2021 3rd Quarter Update

Top Headline for Q3: Inflation and a Mini-Taper-Tantrum

For the first time in a long time, risk returned to the equity and bond markets. The Federal Reserve began hinting about “tapering” (i.e. slowing its program of monthly bond buying), and at the same time, it’s becoming increasingly clear that inflation is proving more persistent than expected. The combined effect of these factors is starting to cause some strain in the interest rate and bond markets and thus is causing some rumblings in the equity markets. 

Below is a YTD chart of the 10-year yield. This chart reflects what we think has been three distinct time periods for the treasury market and equity markets. The first quarter saw a spike in the 10-year yield, peaking on March 31st at 1.75%, as optimism for the economy reopening increased during the vaccine rollout. During this time period Value (LCV) significantly outperformed Growth (LCG). Then, the 10-year yield dropped from 1.75% down to 1.17% in early August. During these four months Growth significantly outperformed Value. One factor driving down yields was the increase in the COVID-19 Delta variant, which raised concerns about the economy slowing down again. As Delta variant numbers began to peak and booster shot information emerged, the 10-year yield started to turn up again. Higher P/E segments of the market (generally, Growth and Technology) tend to perform more favorably in lower interest rate environments, whereas lower P/E segments of the market (Value and Financials, for example) tend to outperform during rising interest rate environments. As such, clients have likely noticed that we have made some adjustments to portfolios during these changes throughout the year.

As an additional illustration, the YTD chart below from DailyShot.com shows the general inverse relationship between the US 10-year and the Nasdaq 100, which has a heavy tilt toward Growth and Technology. 

With continued tapering likely in the coming twelve months and inflation proving persistent, one would expect continued volatility in the markets. With volatility comes opportunity for those with good risk-management discipline. We will continue to rebalance portfolios in response to increased volatility in an effort to capitalize on short-term drops and spikes in price.

General Market Update

US Equities:  The S&P 500 Index finished the quarter +0.2%; however, this doesn’t tell the full story. The first two months of the quarter were strong with the S&P 500 rising as it had for much of the year before pulling back sharply in September (down almost 5%). September’s pullback was mainly driven by the S&P 500’s heavy technology exposure as the Nasdaq composite was -5.3% for the month. The Nasdaq Composite ended down 0.4% for the quarter while the Russell 2000 Index dropped 4.6%. During the quarter, Large Cap Growth outperformed Value as the Vanguard Large Cap Growth ETF (VUG) was +1.3% while Large Cap Value (Schwab Large Cap Value, SCHV) was -0.8%.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 1.9% in Q3, and the Schwab Emerging Markets ETF fell 7.9%. Emerging market equities were hurt by a dramatic fall in mega-cap technology stocks in China. The Chinese government continues to take action that is unfavorable to its large technology companies. These actions include tightening regulations, forcing break-ups of conglomerates and cracking down on anti-government speech. The Chinese government has injected a lot of uncertainty into its equity markets and investors are clearly concerned. 

Fixed Income and Credit: The 3rd quarter was a quiet one for the corporate bond market despite the sharp movement in interest rates. Both short and long bonds were generally flat for the quarter. It’s clear that the government bond buying program continues to have a stabilizing influence. 

Commodities and Precious Metals: We continue to see price volatility in commodities as geopolitical tensions remain elevated and supply lines remain strained. However, it appears that the near-term COVID-driven peak in commodity prices is behind us. Much of the “transitory” inflation can be found in this category. In response to rapidly rising interest rates, precious metals and other inflation hedges pulled back slightly during the quarter. However, the global bond market still has over $15 trillion in bonds that are producing “negative yield” when factoring in inflation. Therefore, the short-term sell-off may prove to be a buying opportunity.      

A Look Ahead

As we’ve stated for several quarters now, all eyes remain on the Federal Reserve. Given the movement in inflation and rates, one would expect much more price movement in bonds. However, we’re not seeing it. Why? The Federal Reserve continue with “dovish” policies (i.e., low interest rates and bond buying among others). We think this will continue to be favorable for equities. The bond buying has artificially inflated bond prices, especially in the higher-risk (“high-yield”) segment of the market. Without the support, we would likely see lower bond prices, higher yields and, consequently, increased volatility in other risk assets. 

So, when do they stop or slow these policies? Among financial experts, the general consensus is that the policies will slow or abate only when the Federal Reserve is forced to alter them. If that is true, then it’s likely that persistent inflation will be the only reason that they may act. We’re starting to see some of that, and Chairman Powell’s recent comments acknowledge that it’s officially “above target.” Our guess, based on Federal Reserve comments, is that we will see the tapering of the bond buying to begin in the coming quarters. However, it is expected that the tapering will be very slow and that raising rates may be quite a ways off. One should pay close attention to inflation, as any major shift on that front could cause the Fed to act more quickly.

We continue to see volatility in the near-term. It’s going to be a messy process to wean off such a high level of government support. Bonds are likely to gyrate as investors try to make sense of any changes. Also, the overall backdrop of low interest rates and light regulation is favorable to stocks, but a changing interest rate environment could outweigh any good news on that front in the short-term. It’s also worth noting that fiscal austerity seems to be the last thing on anyone’s mind right now. As we finish this summary, the US bureaucrats are arguing over a rise in the federal debt limit. They’re spending money at an unprecedented pace and there appears to be no end in sight.