View/Download PDF version of Q3 Commentary (or read text below)

Stocks
U.S. stocks were modestly down, between 1-2% in the case of each of the major indices, during Q3. Although Q2 corporate earnings (reported during Q3) were very strong, the positive results were already priced in, given that equity markets rose about 15% in the first half of 2021. Moreover, supply chain challenges were noted widely in company commentary, dampening the earnings outlook for Q3 and Q4. In the present environment, demand remains extremely strong – even in the face of the Delta Variant – but companies are struggling to meet said demand as labor and material shortages abound, while global logistics are obstructed by recurring covid outbreaks in Asia. Expectations are that consumer sentiment will remain very healthy for the foreseeable future, with the unemployment rate nearly back to long-run central bank targets, from as a high as 14.8% in April 2020, so the key determinant to corporate earnings over the coming periods is the health of the global supply environment.

Bonds
The ten-year Treasury Bond ticked up a bit, from 1.44% to 1.48%, between the first and last days of the quarter; correspondingly, bond indices were basically flat in Q3. However, rate volatility tells a different story: the ten-year declined to as low as 1.19% in early August and peaked at 1.55% in late September. In turn, bonds performed negatively in the last month of Q3 as rates rose. Nonetheless, rates remain very low, that is, accommodative to economic growth, in the context of the long-term precedent, with the U.S. economy historically operating with a ten-year around 4-5%.

Inflation was high during the quarter, with CPI readings near 5%, because of the tight supply environment combined with booming consumer demand. Although economists and central bank personnel now believe inflation may be of greater permanence than previously considered, Q3 2021 could represent the inflation peak. Inflation was quite low following the Great Financial Crisis, so modestly higher and persistent price increases relative to pre-covid is not necessarily concerning. Fed Chairman, Jay Powell, indicates he will not be increasing rates until the end of 2022, and the probable future environment in which rates move higher, slowly and at a consistent pace, with inflation readings near 3%, is unlikely to be harmful to economic activity. Should inflation continue at clips near 5%, more rapid and material rate increases could be in order, which may present an obstacle to economic growth.

Outlook
Looking forward to the next 6-18 months, the most important economic issue is the status of supply. As previously noted, supply challenges are primarily deriving from 1) sheer natural resource shortages, 2) labor shortages, 3) logistics congestion resulting from covid outbreaks. It is impossible to know with certainty when global supply will resume in a fully functional, normalized way, however, generally speaking, the global economy is extraordinarily good at allocating resources such that demand is fulfilled. It may take up to a couple years for supply to resolve itself fully, during which inflation may be elevated around 3%, but as mentioned, this scenario is not a bad one for economic health. Demand should remain strong, though the U.S. labor shortage is likely to persist, challenging employers. Finally, a fiscal infrastructure bill remains up for vote, providing additional demand stimulus if passed.

by William Henderson, Vice President / Head of Investments
Last week seemed to be a tale of two markets. After starting the week off lower Monday and Tuesday, the markets came roaring back in a big way by week’s end after earnings announcements surprised to the upside and weekly unemployment claims declined much further than expected. Last week, the Dow Jones Industrial Average rose 1.6%, the S&P 500 Index increased by 1.8%, and the NASDAQ moved higher by 2.2%. Investors took advantage of the market’s 5% pullback in September and continued to pour money into equities. Last week’s rally added to an already strong year. Year-to-date, the Dow Jones Industrial Average has returned +17.0, the S&P 500 Index +20.4% and the NASDAQ +16.2%. Bond yields continued to rise as expectations of tapering of bond purchases by the Fed and higher short-term rates next year crept into fixed income traders’ plans. The 10-year U.S Treasury closed the week at 1.61%, 86 basis points higher than one year ago but still modestly below the March 2021 high of 1.74%.   

As mentioned, the economy and resultant earnings announcements continue to surprise to the upside suggesting there is still plenty of steam left in the economic recovery. A clear indication of the strength of the economy was last week’s decline in unemployment claims. See the chart below from the Federal Reserve Bank of St. Louis showing the continued precipitous drop in unemployment claims over the past year and reaching the lowest level since March 2020. 

One piece of information released last week was certainly good news for retired folks and Social Security Income recipients. According to the Social Security Administration, payments of America’s 64 million retirees will increase by 5.9% next year in the retirement benefit’s biggest cost of living adjustment (COLA) since 1982. While this “wage inflation” adjustment seems like good news to retirees, the reality is that the cost goods and services in the U.S. is increasing at recently unprecedented levels. Last week’s release of September CPI (consumer price index) showed inflation is continuing to heat up. CPI was up 5.4% year-over-year due mostly to food and energy prices, while Core CPI (ex food and energy) was up 4% year-over-year. (See chart below from Bloomberg). 

Clearly, the Fed has successfully engineered inflation (as was their plan all along). And having annual inflation well below their 2% target level, we are going to get numbers well above 2% to move the average number higher. The question for the markets and investors is: Will inflation be transitory or permanent? Generally, energy prices can be transitory as supplies eventually catch up to demand and prices adjust. However, wages and food price increases tend to stick around much longer. Large and powerful unions such as the Longshoremen and Teamsters will use the current supply chain disruptions and cargo ship back log to negotiate labor contracts more favorably for workers. Conversely, continued improvements in technology such as microchip capacity and cloud storage prices will put negative pressure on inflation and resultant prices. 

The concerns with China seem to have softly abated this week as the Chinese Central Bank (PBoC) reported that the problems with Chinese real estate developer Evergrande, are unique to the company and not endemic of the overall real estate market in the country. Additional positive news for the U.S. came around shipping rates from China. China’s official Global Times reported last week that shipping rates from China to the U.S. west coasts are down 22% over the past 4 weeks. While west coast ports are still congested, the tide may have turned on the supply of available goods which will clearly help to ease inflationary pressures.    As mentioned above, earnings announcements from companies last week surprised to the upside; specifically bank and financial stocks topped analysts’ expectations with names like Goldman Sachs showing higher revenues from trading and investment banking. The threefold pressures on economic growth: positive earnings releases, unemployment claims dropping, and softening of global supply chain disruptions all point to the potential of solid market returns for 2021. Inflation will remain a concern and COVID-19 variant cases, while lessening globally, could impact the economy going forward if we see a spike later in the year. As always, keep to your long-term financial plan and understand the markets are more efficient than investors.