Quarter in Review
• After stellar performance in the first half of the year, equity markets took a pause during the third quarter.
• Bond returns also proved flat as inflation remains a top concern. Domestic bond yields, while still low, remain attractive to foreign buyers.
• Supply problems in both the manufacturing and service sectors continue to nudge inflation higher and are the source of much consternation for consumers, businesses, and political leadership.
Commentary
“Supply chains” may not have been top of mind for most of our readers in the past, but the recent bottlenecks across many industries now make them a key area of focus. A supply chain is a network between a company (or any organization) and its suppliers for the various inputs making up an end product. Supply chains can be quite complex, particularly for global companies since the suppliers themselves often have supply chains of their own, making the entire process a substantial logistical effort requiring precise design. Any misstep along the way can have compound effects that could lead to spoilage, cancellations, and delays, and the process is further challenged due to “just in time” inventory planning. Labor shortages are also part of the narrative since they can also affect the production cycle, distribution, or both. These myriad supply chain problems have in turn led to higher inflation as higher costs to obtain product are passed along, or as worker shortages have bid up the price employers are willing to pay.
Earlier this year, many were predicting a booming economy due to the lifting of COVID-related restrictions, pent-up demand, and the robust savings of the U.S. consumer thanks to government largesse. This smooth ride envisioned by some was disrupted during the third quarter by the Delta variant, signs of growth peaking, rampant supply chain disruptions, and China’s actions to combat inequality. Each of these developments impacted financial markets in different ways.
Higher coronavirus cases and increased hospitalizations due in part to the Delta variant pressured many local governments and businesses to reimpose pandemic restrictions. These actions surely had a negative impact on consumer spending, and supply shortages and service disruptions were also part of this narrative. For example, a key Chinese port was shut down due to infections which resulted in more ships idling offshore, unable to either load or unload their wares. These kinds of events cause untold reverberations up and down the supply chain for a great many products, leading to service delays and shortages that have a broad impact across many industries around the world.
The slower pace of spending, due in part to rising restrictions and also to product shortages, has started to influence economists’ views on the recovery. This “peak growth” story takes the view that the roaring recovery is already fading which, if true, could lend credence to Fed Chair Powell’s view that higher inflation will prove transitory: a slower-growing economy is less likely to produce high inflation for long. Recall that before the pandemic, the economic recovery was the slowest of the post-WWII era. With population growth continuing to edge lower, this appears to be what is on the horizon once again.
While we could write much more on each of these themes, it becomes pretty obvious they are indeed interrelated. More restrictions leads to reduced hours, closures, or foregoing normal activities, leading to slower spending by consumers and businesses, leading to supply chain disruptions, leading to price increases, leading to reduced demand for some products and services, and the cycle starts all over again.
China’s new focus on inequality was likely behind its weak equity market during the quarter. China represents approximately one third of the MSCI Developing Markets Index, which was down 8.09% in the third quarter. This new focus, combined with a new environmental commitment and some clear problems emerging in its real estate sector, could portend a more significant deceleration in growth.
We have noted many times that markets are forward-looking and tend to embed expectations of future events in securities prices. Since the equity market has had a spectacular run from April of 2020 to early September 2021, it appears logical that a pause may be in order, particularly since the recovery from the pandemic has hit so many bumps. As actual events diverge from expectations, investors begin to question assumptions and step back to reevaluate. This pause and accompanying increase in volatility can be healthy for the market and does not trouble us, and it certainly explains the flat results for equity and bond markets during the third quarter.
Bond yields did begin to break out of the range they had held for most of the third quarter during September, mainly due to a set of subtle policy shifts by the Fed. While still quite low, yields may continue to edge higher if the progress on the pandemic continues. We believe the Fed is probably content to see a gradual increase in bond yields since it reflects a more normal economy, and financial conditions were quite loose with low yields for such an extended period. For more detail on the bond market, see our latest Fixed Income Commentary.
With respect to the debt ceiling issue, we believe Congress will ultimately approve an increase after recently agreeing to a temporary resolution expiring near year end. Even with the overwhelming odds of an agreement and therefore unlikelihood of any sort of default, there is always the potential for financial markets to get nervous around such events. Equity markets have seen volatility around this event each time it has reared its ugly head and this sometimes bleeds over into bond markets as a flight to safety or as money markets in particular are forced to avoid certain maturities around the potential end of funding. Despite ever-increasing brinkmanship on this issue, it has always ended with an agreement, so any preemptive portfolio action seems superfluous.
Looking ahead, we expect the economy to gradually return to normal as it does appear the spike in coronavirus cases is now ebbing. However, the supply chain bottlenecks will continue to be disruptive for certain segments of the economy such as autos, where production is hampered by the semiconductor chip shortage. Some disruptions are solely due to the inability of ships to unload their wares at our major ports, so the products are not able to get to market. It will also continue to be challenging to interpret incoming data due to the unprecedented economic shutdown last year and the formidable challenges of the supply chain disruptions. These types of one-time effects, which are short-term in nature but more prolonged than expected, could increase the risk of a policy error by the Fed from misinterpretation of the facts.
We hope you find this commentary helpful in understanding recent market performance and we welcome your questions or comments.
Index Definitions
The S&P 500 (S&P 500) Total Return is a market capitalization-weighted index composed of the 500 most widely held stocks whose assets and/or revenues are based in the US; it’s often used as a proxy for the U.S. stock market. TR (Total Return) indexes include daily reinvestment of dividends.
The Dow Jones Industrial Average® (DJIA), is a price-weighted measure of 30 U.S. blue-chip companies.
The Nasdaq Composite Index (Nasdaq) is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange
The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
MSCI EAFE Total Return Net is the Morgan Stanley Capital International Europe, Australia, and Far East index that is a market-capitalization-weighted index of 21 non-U.S. industrialized country indexes. The index includes net dividends reinvested minus-tax-credit calculations, but subtracts withholding taxes retained at the source for foreigners who do not benefit from a double taxation treaty.
The MSCI Emerging Markets (MSCI EM) Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.
The Bloomberg Barclays U.S. Treasury Bond Index (US Treasury) includes public obligations of the US Treasury, i.e. US government bonds. Certain Treasury bills are excluded by a maturity constraint. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded.
The Bloomberg US Credit Total Return Value Unhedged USD (US Credit) measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD (Municipal Bond Index) covers the US-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD (US Corporate High Yield) measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
