October 1, 2021
Tagged As: Wealth Management
Global equities rallied to new highs in the third quarter of 2021 before giving up most of the gains over the last few weeks. The S&P 500 gained 0.58% for the quarter, and international stocks—as measured by the MSCI EAFE—declined, losing 0.42%. So far this year, the S&P 500 and MSCI EAFE have returns of 15.91% and 8.44%, respectively. Strong year-to-date returns have been powered by strong economic and corporate earnings growth, particularly in the U.S. and Europe. Unusually, this has coincided with a sharp fall in bond yields, with the U.S. 10-year Treasury yield dropping as low as 1.18% before rising again and closing the quarter near where it started at 1.53%. The quarter was not without volatility though, and investors were reminded of that as the S&P 500 fell nearly 5% in September. The increased volatility is due to mounting economic and policy risks described below.
Economic growth remains strong, and many investors are watching the Fed for an indication on when they might begin to pull back from the large amount of monetary accommodation they have been providing since the start of the pandemic. The Fed has grown its balance sheet by $80bn in Treasuries and $40bn in agency mortgage-backed securities per month since March of 2020. The first step in the process of ending these purchases is to reduce the pace at which the Fed builds its portfolio. This process is known as “the taper.”
Last December, the Federal Open Market Committee (“FOMC”) indicated it would start tapering only after the economy made significant progress toward sustained 2% inflation and maximum employment. Employment continues to improve slowly but inflation has run well above the 2% target for several quarters, driven by idiosyncratic factors and supply-demand mismatches. Most Fed officials and many economists believe that this situation is transitory but also say that price pressures are expected to persist through next summer. As a result, many market participants and some at the Fed are beginning to worry that inflation above 2% may persist long after supply chains normalize.
The cautionary voices are gaining sway and now most believe the FOMC will begin to taper following their November meeting. This is likely a positive development because the economy seems ready for it. It appears liquidity in the financial system is more than sufficient and financial conditions are easy, so leaving too many reserves in the system could foster unwanted inflation in the prices of goods or assets. Additionally, the Fed has been dropping hints about reducing bond purchases for two months, and long-term interest rates have only recently moved higher. A repeat of the 2013 “taper tantrum” seems highly unlikely. However, good communication and vigilance with regard to ongoing economic activity will be key. Should the FOMC move too quickly they risk slowing the economy too much. On the other hand, if they wait too long inflation may become more persistent.
As of the writing of this memo, negotiations have stalled on the much discussed infrastructure bill. The measures—actually two separate bills—and their passage are being tied to the overall budget debate and with the negotiations surrounding raising the debt ceiling. This poses some risk to the market. Most notably respecting the debt ceiling. Should Congress fail to raise the debt ceiling in October, the U.S. Government risks defaulting on its debt. This could have serious ramifications on the credit worthiness of U.S. Government Debt and roil financial markets. Much of the recent market volatility has been centered on this negotiation.
The Delta variant of COVID-19 curtailed economic activity in the late summer, but should ease as we move through the fall. Consumers still have substantial pent-up demand, are sitting on high levels of savings, and further employment gains will provide additional means. Inventories in the U.S. economy are at very low levels and will need to be rebuilt, which should keep producers very busy. Housing is likely to remain strong well into next year, and further fiscal stimulus could provide fuel for continued economic growth.
The Fed, as mentioned above, is likely to announce its plans to taper quantitative easing in the fourth quarter. They have stated they will remain data dependent, and that the start of tapering does not imply any particular timeframe for interest rate increases. This creates a supportive fundamental backdrop for equities, and we continue to recommend investors buy into markets and sectors best positioned to win from this period of higher-than-trend global growth. At this point, we remain risk-on with an overweight position in equities by approximately 4%.
While we continue to invest for the long-term, we will keep an eye on developments in the short-term, primarily those centered on Capitol Hill. Fiscal policy is likely to be a drag on expansion over the next four quarters. Benefit programs are coming to an end and, though not yet final, we believe there will be some form of tax increase as a result of the impending infrastructure legislation working its way through Congress. We believe it is very likely that individuals in the highest tax bracket and those that realize significant capital gains from investments will bear the brunt of the tax increase. It appears that changes to the way assets are treated at death–eliminating the step-up in basis–will not be enacted at this time. We believe Congress will raise the debt ceiling and avoid a government shutdown but continued delays will cause near-term market volatility. We would view this as an opportunity to add to risk.
COVID-19 will continue to be a lingering threat, with periodic outbreaks interrupting economic activity and the risk of another variant circulating is ever present. Over time, however, it will garner less attention as vaccination rates increase and vaccines become available to younger members of the population.
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