|Index||3rd Qtr Return||YTD Return|
|MSCI ACWI Ex USA||-2.56%||6.77%|
|Bloomberg Bond Index||0.05%||-1.55%|
|Consumer Price Index||1.17%||4.81%|
Large company stocks in the U.S. were barely positive for the third quarter, with the S&P 500 increasing 0.6%. Smaller stocks trailed their larger counterparts as the Russell 2000 declined 4.4% over that time.
Non-U.S. stocks declined 2.6%. Emerging markets lagged substantially, declining 8.1% during the quarter. As with other indices, much of the drop in emerging markets was concentrated in September, which, among other things, saw concerns over a default by Chinese real estate developer Evergrande. Evergrande is among the largest Chinese real estate developers.
Bonds also posted very modest returns for the quarter, with the Bloomberg Aggregate Bond Index up only 0.05%. While the interest rate on the 10-year Treasury Note only increased 0.04% during the quarter, interest rates were volatile. September saw the 10-year rate increase 0.23% from 1.29% to 1.52%, representing a majority of the volatility.
The economy continues to improve on a number of metrics. Employment continues to increase, albeit at a slower pace. Real personal income remains above pre-pandemic levels, despite the removal of many pandemic-related government transfer payments. While industrial sales have been more volatile than is typically the case, they have trended positive over the past year. Retail sales have shown the largest decline of these measures in the recent past and bears watching. However, this measure still remains well above its pre-pandemic trend line.
The second quarter saw 87% of S&P 500 companies report positive earnings surprises (exceeding their expected earnings per share). This is the highest reading for this measure since FactSet began tracking it in 2008. If nothing else, it’s fair to say earnings were strong and that analysts were not overly optimistic about second quarter earnings. Generally, estimates take more than one quarter to become “optimistic enough” after such an undershoot. It’s highly unlikely that we’ll see a substantial number of companies miss their earnings estimates. This should be positive for equity markets. It is worth noting that forward looking expectations have continued to increase which should provide a higher bar for further outsized positive surprises. Analyst consensus earnings expectations for 2022 are about 36% above the last full year of pre-pandemic earnings in 2019.
Much has been discussed about inflation, including in our previous writings. Two data points of note on this topic. First, according to BCA Research, the overall level of the Consumer Price Index has not returned to pre-pandemic levels once automobile prices are stripped out. Second, if measuring the median CPI category (which this month just so happens to be rent of primary residence), inflation has run at 2.8% for the past 12 months through September. This is slightly below the long-term average of 2.9%. This shows that during the most notable large scale supply chain disruptions we’ve seen in decades, the price of the average good is increasing at a rate consistent with history. This suggests that inflation expectations, which are high relative to history, may be too high.
We wrote about the potential tapering of asset purchases by the Federal Reserve (“The Fed”) last quarter. While the Fed will remain flexible as their outlook changes, at this point in the cycle it seems that investors can expect emergency stimulus, including asset purchases, to begin to wind down after serving their purpose over the last 18 months. The Fed’s current expectations (as seen in their “dot plot”) reflect that increases in the federal funds rate may begin towards the end of 2022.
We continue to monitor progress on both tax reform and infrastructure. The last time we saw an increase in the top marginal tax rate was the 2013 tax year when the Bush tax cuts expired. The fourth quarter of 2012 saw a decline in the S&P of 0.4%. The largest decline of 2012 was 10% peak to trough. Further, 2013 itself was strong for equity markets. This is not to say there is a cause-and-effect relationship for either of these, only that increases in the highest marginal tax rate is not sufficient to send markets substantially lower. It looks likely that any new bill will have both positive and negative factors from a market standpoint. Increases in corporate and individual tax rates will likely be perceived as negative by markets, although it seems unlikely that corporate rates will increase back to the 35% seen before the most recent tax cuts. Incremental infrastructure spending will likely be seen in a positive light by markets.
There were no significant changes to client allocations during the quarter. The inflation discussion above suggests that there is room for interest rates to actually decrease based on the fact that inflation expectations may fall. Despite this, we’ve chosen to keep client fixed income allocations less sensitive to interest rates than the broad market. The rapid increase in interest rates during September piqued our interest as an opportunity to increase interest rate sensitivity, but rates have not reached a level that we judge justify an allocation change.
Stocks continue to look expensive on a historic basis and we feel comfortable with a relatively neutral allocation to risk assets across client risk profiles. While asset prices broadly are high, it is worth remembering that low risk assets will likely deliver historically low returns, and we are still in the early stages of an economic cycle. At this point it looks like the initial stages of the recovery are coming to an end and we will begin the shift into mid cycle. That likely means that the “easy money” has been made but we expect markets to continue to deliver growth over the next stages of the cycle, even if that growth is not as impressive in magnitude as is typical in the early stages of an economic cycle. Investor sentiment has begun shifting to a more negative stance in recent months given the concerns with the delta variant, high valuations, supply chain and inflation related concerns, as well as continued geopolitical concerns. While we would still agree that today’s current high valuations will likely lead to low (by historic standards) longterm returns, we do believe it is prudent to stay invested.
We will continue to diligently monitor changes in asset prices, policy and economic conditions to identify and take advantage of opportunities if and when they present themselves. The last several years, despite the pandemic related volatility, have been good for client portfolios, and our performance has generally outperformed the expectations we’ve built into long-range financial plans. While we certainly hope that this continues, we caution clients to curb their enthusiasm and to have more modest expectations over the coming years.
Heading into the end of the year, we hope our clients are able to take advantage of a more normal holiday season than last year and spend valuable time with family and friends. Please do not hesitate to reach out to us if you have any questions.
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