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by William Henderson, Vice President / Head of Investments
Equities notched yet another win last week with each of the major market indexes adding gains to already strong year-to-date returns. The Dow Jones Industrial Average rose +1.1%, the S&P 500 Index increased by +1.6% and the NASDAQ moved higher by +1.3%. Year-to-date, the Dow Jones Industrial Average has returned +18.3, the S&P 500 Index +22.4% and the NASDAQ +17.7%. Bond yields continued their slow rise recognizing that Fed tapering of bond purchases and higher short-term rates could happen sooner rather than later as the economic recovery from the pandemic continues in force. The 10-year U.S Treasury closed the week at 1.65%, up four basis points from the previous week and only slightly below the 1.74% level reached in March of this year.
Comments from Federal Reserve Chair Jerome Powell late last Friday afternoon seemed to temper the bond market a bit. He stated that the U.S. Central Bank was on track to begin reducing asset purchases soon; however, he added that it is not yet time to raise interest rates because employment levels are still too low. Lastly, he added that inflation is likely to ease next year as pandemic-related pressures fade and supply chain disruptions settle. Powell’s comments cooled the bond market and helped to heat up the stock market and temper risk levels. The Chicago Board of Exchange Volatility Index (VIX) fell to its lowest level in more than four months. The VIX measures investors’ expectations of short-term market volatility. See the chart below of the VIX from the Federal Reserve Bank of St. Louis.
This week we will see two important measures of the strength of the economic recovery: Continued 3rd quarter corporate earnings releases and the U.S. government’s initial estimate of third quarter GDP growth. Earnings announcements thus far have bested Wall Street Analysts’ expectations so watch for this pattern to continue, which would bode well for the stock market. Conversely a miss by a major technology firm would put negative pressure on equity prices. The third quarter GDP growth report will give us a clearer picture of the negative impacts of the delta variant and oft talked about supply chain disruptions. Recall the second quarter GDP rose at a healthy 6.7% annual rate.
It is important to recognize that as bond yields rise, their relative attractiveness as an investment also rises. The 10-year U.S. Treasury at 1.65% yield offers substantially higher returns than parking money in cash which is effectively paying 0.00%. Further, while not offering stellar yields, fixed income investments also provide ballast to a balanced portfolio in times of market turmoil. See the chart below from Factset showing Domestic Fixed Income Yields.
Certainly, rising bond yields are generally bad news for bond prices because prices move inversely to yields. The current projections for yields as predicted by the FOMC (Federal Open Market Committee) shows short-term rates peaking around 3.00% in this current cycle and the 10-year U.S. Treasury peaking nearer to 2.50%. See the chart below from Bloomberg showing Fed policymakers predictions for short-term rates and the 10-year Treasury yield.
Recall also that while low by historical standards, U.S. bond yields are higher than most developed countries and there is still $11 trillion of negative-yielding debt globally. Global demand for U.S. Treasuries will likely remain strong for some time which will keep a virtual cover on a significant rise in domestic rates. We have pointed out for many weeks that the markets are indeed more efficient than investors ever believe. This is witnessed by the fact that it continues to climb the ever-present “Wall of Worries,” which includes: COVID-19 variants, inflation, Fed Tapering, supply chain disruptions and concerns about China. As we move into the fourth quarter, the consumer, flush with cash and sitting on a clean balance sheet will take over as the engine of economic growth. Analysts are already predicting a stunning increase of 15% or more in holiday spending this season and remember, domestic consumption makes up about 70% of the U.S. economy.
THE NUMBERS
Sources: Index Returns: Morningstar Workstation. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. Three, five and ten year returns are annualized. Interest Rates: Federal Reserve, Mortgage Bankers Association.
MARKET HEAT MAP
The health of the economy is a key driver of long-term returns in the stock market. Below, we assess the key economic conditions that we believe are of particular importance to investors.
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US ECONOMY |
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CONSUMER HEALTH |
POSITIVE |
September retail sales surprised to the upside, increasing 0.7% month-over-month (m/m) and 13.9% year-over-year (y/y). Economists expected September’s retail sales to decline slightly m/m. |
|
CORPORATE EARNINGS |
POSITIVE |
With 23% of S&P 500 companies having reported Q3 results, sales and earnings are up 15% and 32%, respectively. However, company commentary suggests that the supply chain will be problematic in the coming quarters. |
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EMPLOYMENT |
POSITIVE |
The unemployment rate is down to 4.8%, as of September. The labor market is very tight at present, as many employers, particularly in the Leisure and Logistics sectors, are struggling to fully staff. The labor shortage is one of the causes of the global supply chain glut. |
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INFLATION |
NEUTRAL |
CPI rose 5.4% year-over-year in September, driven by the global supply chain backlog. |
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FISCAL POLICY |
POSITIVE |
A bill to lift the U.S. debt ceiling by $480 billion – which should provide enough headroom for government operations until December 3 – was passed. |
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MONETARY POLICY |
POSITIVE |
In recent communications, the Fed has indicated bond tapering may begin by the end of 2021 while rate hikes could commence by the end of 2022. Nonetheless, monetary policy remains relatively accommodative with rates at historical lows. |
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GLOBAL CONSIDERATIONS |
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GEOPOLITICAL RISKS |
NEUTRAL |
Although the Taliban’s control in Afghanistan is concerning, it is unlikely to have a meaningful economic impact. |
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ECONOMIC RISKS |
NEUTRAL |
Supply chain disruptions are hampering the economy; however, demand remains very strong. The hold-ups appear primarily transitory and should ease progressively over time. |
The “Heat Map” is a subjective analysis based upon metrics that VNFA’s investment committee believes are important to financial markets and the economy. The “Heat Map” is designed for informational purposes only and is not intended for use as a basis for investment decisions.
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.
“Our thoughts are limitless. The meaning we give to our life is therefore limitless. Think wisely!” – R.H. Lelchuk
Tune in Wednesday, 6 PM for “Your Financial Choices” with Laurie Siebert on WDIY 88.1FM. Laurie welcomes William Henderson, VP/Head of Investments for Valley National Financial Advisors to discuss: Third Quarter Market Review & Investment Terms
Laurie can address questions on the air that are submitted either in advance or during the live show via yourfinancialchoices.com. Recordings of past shows are available to listen or download at both yourfinancialchoices.com and wdiy.org.