The third quarter of 2021 has been volatile for equities with the Dow, Russell 3000 and Nasdaq Composite all losing ground, while the S&P 500 did eke out a small gain.
Treasury yields, the dollar, and crude oil prices ended the third quarter higher, while gold prices dipped lower.
First Real Pullback in the Major US Indexes in a Year
The quarter started strong for equities as investors looked past a resurgence of COVID-19 cases and instead focused on the positive combination of a resilient economic recovery, ongoing support from the Federal Reserve and strong corporate earnings.
Second quarter earnings results, released in mid-to-late July, were stronger than expected and didn’t show signs of the margin compression that some analysts feared might hurt corporate profitability.
That positive momentum for markets continued in August, powered by similar factors such as positive corporate commentary, solid economic activity, and continued supportive Federal Reserve rhetoric. The S&P 500 ended August at essentially all-time highs.
The market tone changed in September as many of the positive factors that supported stocks earlier in the quarter began to fade somewhat:
- Corporate commentary turned more cautious and several industries warned of potential margin and profit compression due to supply chain constraints.
- Economic data from August showed that the rise in COVID-19 cases weighed slightly on the economic recovery.
- Politics once again became an influence on markets as details surfaced on the $3.5 trillion spending and tax plan that could include increases to corporate taxes, personal income taxes for high earners, and changes to capital gains and inheritance taxes.
The above factors weighed on markets initially in September, but the volatility significantly increased when news hit that the second-largest property developer in China, Evergrande, would likely default on debt payments. Fear of potential financial market contagion led to the first 5% drawdown of the S&P 500 in nearly a year.
Markets remained volatile into the end of the quarter as the 10-year treasury yield rose back toward the 1.5% level and the Federal Reserve confirmed market expectations that it will likely begin to reduce quantitative easing before year’s end.
At the same time, lack of traction on a resolution regarding the looming debt ceiling heightened market jitters.
The S&P 500 finished September with moderate losses although the index was still able to log a positive return for the third quarter.
Equity Drawdowns Are Normal, Even Healthy
One of the biggest worries strategists cited heading into September 2021 was that equities, at least the broad US indexes, hadn’t had a significant correction at all this year.
For the market to have an uncomfortable pullback at some point during the year is normal and healthy, and September is both seasonally and historically a weak month. Since 1980, despite drops of 14.3%, 31 of 41 annual returns were positive.
As of September 30, 2021, the retracement off the all-time highs totaled approximately 4%.
Additional headwinds unnerving the markets included:
- Rising inflation—recent inflation indicators have been running above trend due to labor shortages and supply chain issues
- Rising gas prices—also due to supply imbalances
- Rising interest rates—– it is widely believed that the Federal Reserve will soon begin cutting back on its bond purchasing program
- Chip shortages—many companies from automobile to toothbrush manufacturers have struggled to meet demand for their products due to semi-conductor shortages. Demand continues to outstrip supply, hence sales are falling short for companies that require chips in their products.
On the constructive side, much of these concerns stem from an imbalance of demand which outstrips supply—arguably a preferable problem than too much supply and not enough demand. Supply imbalances will likely resolve over time.
Insight from the Federal Reserve
During the quarter, the Federal Reserve noted that the economic recovery remained on track. Chair Jerome Powell said the central bank could begin tapering as soon as their next meeting in November 2021.
Powell did emphasize that the so-called liftoff for rate hikes would likely not commence until after the taper process is complete, which could happen by the middle of 2022.
Despite consumer price inflation running 5.3% in August, Powell expects to see relief in the coming months and over the course of the first half of 2022, and that inflation expectations are still at levels consistent with the central bank’s 2% long-term inflation target.
Improving Economic Conditions
Strong corporate earnings reports and improving economic conditions helped bolster investor confidence during the quarter.
Despite the interruption of the Delta variant, the recovery continued to be solid. Gross domestic product (GDP) posted strong data for the second quarter—6.5%—although some estimates suggest that the third quarter won’t be quite as strong.
On the jobs front, consumer confidence has been boosted by an improving employment picture with the unemployment rate dropping to 5.2% in August and wage growth continuing to climb.
Job seekers feel more confident about their prospects as a result of nearly 11 million jobs available, according to recent JOLTS data, while only 8.7 million unemployed individuals actively job hunted.
Bond yields ticked higher during the quarter as it is widely believed that the Federal Reserve will begin to taper its bond purchase program before year-end.
However, even as the stock market volatility increased in late September, there’ was no sign of distress in the credit markets.
Emerging market equities declined during the quarter, initially on concerns that rising COVID-19 cases would slow the global recovery, but later in the quarter fell under increasing pressure on the strength of the US dollar and concerns that the Evergrande debt issues might derail Chinese growth.
Foreign developed markets meanwhile declined modestly during the final few weeks of the quarter on general global growth concerns combined with potentially higher global interest rates, as well as spiking natural gas prices in Europe.
In sum, the market was volatile but remained mostly resilient in the third quarter. However, the final few weeks of September 2021 reminded investors that markets will face the resolution of numerous macroeconomic unknowns in the fourth quarter; and, while fundamentals remain decidedly positive, an increase in market volatility could be expected.
Risk to Q4: Variants, Inflation, and China Weakness
Key risks may be that the Delta or similar variants prove resilient to vaccination or that infection rates escalate during the winter. The evidence so far illustrates vaccinations successfully prevent serious illness, and in Israel, booster shots appear to slow the rate of new cases.
Inflation and the response of central banks represent another watchpoint. Our expectation is that this year’s inflation spike may not last long and that the major central banks, led by the Federal Reserve, won’t raise interest rates for some time.
Finally, a sharper-than-expected slowdown in China poses another risk. Credit growth has slowed this year and the purchasing managers’ indexes (PMI) have trended lower.
Monetary and fiscal policy have been eased, however, and senior officials in China signal more stimulus to come. China policy direction and credit trends will be important to monitor over coming months.
While risks always remain, macroeconomic fundamentals are still decidedly positive; remember, a well-executed and diversified, long-term financial plan can overcome bouts of volatility.
Though headlines can be unnerving, staying invested and not trying to time short-term market actions have historically rewarded long-term investors. We remain constructive on the equity markets for the long term and continue to advise clients to stay the course.
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