Q-3, 2021 MARKET REVIEW:
The domestic equity market opened the third quarter on a high. Over the ensuing three months, however, the market was characterized by swings between risk taking and defensive positioning. By September the Standard & Poor’s 500 index remained barely positive and the 10-year bond yield had fluctuated as much as 0.40% over the three-month period.
Going behind these general statements the following economic and financial market forces were at play.
Economic activity remains adversely impacted by supply constraints. Exacerbated by COVID related production suspensions, consumer demand exceeds supplier ability to keep pace with product demand. Intermediate product supply interruption, inventory shortfall, manufacturing and production constraints, and logistics all contribute to this imbalance between demand and supply. The shortage is most apparent in the semiconductor space: microchips that are used across product lines from automobiles to appliances. Additionally, in the past eighteen months a shift in labor availability has occurred as potential employees reconsider where and how they choose to offer their services. For suppliers, catching up means not simply addressing customary demand but also satisfying many months of pent-up demand.
Attributing the lack of product supply solely to the pandemic may be an overstatement. In the past three to four years a shift in supply chain solutions has occurred. Companies have diversified where they source manufacturing. There has also been greater emphasis on repatriating manufacturing. Layered on top of these ongoing changes, the unique challenges posed by the pandemic complicate the existing problem.
Unsatisfied demand contributes to high prices and a supply driven inflation bubble. Initially suppliers absorbed down-stream price increases in their price of delivered goods margins. As intermediate product prices continue to climb suppliers are becoming more comfortable passing through these price increases to consumers.
Pre-pandemic, the Federal Reserve mulled solutions for stimulating the economy to meet its 2% annual inflation target. Today’s problem is the reverse; discerning whether inflated prices are transitory or whether there is a structural economic dynamic afoot that may make systemic inflation more the reality.
The general consensus is that this spike in inflation is transitory and will ameliorate once supply catches up with consumer demand. The length of time this takes will influence volatility in both the equity and bond markets.
Inflation pressures, temporary or structural, do exert an impact on both the equity and debt markets.
Inflation drives higher borrowing cost. If inflation is temporary, yield will be higher in the short to mid-term. Long-term rates may not be affected. If inflation is structural, rates will increase regardless of the duration of borrowing. Differentiating between transitory and structural is, therefore, important to bond market yields.
Inflation also impacts corporate earnings impacting corporate valuation and the price of equity shares. Determining business by business whether lost sales are profits permanently lost or temporarily deferred is an analysis that underlies investor analyses of corporate share prices.
Inflation does not impact all businesses the same. Some are more able to pass through price increases. As an example, software, medical and technology providers are more insulated than are companies offering discretionary products. Higher borrowing cost impacts firms that are capital dependent for spending on research and development. As a result, the profitability of the technology sector may be more exposed than financial institutions, which may benefit from higher interest yields payable on loans.
Inflation is not just driven by supply constraints.
The financial system has been awash with liquidity injected by the Federal Reserve to off-set market disruption caused by the COVID pandemic. Quantitative Easing, the Federal Reserve’s purchase of debt instruments to inject liquidity into the financial system, is $120 billion monthly comprised of $80 billion in Treasury and $40 billion in mortgage-backed securities. This activity has kept both short and long-term interest rates low.
Quantitative easing has its downsides. It has limited the investment return from debt investments and exacerbated investor risk-taking in the search for investment returns. Low interest rates have fueled an escalation in housing prices as consumers finance higher mortgages without a change in income. Businesses that might have otherwise failed, survive in an environment where the low cost of funds allows financing operating cost.
A seemingly imminent return to a stabilized economy now allows the Federal Reserve to consider reducing quantitative easing and contemplate raising short term interest rates. The when and amount of that reduction and any subsequent increase in interest rates will undoubtedly destabilize markets, albeit temporary. The question is how much.
In September, the Federal Reserve signaled its intent to reduce asset purchases before year-end with an outlook for terminating future purchases by mid-year 2022. The end to asset purchasing will make way for a possible interest rate tightening. Projections suggest a Fed Fund rate of 1.75% by the end of 2024, an increase from the virtual 0 cost of Fed Funds today. The European Central Bank also views a paring back of asset purchases but is non committal as to when these purchases will end. In Japan, a recent change in the leadership of the ruling Liberal Democratic Party suggests further infusion of government stimulus to reinvigorate that economy. Interest rates will undoubtedly remain unchanged and the government is expected to make a concerted push for economic reopening as Covid cases decline.
Throughout the third quarter news from China contributed to adversely impact the trading of securities linked to that economy. .
The Chinese government’s announced its intention to rein in economic disparity and has imposed regulations that affect operations in its technology, education and entertainment sectors. The target of these regulations is activity not viewed as positively contributing to overall patriotic well-being. The number of hours its citizens devote to computer gaming as well as spending on pop culture have received attention. Providers of after school tutoring must now operate as not for profit businesses. Regulations impacting several of the largest technology companies give rise to concerns as to what more is to come. A large Chinese property developer, Evergrande Real Estate Group, has missed its debt payment date. There is risk that a default will have ripple effects for institutional and retail investors as well as the company’s suppliers and third-party related entities. The Bank of New York Mellon China ADR Index is down -33.03% over the past three months. (https://www.marketwatch.com/investing/index/bkcn?countrycode=xx).
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The statistics below illustrate the breadth of change in the domestic equity and debt markets over the past three months. Asset Class: |
Q-4 2020 |
Q-1 2021 |
Q-2 2021 |
Q-3 2021 |
|
US S&P 500** |
12.2% |
6.2% |
8.5% |
0.6% |
|
Growth** |
12.6% |
0.3% |
11.0% |
0.8% |
|
Value** |
15.9% |
9.8% |
4.9% |
-0.7% |
|
Small cap** |
24% |
9.5% |
5.1% |
-1.3% |
|
Barclays US Aggregate Bond Index* |
0.669% |
-3.372% |
1.8% |
-0.9 |
**Asset Class Data: JP Morgan, Quarterly Review of Markets
* Bloomberg PLC: Barclay Aggregate US Bond Index
SESLIA ACTIVITY:
Our activity throughout the quarter was limited. We executed some 40 trades in client accounts these were mostly associated with investing new cash or liquidating securities consistent with client cash requirements. Market volatility throughout the quarter and the absence of market direction informed our investing behavior. We believe client portfolios are appropriately diversified to either benefit from or weather through market changes without significant distortion from the key market indices.