Monday, October 11, 2021
U.S. and International Equities
This quarter provided mostly negative results for the major market indices. The top performer and standout was the bellwether Dow Jones Industrial Average. The international developed and emerging markets, as denoted by the MSCI Europe, Australasia, Far East (EAFE) and Emerging Markets (EM) indexes, both finished the quarter lower.
Value vs. Growth
Slower growth in the third quarter, largely because of the spread of the Delta COVID-19 variant, presented a bit of a headwind for value-style stocks. LPL Research still believes value stocks may reassert themselves and outperform growth over the rest of the year. The increase in the 10-year Treasury yield since early August could mute future returns on highly-valued growth names through year end, especially if Treasury yields continue to trend higher.
Emerging Challenges in China
China’s stock markets have been hit hard in response to several sudden regulatory actions that rattled investors during the past quarter. China’s government has not indicated a timeframe on when its regulatory crackdown might end, putting further strain on emerging market equities as China composes approximately 35% of the MSCI Emerging Markets Index.
In addition, China’s property giant Evergrande, has defaulted on its most recent debt payments. With more than $300 billion in liabilities and only $15 billion in cash on hand, Evergrande is currently the world’s most indebted real estate developer. Moreover, the most important aspect of the Evergrande situation is that the Chinese government has not indicated how this company’s default might be handled.
Given the company’s size as well as the challenges Evergrande faces, how debtholders and thus stockholders are treated in this situation could have major implications for future capital investment in China.
As if that wasn’t enough for China investors to worry about, the country is battling coal and natural gas shortages despite the nation’s attempts over the past year to stockpile energy. This has been a big driver in recent energy price appreciation. In addition, energy supply concerns in China have some investors worried about future China industrial production.
Quarterly Fixed Income Results
The benchmark Bloomberg Barclays U.S. Aggregate Index increased slightly during the third quarter as yields declined. High yield corporate bonds, as denoted by the Bloomberg Barclays Government Long Index, were standout performers as traders expected improving economic conditions would benefit more highly-leveraged companies.
International bonds, denoted by the FTSE World Government Bond Index, and emerging markets debt, measured by the JP Morgan Emerging Markets Bond Index (EMBI), ended the quarter lower while their bond yields increased.
Natural Gas Propels the Quarter
Commodities finished mixed this quarter. A more than 60% rise in natural gas prices during the quarter was the major highlight as demand outstripped supply worldwide. After finishing in the green during the second quarter, copper, silver, and gold all finished the third quarter lower.
U.S. Economic Data Recap
Inflation: Consumer prices increased for the six straight month ending August. That being said, we are seeing signs of inflation subsiding given that headline Consumer Price Index (CPI) came in below expectations with a 0.3% month-over-month increase in August. Base effects from rolling off weak numbers a year ago contributed to higher annual changes, as headline and core CPI increased 5.3% and 4.0%, respectively, year over year.
Producer price inflation remains elevated, but decelerated in August on a month-to-month basis, which could be a positive sign. Year-over-year, PPI increased over 8% year-over-year in August, which, according to the Labor Department, was the fastest annual pace since the federal government began calculating PPI. Core PPI, which excludes food and energy prices, rose 6.7% year over year.
U.S. Consumer: The Conference Board’s Consumer Confidence Index weakened in Q3 declining in August to its lowest level since February as concerns about the spreading COVID-19 Delta variant and higher inflation (especially energy and food prices) weighed on consumers. The University of Michigan consumer sentiment survey saw a similar trajectory during the most recent quarter.
Retail Sales: Retail Sales were quite choppy during the most recent quarter, beating economists’ expectations in June, missing them in July, and then beating them again in August. In August online store sales increased over 5%, while the furniture and home furnishings, as well as general merchandise categories, increased over 3%.
U.S. Home Sales: Home sales in the U.S. fell during the latest quarter. Rising home prices and low inventory are driving potential buyers out of the market. In addition, builders have been constrained by higher lumber prices along with building material and labor shortages. During August, home re-sales, which account for the majority of home sales in the country, declined over 1% on a year-to-year basis.
Small Business Sentiment: The National Federation of Independent Business (NFIB) Small Business Optimism Index increased to an eight-month high in June but stagnated during the rest of the quarter. The NFIB report reflected concern about a tightening job market, which could put additional upward pressure on wages and compensation. Moreover, unfilled job openings remain an issue with small business sentiment. The percentage of owners expecting an improved business climate over the next six months declined by eight points to a net negative 28% in August, the lowest reading since January 2013.
Federal Reserve (Fed) Policy: Fed policy has remained fairly consistent for the most recent quarter. No changes were made to interest rate or bond purchasing policies. That said, the Fed continues to prepare the market for a reduction (taper) of bond purchases which, in our view, will likely take place later this year.
The Fed reduced its GDP expectations in 2021 from 7% to 5.9% in September. In addition, the Fed expects much higher inflation, seeing personal consumption expenditure (PCE) headline and core metrics at 4.2% and 3.7%, which is up from their June forecast of 3.4% and 3.0%, respectively. However, the Committee sees inflation falling slightly in 2022 and raised its economic growth forecast for that year as well.
U.S. Employment: The U.S. unemployment rate has declined substantially from last year’s peak, but at over 5%, it is still well off full employment levels and has stagnated for the most recent quarter. Even as the economy reopens and demand for labor improves, labor market supply needs to improve in order for the economy to reach full employment.
The economic recovery has continued at a steady pace even as the battle against COVID-19 and its variants continues. Strong earnings have been an important driver of this year’s strong stock market performance and are poised to grow solidly through year end. The ability for companies to successfully absorb higher input costs and pass them onto their consumers will play an important role in future earnings results and thus the equity markets as supply chain challenges remain. With third quarter earnings season to begin shortly, we will get an indication of how well corporate America is handing supply-chain disruptions, which should provide an indication of where inflation is headed.
We continue to believe that inflation is mostly transitory and will stabilize once the economy completes its reopening, when supply chains are fully operational, and labor shortages ease. The mitigation of the Delta variant is going to be important given the present tightness of the labor market. Key questions that market participants want answered are how long the “transitory” period will last and what impact that may have on Fed policy, interest rates, economic growth, corporate profits, and stock valuations.
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