Investor sentiment turned from bullish to bearish as the number of COVID-19 cases in the United States remains stubbornly high and inflation surpassed 5% for the first time in decades. In addition, the Senate was unable to reach an agreement regarding the federal debt limit in the final month of the quarter. Despite these obvious headwinds, the S&P 500 Index added .6% over the third quarter and is up 15.9% year-to-date. Overseas, the MSCI EAFE Index dipped -.5% and the MSCI Emerging Markets Index fell -8.1%. In fixed-income markets, the Bloomberg U.S. Aggregate Bond Index was mostly flat, with the yield on the 10-year U.S. Treasury ticking up slightly. The Federal Reserve announced that it will soon begin cutting back open market bond purchases later this year or early next year. Interest rates jumped on the news and put downward pressure across the bond market landscape. U.S. gross domestic product (GDP) increased at an annualized rate of 6.7% in the second quarter and is forecast to increase 5.9% over the year.
A rangebound S&P 500 added a marginal .6% over the third quarter of 2021, bringing yearly returns for the large-cap index to 15.9%. Stocks struggled to find their footing as a confluence of factors dragged on investor sentiment. The number of COVID-19 cases in the U.S. increased dramatically over the quarter, reaching their highest levels in six months in September. At the same time, COVID-19 inoculation rates in the U.S. largely stagnated. By the end of September, 56.2% of the population was fully vaccinated, compared with 50.2% at the end of June. Also spooking investors, the Senate appeared at an impasse over whether to raise or suspend the federal government debt limit. Lastly, the Federal Reserve announced that it will soon begin cutting back open market bond purchases later this year or early next year. Interest rates jumped on the news and put downward pressure on stocks, particularly growth stocks, which sold off in September.
Seven of the underlying 11 sectors within the S&P 500 posted positive returns, with Financials and Utilities leading the pack. Materials and Industrials, which tend to be more closely tied with the economy, experienced the greatest declines, dropping -3.5% and -4.2% respectively. Large-cap stocks bested small-cap stocks despite trailing in September. Outside of large caps, value stocks outperformed growth stocks, but large-cap technology stocks continued to hold up well regardless of the economic backdrop. Reported earnings for the quarter exceeded analyst expectations for 87% of the companies in the S&P 500 Index.
The MSCI EAFE Index of international developed stocks dropped a slight -.5% over the quarter. After a slow start to its COVID-19 vaccine rollout, Japan has now surpassed the United States’ inoculation rate, with 59% of its population fully vaccinated. Japanese stocks rose 4.6% during the quarter. European stocks fell 1.5%, but the decline was due to the Euro currency dropping 2.3% versus the U.S. dollar. In local currency, the MSCI EAFE was up 1.3%. The MSCI Emerging Markets Index dropped a sizable -8.1% for the quarter. China, the largest weighting within the Index, tumbled -18.2%. The selloff in Chinese stocks was largely driven by two factors. First, President Xi Jinping and the Cyberspace Administration of China intensified their ongoing crackdown of technology companies in the name of common prosperity. Chinese officials have increased regulation in some industries that they view as in conflict with their latest five-year plan and these actions caused investors to sell stocks across the board. Second, property developer China Evergrande Group, the largest issuer of junk-rated debt in China, appeared to be teetering on the verge of default.
The Bloomberg U.S. Aggregate Bond Index inched up a mere .05%, while the broader Bloomberg U.S. Universal Bond Index added .07%. On the year, the Aggregate Index is down -1.55%. The yield on the 10-year U.S. Treasury ticked up 7 bps over the quarter, starting at 1.45% and ending at 1.52%. Most of the decline occurred in September, following the Fed’s meeting, after officials seemed more willing to start reducing bond purchases ahead of market expectation. The 10-year yield jumped over .20% in the last ten days of September. Floating-rate bank loans, which tend to deliver strong returns during rising interest rates, were a standout in a lackluster asset class, adding 4.4% over the quarter.
Over the second quarter, the latest quarter for which data is available, U.S. GDP increased at an annualized rate of 6.7%, below most economists’ expectations. The lower figure was attributed to a stubbornly sluggish labor market and persistent fallouts related to the ongoing pandemic. The U.S. unemployment rate dropped to 4.8% in September from 5.2% in the previous month, well below market expectations of 5.1%. The consumer price index (CPI) rose 5.3% year-over-year in August. Core CPI, which removes inflation in volatile food and energy prices, rose 4% year-over-year in August. Inflation was initially believed to be transitory and had little impact on stocks or bonds. However, supply chain bottlenecks and rising labor costs appear to be stickier than initially projected. Against this backdrop of moderating unemployment and sustained inflation, the Fed has signaled that it could begin to taper its monthly purchases of $120 billion of Treasury bonds and mortgage-backed securities as soon as November. Similarly, the Fed now appears poised to raise the federal funds rate in 2022.
After opening the year at a blistering pace, the S&P 500 took a breather in the third quarter. Going forward, U.S. stocks should climb modestly higher over the remainder of 2021 and into the opening months of 2022. For one, the U.S. economy is on decidedly strong footing, a time when stocks have traditionally performed well. GDP is forecast to rise 5.9% in 2021 and 3.8% in 2022. Likewise, the unemployment rate is forecast to fall to 4.8% by the end of 2021 and 3.8% by the end of 2022. At this point, the one wrench thrown in the U.S. economy is inflation, which has proven to be more persistent than originally thought. However, there has historically been little correlation between inflation and stock-market returns.
International stock valuations are at all-time lows relative to the U.S., and earnings for international stocks are expected to outpace their U.S. counterparts in the upcoming quarters. Additionally, inflation has largely been kept in check abroad, and COVID-19 vaccination rates in most developed countries have now surpassed that of the U.S. On the emerging-markets front, the recent bout of underperformance is likely to come to an end once clarity surrounding regulation in China materializes. Chinese officials have already discussed measures to support growth in the event of a slowdown. In general, emerging markets have strong growth potential and, like international developed stocks, are priced at attractive valuations.
The Fed has signaled that it could begin reducing its $120 billion monthly purchases of Treasurys and mortgage-backed securities as early as November. The move paves the way for a potential increase to the federal funds rate in 2022, earlier than initially anticipated. As the economic recovery advances in the U.S., bond yields should move higher. At the same time, yields for riskier bonds are near all-time lows and have little room to contract from here. Bond investors are facing a difficult environment with historically low-interest rates and elevated inflation. Return expectations are anchored at below-average levels for traditional bonds.
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Darin Richards, CFA®
Aldrich Wealth LP
Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
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