The first two quarters of 2021 were great for global equity markets. The third quarter saw the rate of ascent in equity markets slow in some markets or decline in others. The S&P 500 finished the quarter up 0.23%, although below its September 2nd highs. Small and midcap stocks pulled back slightly during the quarter. The Russell 2000 and S&P Midcap 400 finished the quarter down 2.06% and 4.60%, respectively. Despite the quarterly decline in smaller stocks, all three indices are up more than ten percent year-to-date. The best performing sector was the financial services sector which benefits from rising interest rates. Six out of the eleven GICS sectors finished up for the quarter. Despite finishing down 2.82% for the quarter, energy remains the best performing sector by far, up 38.35% year-to-date after declining 37.31% last year.
International indices lagged the S&P 500 in the third quarter. The MSCI Emerging Markets Index fell 8.84% in the quarter. The region was hit by Covid-19 related lockdowns. Additionally, Chinese equities fell due to problems at China Evergrande Group and corporate clampdowns by the Communist Party. The MSCI Emerging Markets Index is down 2.96% year-to-date, while the MSCI EAFE Index is up 6.23%.
Bond investors also treaded water in the third quarter as Treasury rates rose on the intermediate end of the curve and fell slightly on the long end, although investors in TIPS did make money in the quarter. The Bloomberg Barclays Aggregate Index fell 0.05% in the third quarter. High-yield credit and bank loans outperformed in the quarter, but most other sub-asset classes lost money.
Commodities saw minimal action during the third quarter despite the dollar’s 1.94% rise. The CRB BLS Commodity index fell 0.41% in the third quarter but is still up 24.77% through September. Oil rose slightly up 2.12% for the quarter and 54.64% year-to-date. Meanwhile, gold fell 0.74% in the third quarter and is down 7.45% year-to-date.
The Pace of Equity Gains Slows
The S&P 500 pulled back 5.06% from its September 2nd closing high. Fears of a contagion from China Evergrande Group appeared to be the main reason for the decline. Additionally, rising interest rates, albeit ones that are still at a very low level, contributed to an ongoing market consolidation. NPP thinks the breather was much needed as the returns over the last year and a half are unsustainable. Despite the robust market environment, price earnings ratios have fallen for the S&P 500 as revenues have boomed and profit margins expanded. The S&P 500 traded at a multiple of about nineteen and a half times 2022 earnings at the end of the quarter according to Bloomberg. This multiple has fallen in 2021 as earnings reports and projections have risen significantly in aggregate. The multiple is elevated on a long-term basis but does not account for the low level of interest rates. NPP does not believe the case for a massive overvaluation in equities is strong with ten-year Treasury rates at around one and a half percent. However, earnings must hold up and multiple expansion is unlikely from here. In other words, future equity gains will need to come from further earnings improvement. We think this will be the case although the rate of increase will likely moderate moving forward.
Interest Rates Climb
Intermediate Treasury rates resumed their post-COVID-19 climb in the third quarter following a drop from April through July. Long-term rates fell slightly. The result was interest rates showing only a small change over the period. The US Bloomberg Aggregate Index gained 0.05% in the quarter but lost 1.55% year-to-date. Long-term rates are still off their 2021 highs, but intermediate yields exceeded their prior 2021 peaks. Additionally, markets are starting to price in a rate hike for the Federal Reserve at some point in 2022 or 2023 after the Federal Reserve stops expanding its balance sheet. As tapering approaches and the economy heals, we expect rates to move higher in the last quarter of 2021.
Supply Chain Bottlenecks and Inflation Persist
COVID-19 has led to major disruptions in the global supply chain. On a recent conference call, Federal Express mentioned that they were having problems finding workers at ports. There are container ships parked outside major U.S ports waiting to unload while the workers cannot move inventory fast enough. Some inventory previously flown across the world on commercial flights now must find other means of transport. The reduction in air travel has led to a reduced ability to ship certain goods cheaply or quickly. These are just a couple issues contributing to the increased time and cost incurred shipping goods internationally.
Another key issue hanging over the fixed income markets, equity markets, and the economy in general is inflation that has remained persistently high. NPP thought that some of the temporary factors would have eased by now and allowed prices to moderate. However, many supply bottlenecks remain, and normalization is now a 2022 story. Car prices, and especially used car prices, have soared as a shortage of semiconductors used in cars has led to a decline in production and a shortage in inventory (see chart). The consulting firm Alix Partners estimates that the chip shortage will cost the auto industry $210 billion in 2021 and lead to reduced production of 7.7 million units. This is up from May when it projected losses of $110 billion and 3.9 million units. Some of the wounds are self-inflicted as U.S automakers failed to lock in vital chip supplies with long-term contracts. Nevertheless, that is an astonishing figure and illustrates the economic output lost in just one key industry. High prices often lead to demand destruction and we think this will be the case. The index is off its all-time peak although prices remain elevated.
Many companies are having problems finding workers. There are several factors that will subside over time. Some people are worried about contracting COVID-19 or spreading it to their children who are not vaccinated while others cannot find childcare. The recent lapse in emergency unemployment benefits may increase the labor supply, but that is not assured and the data at this point is not indicating that unemployment benefits were as large a factor in the labor shortage as initially suspected. The labor shortage is so great that there are currently more job openings than unemployed workers (see chart).
Some of the temporary, COVID-19 related factors, will subside and workers will return to the workforce. However, the labor market was stretched thin before COVID and the continued aging of the baby boomers has not helped. Companies concentrated in the service industry are having difficulty attracting workers to lower paying jobs to maintain their businesses at lower levels. NPP thinks that the coming months will see more workers return to the workforce as the current COVID-19 wave caused by the Delta variant subsides. We should caution that trying to predict the path of the virus is almost impossible. However, if the downtick in new cases and hospitalizations continues, an improvement in the service sector should occur. This in turn may lead to a shift in spending from goods to services which would alleviate some of the pressures in the supply chain. Until supply chain strains lessen, inflation will remain elevated. We still believe inflation is transitory, but it now looks like it will take a few more quarters before some of the bottlenecks unwind and inflation subsides from its current level. Additionally, our opinion of transitory is longer than the Federal Reserve’s. The risk of a policy mistake if the Federal Reserve waits to long to reduce what we consider to be excess stimulus is higher than it has been for a while.
A weaker dollar leads to higher inflation and often coincides with inflation. The United States imports a lot of finished goods that become more expensive when the dollar declines in value relative to the currencies of our trading partners. That has not happened, and the dollar has strengthened in 2021. Interest rates that are higher here than overseas surely help. We import a lot of finished goods and think that if inflation was going to remain for years that the dollar would be weakening given our budget and trade deficits.
Slightly Positive on Equities, Neutral on Bonds
The first nine months of 2021 were rewarding for equity investors. We think the trend will continue in the fourth quarter, but the rate of gains should slow. Equity markets are likely to remain choppy until earnings are announced in mid-October. Companies aren’t allowed to buy back stock immediately before earnings. Once the lockdown ends, one of the biggest buyers of equities will return to the market. We also believe that the recent trend of companies in aggregate beating estimates and raising forecasts to continue although some companies will be hurt by the stretched global supply chain. Strong earnings will help move the market higher. However, we expect interest rates to continue to rise for a variety of reasons leading to a slight compression in multiples. NPP’s fixed income duration positioning is still conservative. This is partially due to higher inflation risks but more so due to the low current yields. Traditional fixed income investments are likely to tread water as rates increase in the fourth quarter. Other than drastic COVID-19 developments, supply chain developments are the biggest variable to our outlook. A quicker resolution in supply-chain issues could lead to rapid economic growth, while slower improvement in global supply chains could lead to permanently high inflation, rising interest rates, and lower equity multiples. We are almost two years into the epidemic and we still don’t know what the post-COVID economic trendline will look like. The issues bear watching but for now NPP thinks strong fourth quarter earnings will outweigh supply chain issues and rising interest rates.