October 8, 2021
Global equity markets exhibited a mixed performance in the third quarter. The U.S. remained the best performing market with a slight gain, while the developed international markets declined slightly after reaching an all-time high in September. In contrast, emerging markets were weak throughout the quarter. The divergent performances reflected an uneven pace of economic recovery in the face of the ongoing COVID pandemic and supply chain bottlenecks. China’s heightened corporate regulation also pressured emerging markets equities. As the quarter progressed, volatility increased in global equity markets with shifts between equities benefitting from the economic reopening, such as energy and finance, and technology, which would benefit from a slowing pace of post-pandemic economic rebound. Following is a performance summary:
The global economy should continue to rebound from the brief but significant pandemic-induced recession of 2020. In the U.S., the Federal Reserve announced plans to gradually reduce the pace of quantitative easing beginning in November and ending next June. This pace still allows for the significant increase in the Federal Reserve’s security holdings and for monetary policy to remain highly stimulative in the coming months. Interest rate increases are not scheduled to commence for months after quantitative easing is wound down.
Higher inflation rates have accompanied the recovery in the U.S. and international economies. Supply chain bottlenecks are a significant cause of inflation, which should be resolved over time. Also, the high number of unfilled positions are resulting in wage inflation. However, there is evidence that companies are responding by increasing capital expenditures to increase manufacturing capacity and improve worker productivity. Should these investments continue, the inflationary impact of higher wages will eventually be offset. On balance, we continue to believe that the current rise in inflation will not be permanent, and inflation rates should ease over time.
On the fiscal front in the U.S., uncertainty persists over the prospects for the enactment of physical and human infrastructure proposals by Congress. As of this writing, negotiations continue over the human infrastructure proposals, which appear to be scaling back from the original level of $3.5 trillion. It is likely that agreement will be achieved, and both programs will be enacted, although the size and timing are uncertain. The other major issue as of this writing is the raising of the debt ceiling. It appears that a temporary extension of the debt ceiling will be approved, followed by a “resolution” later this year.
With federal budget deficits escalating to levels not seen since World War II, it is understandable there is U.S. Senate disagreement on the debt limit and infrastructure bill:
Source: U.S. Department of the Treasury, Congressional Budget Office
The prospects for China, the second-largest economy, are important to the 2022 global economic outlook. The Chinese economy has been in an evident slowdown throughout this year. Problems in the real estate sector and with Evergrande, in particular, are exacerbating the situation. According to the Center for Economic Policy and Research, real estate now accounts for 29% of the Chinese economy, up from 13% in 2018. Consequently, the sector is too large for the government to allow a meltdown, given the political risk to the Communist Party and President Xi. Policy response is highly likely to occur in the coming months, with the resultant stimulus having a favorable impact on the Chinese economy and global economic prospects.
Following the uninterrupted strength in the stock market and a year marked by new record highs, the market has pulled back and entered a near-term trading range. On the last day of the third quarter, we ended the 12th longest period on record without a 5% correction:
We believe this “reset” is healthy while the market digests elevated inflation, rising interest rates, and political uncertainty during the historically weakest seasonal period of the year. While we anticipate supply chain disruptions and labor shortages will impact corporate earnings, overall earnings results should remain strong for several quarters. Demand from the economic reopening has supported the consumer and commodity sectors, and there remains continued revenue momentum in the growth sectors with leaner cost structures.
Our portfolio turnover remained low (and tax-efficient!) in the third quarter. New portfolio additions over the past year have remained focused on beneficiaries of pent-up consumer spending, recovering employment, and capital spending. We maintain our “structural” overweights to the Technology and Health Care sectors, particularly innovative leaders benefiting from digital adoption and demographics. We are monitoring the supply chain disruptions and labor shortages, which may be creating buying opportunities within specific industries, including Machinery, Transportation, Tech Hardware, and Consumer Goods.
The global stock market has entered the “second phase” of the post-recession bull market. Future market returns will be driven by earnings growth and cash returns to shareholders, while equity valuations are unlikely to push higher. Year-to-date stock returns have been driven entirely by corporate earnings growth, not valuation expansion. We anticipate this relationship between earnings and prices will continue.
Source: Wolfe Research
In our global portfolios, China’s regulatory crackdowns on domestic companies and common prosperity policies are a “double-edged sword.” Our emerging markets’ allocation conviction has been tested. Successful Chinese companies face an increasing overhang of regulatory pressure, and multi-national companies exposed to the Chinese consumer may see a long-term growth tailwind reverse to a headwind. Emerging market valuations remain very compelling compared to other markets but lack a catalyst to close the gap. On the positive, we believe the actions of China’s government improve the long-term growth prospects of the U.S. Technology leaders, which are key considerations for our overweight to the U.S. market.
U.S. interest rates exhibited a modest increase during the third quarter with considerable volatility in the longer end of the fixed income market. By the end of the third quarter, yields on two-year Treasury obligations had increased from 0.25% to 0.28%. Five-year Treasury yields rose from 0.89% to 0.97% during the third quarter. The quarter-to-quarter increase in yields on ten-year Treasuries was minor, from 1.47% to 1.49%, although the yield had risen from a low point of 1.18% in early August. The uptrend in yields reflected market recognition that the uptrend in inflation will persist for a lengthier period than earlier expected.
The historically low level of yields across the maturity spectrum applies to credit quality across the spectrum. We are experiencing near-record low yields and credit spreads in higher-yielding credits. Even if inflation rates returned to the 2.0 to 2.5% level that prevailed before the pandemic onset, the current level of returns fails to provide adequate compensation. The risks in the bond market of an eventual upward adjustment in yields are significant.
In the current environment, we are taking a non-traditional approach to fixed income allocations. We prefer short duration (including higher cash balances), floating-rate, and inflation-linked bonds in our taxable and tax-exempt fixed income portfolios. We have also added selective higher-yielding fixed income securities, currently favoring fixed to floating rate preferred stocks. We are awaiting more attractive yields before extending “traditional bond” maturities.