FirstBank & Trust
Quarterly Market Review Q3 2021

Quarterly Market Review: Q3 2021

By: Paul Dickson, Director of Research and Mark Stevens, Chief Investment Officer

Once More Unto The Brink!

The quarter saw many worrisome headlines that could have caused significant consternation for market participants and did lead to some volatility and weakness towards the end of the quarter. Overall, however, the general stability of the markets was a testament to their fortitude.

Unemployment

The US -- and Global -- Economy was on the brink of an extraordinary recovery until the Delta Variant of the Covid-19 Virus intervened. An ongoing survey of market economists published by Bloomberg estimated that growth in the second quarter was expected to exceed 9% but ended up only showing a 6.7% year-on-year rate. According to the US Government, the third quarter is expected to have only expanded at something less than 5%. The pandemic continues to sideline workers and has complicated supply lines to such an extent that many economic sectors are experiencing significant disruptions. These disruptions have not only translated to a slower recovery but also contributed to rising prices as supply shortages have increased. While the US Federal Reserve and the Treasury Department expect that this increase in inflation will only be transitory, risks have grown that the longer the global economy remains constricted, price increases could become more entrenched and perhaps inertial.

Quarterly Market Review: Q3 2021

By: Paul Dickson, Director of Research and Mark Stevens, Chief Investment Officer

Once More Unto The Brink!

The quarter saw many worrisome headlines that could have caused significant consternation for market participants and did lead to some volatility and weakness towards the end of the quarter. Overall, however, the general stability of the markets was a testament to their fortitude.

Unemployment

The US -- and Global -- Economy was on the brink of an extraordinary recovery until the Delta Variant of the Covid-19 Virus intervened. An ongoing survey of market economists published by Bloomberg estimated that growth in the second quarter was expected to exceed 9% but ended up only showing a 6.7% year-on-year rate. According to the US Government, the third quarter is expected to have only expanded at something less than 5%. The pandemic continues to sideline workers and has complicated supply lines to such an extent that many economic sectors are experiencing significant disruptions. These disruptions have not only translated to a slower recovery, but also contributed to rising prices as supply shortages have increased. While the US Federal Reserve and the Treasury Department expect that this increase in inflation will only be transitory, risks have grown that the longer the global economy remains constricted, price increases could become more entrenched and perhaps inertial.

Let one of our Wealth Advisors help you build a financial strategy.

Find an Advisor

Or we can reach out to you.

Due to the Delta Variant wave of the pandemic, anticipated improvements in the labor market have slowed. While it is true the unemployment rate has fallen below the notable 5% mark, at least a portion of that figure’s decline is due to a fall in labor participation where nearly 2% of the workforce has simply stepped out of the market. Some of the decline in participation can be explained by older workers deciding to retire early, coupled with workers that are unwilling to risk infection exposure by returning to the workforce. A portion of the decline in workforce participation is attributed to female workers. With caregiver responsibilities many times falling on females, it’s believed that the exit of females from the workforce is further explained by childcare and eldercare shortages due to the pandemic. The overall share of the population in the workforce had been declining since 2000, but there was some recovery in the years just preceding the present troubles. In any event, the supply of labor is lower than it was before the pandemic and is creating significant bottlenecks to the economy.

Shipping Costs This shortage of workers is part of a more general, and global, supply problem. A recent cover story of The Economist termed the present situation as “The Shortage Economy” and it goes beyond a temporary mismatch of labor. The widespread shortage of computer chips has hamstrung the automotive industry leading to shuttered assembly lines and empty dealership lots, not to mention soaring prices. The closure of some ports has led to a spike in shipping costs and hundreds of container ships idling at sea looking to unload. One risk of higher shipping costs, of course, is that they can feed into final goods prices. For an economy used to on-demand supply lines and low inventories, this disruption translates to lower growth overall as purchases are delayed significantly, not from lack of demand but a lack of supply. According to the Institute of Supply Management, American manufacturers are now waiting a record 92 days on average to assemble the parts and raw materials they need to make their goods.

Natural Gas Prices These developments are being acutely felt in economies across the globe and have reached the energy markets as well where prices are surging. Just as economic activity is trying to recover from the Pandemic shutdown, most nations are also trying to convert from high carbon intensity fuels to greener ones. We believe that at some point, reliable and well-scaled storage for green electrical production (hydrogen, batteries, etc.) will be the norm, but at present, the swing source for power is natural gas and there is not enough to go around.

The shortage of natural gas has many worried about the potential for an energy crisis in Europe and the UK as the temperature drops. In addition to the problem of not having enough natural gas to heat homes, the shortage has also led to several fertilizer companies and ammonia and CO2 producers suspending operations as well and now the UK is on the brink of seeing food shortages.1

China’s Evergrande on the brink of default!

Relative Equity Market Performance in Q3 China was the source of much worry throughout the quarter. The crackdown on many of the country’s most notable companies to reign in “excesses” and “uncompetitive business practices” was broadened during the quarter to include restrictions on video games, private education companies, a crackdown on the DiDi ridesharing company, and a ban on cryptocurrencies among many other market reform efforts. Concerns mounted when it became clear that the conglomerate Evergrande – one of China’s largest property developers – was likely to default on some or all its $300 billion in financial obligations as part of the government’s reformulation of the state of the private sector. The company has already missed payments to creditors including interest payments on foreign debt. The question is how much of the company will be allowed to fail and how much damage to the economy the government will allow. Many are seeing the Evergrande crisis as China’s Lehman Brothers moment, but we think that it is unlikely to be as messy as that. Some parts of the company have already been assigned to other firms and it seems unlikely in our view that the millions of local investors and those awaiting promised homes will be left destitute.

In addition to the Chinese government’s crackdown on technology and other sectors of the economy, the country is also facing the same energy crisis afflicting the UK and EU. In fact, China’s large LNG (Liquified Natural Gas) purchases are part of the problem facing Western Europe on that front. The supply that China procures is no longer available to others. Nevertheless, the energy shortages have caused several Chinese facilities to be idled in recent weeks. We believe that if this continues for very long, China’s growth outlook, already significantly downgraded, will be even worse. When the world’s second-largest economy slumps, so do many others.

The United States – On the brink of default!

Against this challenging backdrop, politics in Washington became increasingly heated as the quarter wore on. For the fourth time since 1995, the US faced the prospect of defaulting on the national debt because of an inability to increase the debt ceiling. Before1995, the “Gephardt Rule” linked the raising of the debt ceiling with the passage of a budget and worked since its adoption in 1979 without incident. Now the debt ceiling has become an almost existential threat to the economy. Ultimately, the ceiling was extended until early December, and given the relative lack of panic in the markets, it does not appear, in our view, that investors deem a default likely.

Fed Funds Forecasts

The Federal Reserve – On the brink of tightening policy

Federal Reserve Balance Sheet The Fed has stuck to its forecast that the present rise in prices and the bottlenecks on the supply side are merely transitory and that once passed the economy will resume a robust recovery. Should this be the case, then we believe the Fed is correct to slow the pace of monetary stimulus. At the September Open Market Committee (FOMC) meeting, where monetary policy is decided, a majority of voting members moved to start the normalization process and revised upward their expectations for interest rates in the future. Unless something awry takes place, it is now widely expected that the Fed will announce the first step in normalizing monetary policy at its November FOMC meeting. That announcement is expected to be that the Fed will start reducing its purchases of US Treasuries and Mortgage-Backed Securities (MBS) with a goal to ending the purchases altogether by mid-2022. At some point after that, the Fed should be expected to increase the overnight Fed Funds rate from the current zero floor.

Vaccination It would seem that a few assumptions are being made by the Fed in the run-up to the November meeting. The first is that the recent hike in prices is transitory. For that to be the case, then another assumption would be that the labor market begins to normalize and that ports and factories around the world begin to re-open so that supply chains can be restored. But that must rely, in our view, on a belief that the Covid Pandemic will be waning significantly in the near term. If that is, indeed, the lynchpin for the global recovery and return to normal markets there is some supportive data. The first is that a kind of herd immunity may be forming in the US. Despite the hesitancy around the vaccine, the levels of vaccination and contagion, taken together, seem to support an eventual exit from the pandemic. The government is making moves to increase vaccine mandates and many companies have followed suit. The second is that a global effort to manufacture and distribute vaccines is making serious progress around the globe. Certainly, there is quite a bit left to do, but the wide distribution of vaccines is encouraging.

Vaccine Supply

Markets flinch as risks mount

Record earnings growth and plunging bond yields drove markets higher in July and August. However, momentum shifted in September as mounting economic risks and renewed inflation fears were compounded by statements from the Federal Reserve that tapering might take place sooner than first thought. The U.S. 10-year Treasury yield jumped back above 1.50%, erasing most of the gains from the previous two months, leaving the total return on The Bloomberg Barclays US Intermediate Aggregate Index up only 0.1% for the quarter.

Stocks followed suit, as investors aggressively sold nearly every risky asset class, including the S&P 500 Index (-4.7%), which posted its first monthly decline in seven months. The 5% decline from the September high also ended a streak of 211 consecutive trading days without a 5% decline in the index.

Index Returns While a 5% decline in the Index is noteworthy, it doesn’t tell the whole story. What it doesn’t tell us is that more than 90% of the stocks in the S&P 500 had already declined by more than 10% from their high (the definition of a correction) by the end of September. The narrowness of the market has been well-documented and deteriorating market breadth in Q3 only confirmed that.

Despite realizing the worst returns in September, the 15.9% year-to-date return on the S&P 500 still places it near the top when compared to other major asset classes.

The Russell 2000 (small-cap stocks) posted one of the better returns (-3.0%) in September, but one of the worst (-4.4%) in Q3. Small-cap stocks have lagged for much of the year, with nearly 98% of the Russell 2000 constituents reaching correction territory (-10% or more) in 2021.

Relative strength in Japan and Europe helped the MSCI EAFE Index post a -0.5% return for Q3, but the 8.4% return year-to-date trailed most U.S. equity indices. The MSCI Emerging Markets (-8.1%) again trailed most indices as inflationary concerns and a major sell-off in Chinese equities hurt the index.

A long-term view is required

The economy is in the middle of a bold recovery, but economic forecasts are projecting slower growth. Supply chain issues, labor shortages, monetary policy, debt ceiling, and proposed tax legislation all threaten the pace of the recovery. While the consensus still views these obstacles as temporary, what temporary means, and how much damage takes place in the interim, is a growing debate.

Despite recent volatility, investors' long-term outlook still leans positive. The premise is that interest rates will likely move higher due to rising inflation, above-trend economic growth, and a less accommodative Fed, but remain low enough to offer investors little to no real yield. Equities will follow earnings growth, provided that monetary policy remains supportive and economic dislocations don’t prove systemic. Low rates and accelerating earnings have encouraged investors to take a risk over the last 18 months.

The Equity Risk Premium (Earnings yield – 10-yr Treasury Yield), a commonly used metric to determine the attractiveness of equities relative to bonds, still favors equities. The spread would indicate that the 10-year Treasury yield would need to rise above 2.5% before bonds would begin to compete with equities.

Earnings have recovered and are now expected to hit a new all-time high in 2021. Companies have beat analyst expectations on both earnings and revenue growth this year, suggesting that companies have some pricing power due to rising demand.

The S&P 500 trades at 21 times forward earnings, down from 26 times only 1 year ago, yet still overstates the multiple of the majority of the market, as most stocks have already dropped over 10%. The P/E multiple outside of the top 25 names of the S&P 500 is far more reasonable.

Companies are now re-visiting dividend policies and could prove to be greater competition to bonds and other yield-oriented investments. Russell predicts that 75% of the dividend payers in the Russell 1000 index will raise their dividend by year-end.

Consensus US GDP estimates for Q3 have fallen 2% (5.0%) in the last couple of months, and full-year estimates (5.9% in 2021 and 4.1% in 2022) have also moved lower. This is good enough to support equities, but the trend is soft, visibility is blurry, and the obstacles real.

The most immediate could be Q3 and/or Q4 earnings guidance. Supply bottlenecks are not improving, and labor is tight. Any evidence that the holiday shopping season will be a disaster, or the general earnings outlook revised, could push a fragile market lower.

Any tax implications that are the byproduct of a new fiscal stimulus package(s) could be disruptive, especially if Congress disproportionately targets financial markets and/or corporate profits, and would likely result in an immediate market adjustment.

We maintain a long-term perspective on the economy and its ability to provide an adequate foundation for equities. The absence of alternative investments that offer a reasonable return helps us remain patient. The reopening trade, which lifts long-term interest rates and favors economically sensitive stocks, is still alive, but the next couple of quarters could give us pause. As long as these roadblocks prove relatively short-lived, significant market declines will be likely be bought with the expectation of a rebound. This not only favors stocks that have been beaten up by this rally but will likely promote a secular shift in leadership outside the US.

 

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For additional insights:

Follow Us on LinkedIn

For more insights on our current market:

Contact a Wealth Advisor Today

For additional insights:

Follow Us on LinkedIn

For additional insights:

Follow Us on LinkedIn

For additional insights:

Follow Us on LinkedIn

 

Products offered by Wealth Advisory Services, Heartland Retirement Plan Services, and Fiduciary and Trust not FDIC Insured, are not bank guaranteed and may lose value.

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. The investment return and principal value of investment securities will fluctuate based on a variety of factors, including, but not limited to, the type of investment, amount and timing of investments, changing market conditions, currency exchange differences, stability of financial and other markets, and diversification. The statements and opinions expressed in this article herein are those of the author as of the date of the article and are subject to change. Content and/or statistical data may be obtained from public sources and/or third party arrangements and is believed to be reliable. This information discusses general economic and market activity and is presented for informational purposes only and should not be construed as investment advice. Views and opinions expressed herein do not account for any specific investment objective, restrictions, and/or financial circumstances of any specific client. Investors are urged to consult with their financial advisors before buying or selling any securities.

1 https://www.inyourarea.co.uk/news/uk-regions-with-most-food-shortages/, https://www.thenationalnews.com/world/uk-news/2021/09/17/running-out-of-energy-supply-fears-grow-as-uk-fertiliser-plants-close/#:~:text=In%20the%20UK%2C%20the%20rising,would%20hit%20the%20food%20industry

News