped -6.75%.
FIXED INCOME: Hawkish Tone
U.S. FIXED INCOME: The U.S. 10-year Treasury yield finished at 1.49%, one basis point (bps) higher. Yields fell initially, as the rapid economic recovery appeared to be moderating. However, as the market’s focus turned to rising inflation and the prospect of the withdrawal of monetary policy support, yields rose back to similar levels seen at the beginning of the quarter.
DEVELOPED INTERNATIONAL FIXED INCOME: European government yields were unchanged for the quarter as an initial decline reversed in September amid a hawkish shift from central banks and continuing inflationary pressure. The U.K. underperformed, with a significant rise in yields on increased expectations for monetary policy tightening.
QUARTERLY FOCUS: Debt Ceiling – A Tradition of Farce
The U.S. debt ceiling is in the news again due to Congressional gridlock, along with the possibility of a U.S. sovereign default. As an historical recap, Congress is the political body that authorizes spending by the U.S. federal government. Prior to 1917, Congress authorized individual bond issuance to supplement tax revenue to fulfill specific spending allocations. Eventually, beyond a certain scale for fiscal spending during World War I, this practice became administratively unsustainable. From 1917 onward, Congress instead would allow the U.S. Treasury Department to issue bonds as it sees fit, albeit constrained by a Congressionally-set debt ceiling. Put simply, Congress (the Legislative Branch) stopped micromanaging Treasury bond issuance to fund spending authorizations – thus leaving it as a function of the Executive Branch – but still retained its authority to ensure a division of powers by limiting the total amount of debt issuance, and still has to authorize federal spending.
According to data going back to 1960 by the U.S. Treasury, Congress has raised or extended the debt ceiling 78 times: 29 times under Democratic presidents and 49 times under Republican presidents. A handful of times in recent years – most notably in 2011 but a few other times as well – Congress used the debt ceiling in order to pressure a presidential administration to either extract a bargain or for narrative gain. As seen below, more recently we have seen this take to the extreme as parties on both sides let these “crises” continue past the budget authority expirations and resulted in government shutdowns for 2-3 weeks, usually under the false premise that it would be fiscally irresponsible to let the debt ceiling continue to rise unabated. However, the debt ceiling is simply paying for things that we have already agreed to buy – akin to making payments on that second mortgage we took out for the kitchen remodel. The time for fiscal restraint is before the purchase and not after. Not paying our bills would have catastrophic consequences, leading to default, skyrocketing interest rates, and a collapse of the dollar that no one is willing to lay at risk.
Therefore, resolution to the debt ceiling farce is a foregone conclusion – as we have seen yet again just a few days ago. In August, the amount of the gross national debt outstanding, $28.43 trillion, became the “debt ceiling” that cannot be breached until Congress raises (or changes). The government would have “run out of money” sometime in Mid-October (the new fiscal year starts Oct 1) if Congress had not graciously voted to extend the debacle into December. So now, as we have done 78 times before, we get to watch the debt ceiling farce unfold with the added bonus of an encore performance later this year. Come late-December, prepare yourselves as the Congressional circus parades around in feigned outrage as their manufactured crisis hits the headlines. But rest assured that this too shall pass – again.
DPWM OUTLOOK: Poised for Opportunity
If the market is to add to its year-to-date gains in the fourth quarter, it will need to overcome a wall of worry: Seemingly sticky inflation rising to levels unseen in 40 years. Fiscal and tax policy uncertainties dictated by fluctuating COVID-19 infection levels. Supply chain bottlenecks. Global central bank tightening. The state of the labor market recovery. The expected start of tapering. It’s a formidable wall to climb.
Still, many of the conditions for continued stock market strength remain in place. A financially healthy consumer, an accommodative monetary policy (the Fed is not expected to hike rates until late 2022), strong corporate earnings, and healthy economic expansion all helped lay the foundation for markets to move higher. As earnings are reported over the course of October and November, American businesses will need to once again show earnings growth that not only supports current price levels but also helps provide the rationale for higher valuations. For now, the credit and equity markets seem to agree with Fed Chair Jerome Powell’s argument that inflation is transitory. The question for investors is whether the markets will continue to accept Powell’s working theory should price pressures continue to rise through the fourth quarter.
Our expectations at DPWM have remained firm over the last few quarters to expect higher interest rates and rising inflation. Our supporting arguments include wage growth showing increased strength, commodity prices continuing to climb, and our grade-school children inquiring after supply chain issues over dinner. If inflation proves to be less transitory than many first anticipated, our portfolios should benefit with our pro-cyclical tilts. We favor value-oriented sectors within the economy such as financials and industrials while our broad exposure to small-caps and international markets should have meaningful tailwinds in this environment. As the globe adjusts to what we hope is the tail-end of a pandemic, our focus is to strategically sway volatility in our clients’ favor and remain in-tune with opportunities before they unfold.
- insight.factset.com, September 2, 2021
- factset.com, September 10, 2021
- federalreserve.gov, September 8, 2021
- CNBC.com, September 10, 2021
- WSJ.com, September 14, 2021
- atlantafed.org, September 30, 2021
- federalreserve.gov, September 22, 2021
- sca.isr.umich.edu, September 30, 2021
- ec.europa.eu, September 30, 2021
- focus-economics.com, September 28, 2021
- focus-economics.com, September 21, 2021
- Reuters.com, July 16, 2021
- msci.com, September 30, 2021
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