Fall is in the air, and this is the time of year you might wonder... will it be tricks or treats for the markets during this autumn season? Only time will tell and, as usual, but there are reasons aplenty for both Bull and Bear to make their case.
This last quarter continued the movement of the prior quarters with stocks merrily higher until September, when increased pandemic worries and fears of inflation caused a modest downturn in both equity and bond prices. By the time the dust had settled we saw the bellwether S&P 500 index close the quarter just a bit higher than it had started, international stocks with a small decline and bonds ending awfully close to where they had begun. It wasn’t a particularly noteworthy quarter by any measure but, after the string of gains we’ve had since March of last year, that isn’t necessarily a bad thing.
Breaking with tradition we’re including two charts this time, the first showing the results of this last quarter:
... and the second showing our traditional one-year trailing movement of the same three indexes:
As we mentioned earlier, two of the things causing market angst are the potential for inflation and the effect of the pandemic on the economy. Interestingly it is the first of these, inflation, that is causing more anxiety currently, perhaps because we’ve been living with and speculating about the former for far longer. Let’s address inflation and in doing so we will cover the economy as well.
We’ve all heard about and most likely experienced the effects of higher inflation. This higher inflation we have been experiencing has been and is still considered transitory and thought to be the result of supply constraints and bottlenecks which have led to higher prices for those currently scarce items.
Semiconductors and other vital part supply disruptions have caused a shortage of all sorts of goods, from cars to appliances and the higher prices of those sorts of items have caused inflation to rise. In addition, low interest rates and easy monetary policy have enabled more money to chase those (temporarily) scarce goods. Those same low interest rates have helped fuel the bull market in equities and provided a boon to bond investors as well.
Low interest rates justify higher stock market valuations since investors are always comparing the expected rates of return from different asset classes. With the paucity of return in bond investments due to those low rates, investments in stocks have looked sensible. What happens though if interest rates rise? It all depends on why rates are rising.
If rates rise because of healthy demand and a growing economy, stock investors will be happier accommodating higher rates, figuring higher quarterly profits will come along with those higher rates. Companies will also be able to take the higher cost of borrowing in stride because of the growth in their business. If, however, rates are rising to fight ‘unjustified inflation’ caused by supply constraints or other measures, rising rates will be perceived differently and stock investors won’t be nearly as sanguine.
The Federal Reserve Open Market Committee meets regularly to discuss these very issues. In their last meeting on Sept 22nd their released statement touches on and is instructive as to their current thinking on the status of the economy and inflation.
The formal statement language noted specifically that a rise in Covid cases has slowed the recovery since the June meeting. More importantly, it mentioned that a ‘moderation in bond-buying pace may soon be warranted.’ This refers to the bond buying regimen the Fed has been involved in since the pandemic began and the timing of starting to “taper” back that program.
The committee had been looking for ‘substantial further progress’ in the economy to warrant such a change. Half of current FOMC members see at least one rate increase by 2022, based on the data released with the statement. In the economic growth projections, the members downgraded GDP growth assessments by a full percent (moving 2022 higher by a half-percent), increased their estimate almost a percent higher in inflation, and eased back unemployment rate projections for 2021. Improvement in employment is expected through 2022-23, however, before reverting to the long-term (normal) trend around 2024.
The Fed’s evaluation metrics however continue to point to an overall economic recovery. Let’s look at their summary in three key areas:
GDP growth in the recovery appears to have peaked in Q2, at 6.6%. Estimates for Q3-Q4 have fallen to a few percent below this pace, to around 4-6%. The Fed has been expecting a slowdown of the growth rate for some time due to slowing of the heady pace of growth as the recovery matured but now threats from rising Covid delta variant cases seem to have delayed stronger activity by a few months, (including travel plans and office reopening even as otherwise strong demand has been held back by supply shortages). Regardless, economic growth has rebounded sharply from last year, and remains at an above-average pace. This strength alone would have likely coerced the Fed to pull back on accommodative policy traditionally, as it appears to be less needed.
Price inflation has remained one of the more discussed data points of the year, largely because it’s felt more tangibly by almost everyone.. The Fed has stuck to an interpretation of rising inflation remaining temporary this year, blamed on Covid-related supply shortages and demand ramp-up in certain areas. The Fed has softened the language a bit, not on the causes, but on the timing, implying this inflation state could last a bit longer than initially expected. Inflation running too hot for too long, despite being desired for a time by the Fed, may have a growing negative influence on consumer demand (which is currently strong).
Labor markets have improved, but not to the degree the Fed would like. The Covid situation still weighs on month-to-month jobs numbers, although the unemployment and job openings rates have continued their improvement. This trend would also traditionally point to an eventual pulling back of monetary easing.
It is important to remember that investors will continue to debate the timing of both a tapering of the Fed bond buying program and the beginning of interest rate increases in the marketplace, buying and selling shares. As such we would not be at all surprised to see additional volatility as these “discussions” play out! Longer term, continued growth in the economy, even if accompanied by modest rate changes, should bode well for diversified portfolios over time.
Needless to say, the growth we’ve enjoyed in our portfolios over the last two years isn’t likely to continue unabated forever. It has been a spectacular rise from the pandemic low in the spring of last year and we’re grateful to see that significant progress in portfolios over that time.
As the year winds down, we’ll hope for a continued abating of the pandemic and an easing of some of the supply shortages that have plagued us for the last little while. In the meantime we hope you enjoy the lovely fall weather and all that this time of year has to offer.
We do not provide legal or tax advice. Reader should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.