Markets Update: A Quarter in Review
ECONOMY
Global economic growth has been strong with economists forecasting ~6% growth in 2021. In the U.S., GDP growth is expected to be around 5% for the third quarter (it was 6.3% in Q1 and 6.7% in Q2). While the rate of growth is expected to slow this quarter relative to earlier in the year, we remain in a much stronger growth environment than we’ve experienced in the past several years; about double to put it in perspective. Along with this growth, long-term interest rates rose, likely helped by the expected Fed asset purchase tapering later this year and continued inflation concerns. Inflation decelerated but remained high relative to historical averages, mostly attributed to supply-chain issues creating an imbalance. This all makes sense in an interconnected economy trying to reopen from a complete shutdown, and an early to mid-stage economic cycle recovering from a recessionary trough. Further economic uncertainty stems from U.S. politics. The twin infrastructure proposals moving through Congress were slated to have been passed already and continue to be hotly debated by legislators. How much additional fiscal stimulus can we expect? The amount will likely be pared back and won’t provide as much of a growth tailwind as it did when we were initially emerging from recession. Other unresolved issues include the tax implications to pay for the spending bills, the Delta variant and how that will continue to impact the labor market and economic growth, and the additional political theater of the debt ceiling debates, the proverbial can of which recently got kicked to early December. This is a different picture from a few months ago when everything seemed to be acting in positive unison. Fundamentals remain strong, but noisy data will likely keep uncertainty heightened relative to how sanguine the macroeconomic environment has been.
STOCKS
In the third quarter, stocks took a pause in their impressive march higher since the recession caused by the pandemic and resulting economic shutdown. Global equities were strong until September, when steeper losses dragged down results for the full quarter, especially in emerging markets. Global stocks were down about 1% overall, with U.S. stocks close to flat at -0.10%. International developed stocks were down -0.66%, while emerging markets stocks were down -8.09% with headlines around the potential collapse of China’s second-largest property developer, Evergrande Group, creating fear and downward price pressures. Global real estate was also close to flat at -0.08% for the quarter. We will soon be hearing from companies on their third quarter results which will be very important for stock markets overall. How are companies managing supply chain bottlenecks and the difficulty finding workers? Are they able to maintain strong profit margins? Strong earnings have kept stocks afloat and will lead to less expensive valuations if prices remain stable.
BONDS
Long-term interest rates rose during the quarter while short-term rates remained extremely low due to the Federal Reserve’s accommodative monetary policy. The U.S. bond market returned 0.05% while global ex-U.S. bond markets returned 0.09%. Bonds are the core ballast of our portfolio and it is encouraging to see them maintaining their stability even at these low yields/high prices. Looking ahead, we expect the Fed to start paring back its asset purchases toward the end of the year and that tapering of purchases will continue into 2022. This has been well-telegraphed and the market has likely priced this in fully. The uncertainty in bond markets stems from inflation, specifically how persistent it will be and whether it comes in higher than expected. The risk is that it causes the Fed to tighten monetary policy further by raising short-term interest rates. We feel well-positioned given this interest rate risk and credit fundamentals remain solid for corporate and municipal bond issuers.
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Topic of the Quarter: Will Inflation Hurt Stock Returns? Not Necessarily.
Investors may wonder whether stock returns will suffer if inflation keeps rising. Here’s some good news: Inflation isn’t necessarily bad news for stocks.
A look at equity performance in the past three decades does not show any reliable connection between periods of high (or low) inflation and US stock returns.
Since 1991, one-year returns on US stocks have fluctuated widely. Yet weak returns occurred when inflation was low in some periods, and 23 of the past 30 years saw positive returns even after adjusting for the impact of inflation. That was the case in the first six months of 2021, too (see Exhibit 1).
Over the period charted, the S&P 500 posted an average annualized return of 8.5% after adjusting for inflation. Going all the way back to 1926, the annualized inflation-adjusted return on stocks was 7.3%.
History shows that stocks tend to outpace inflation over the long term—a valuable reminder for investors concerned that today’s rising prices will make it harder to reach their financial goals.
EXHIBIT 1: THE REAL THING – STOCKS VS. INFLATION
Annual inflation-adjusted returns of S&P 500 Index vs. inflation, 1991–2021
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1. Real returns illustrate the effect of inflation on an investment return and are calculated using the following method:
[(1 + nominal return of index over time period) / (1 + inflation rate)] − 1. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. 2. Based on non-seasonally adjusted 12-month percentage change in Consumer Price Index for All Urban Consumers (CPI-U). Source: US Bureau of Labor Statistics. 3. Year-to-date return for 2021 through June 30. Past performance is no guarantee of future results. Short-term performance results should be considered in connection with longer-term performance results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
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