Posted by Guest Blogger Chad Roope, Vice President, Chief Investment Officer, Sequoia Financial Group, LLC
- Tailwinds from highly supportive monetary and fiscal policy are likely to diminish
- The pandemic, inflation and the Fed, Washington, China, and earnings are key focus areas into year end
- Most Sequoia strategies remain generally neutral in equities/fixed income with modest tilts toward higher quality U.S. equities and lower fixed income duration than broad indices
The third quarter was a period of consolidation for financial markets after a strong first half. Markets had to absorb a new pandemic surge combined with significant supply shortages of everything from semiconductors to labor. It was a quarter that saw economic growth expectations come down given the pandemic surge while also witnessing rising inflationary pressures with supply side issues.
As result, most asset classes were flat to down for the quarter. The S&P 500 was up a modest +0.58% while our global equity benchmark, the MSCI ACWI IMI, was down -1.11%2. Still, equity markets have been strong year-to-date with the S&P 500 up 15.92% and the MSCI ACWI IMI up 11.42% through September 30, 20212. The financial sector was the leading equity sector for the quarter as Treasury yields drifted higher, especially in the belly of the curve, where 5-Year yields jumped from 0.87% to 0.98% and the 10-Year moved up from 1.45% to 1.52%3. Year to date, the 10-Year has moved up from 0.93% to 1.52%3, a substantial change for one of the key rates used to determine prices in markets. As a result, the bond market has been challenged with the Bloomberg Aggregate Bond Index flat in Q3 up +0.05%, but down -1.55% for the year so far2.
Summary of Major Asset Class and Sector Performance
Looking Ahead to Q4
As we look forward into Q4 and 2022, many of the tailwinds that have been supportive of financial markets may start to become headwinds. In light of this possibility, we are focused on the following five key areas.
1. The Pandemic
Thankfully, as we enter Q4, Coronavirus cases appear to be falling after surging significantly throughout much of Q34. The surge was felt by consumers, as both the Conference Board and University of Michigan consumer surveys weakened in Q31. However, it appears that we are learning to deal with the virus better as a society, so broader economic shutdowns appear much less likely. We continue to monitor developments in COVID treatments as they emerge. While grateful for the recent decline in cases, the pandemic is still a clear risk for financial markets as we move into winter.
2. Inflation & Fed Policy
The Federal Reserve’s extraordinarily accommodative monetary policies that were instituted in the depths of the economic lockdowns in early 2020 have been immeasurably stimulative for risk assets like stocks, corporate bonds, real estate and speculative areas such as cryptocurrencies. In most commentaries we’ve written this year, we’ve highlighted that higher trajectories for both the economy and inflation would likely warrant a reduction in the amount of large-scale monetary accommodation as 2021 progressed. With the Consumer Price Index up 5.3% year over year in August1, large supply side disruptions in many materials and labor1 and risk assets near all-time highs1, it would appear there is much less need for the Fed to continue with aggressive monetary stimulus. Further, the demand functions in the manufacturing sector, typically a leading economic indicator, remain mostly robust according to the Institute for Supply Chain Management1.
Without question, the economy has slowed somewhat with the surge of the Delta virus variant, but aggregate demand in the economy still seems quite strong. In our view, the key issue appears to be supply shortages, and therefore, higher inflation. The Fed has clearly been a key supportive force for equities and other risk assets, but we are now likely moving into a period where the Fed may reduce accommodation given that the inflation has been much stickier than expected. We expect reduced Fed support to create volatility as financial markets adjust in Q4 and into 2022. How much, and how quickly, the Fed moves will be something we closely watch.
The political process is always interesting to observe. It’s both comical and frustrating at the same time. We think after much posturing during autumn, Congress and the Executive Branch will likely act on a bill that will offer a decent measure of infrastructure spending (needed to improve productivity and thereby help combat inflation) and measures to increase both corporate and personal income tax rates. We think the bill will be some compromise of what both parties want and likely smaller than early estimates.
As with monetary policy, fiscal policy has been decidedly supportive of the economy and financial markets. Like monetary policy, we worry that the upcoming legislation is likely to foster fiscal drag economically and thereby offer less support of financial assets moving forward. We plan to be patient and largely tune out political noise until more specifics are clear. We believe this is a solid plan for most investors, too.
China’s economy has slowed quite rapidly over the last few quarters. The September Manufacturers Purchasing Managers Index falling into contractionary territory at 49.61 is one data point highlighting this slow-down. Further, stress is showing with real estate developers such as China Evergrande appearing to have defaulted bond obligations on a large scale1. The real estate market, as with most other nations, comprises a large portion of China’s economy. For perspective, it is estimated that China spent about 10% of GDP on real estate development in 20205.
We think China’s leadership will likely turn to stimulative measures and support for these issues in the short-run but worry the slowdown may start to spill over to the global economy. As the world’s second largest economy, a slowing China can have large ramifications on financial markets. Should we see a disorderly unwind of China Evergrande and continued data points like the recent PMI, we would worry it could become contagious for the global economic system. Presently, we do not think this is a likely scenario, but something that was a tailwind (an improving Chinese economy in 2020 and early 2021) now appears to be more of a headwind.
5. Q3 Earnings
Earnings growth has been stellar in 2021 given strong monetary and fiscal stimulus along with economic reopenings. For Q3, the estimated earnings growth rate is 27.6% year over year for S&P 500 companies according to FactSet6. However, rather than focusing on the headline numbers, we will be more interested in what the executive teams discuss during conference calls regarding inflation, supply chains and labor shortages this quarter.
Also, getting a better idea how executives view aggregate demand in the U.S. and Chinese economies prospectively will be top of mind. We worry FedEx’s recent earnings report may offer some clues. FedEx reported decent headline numbers, but management discussed how inflation, supply chains and labor shortages were strongly impacting operations and their ability to conduct normal business1. Shares fell as a result1. Strong earnings growth has been a major tailwind for markets in 2021, but we may start witnessing that support turning into headwinds with earnings season in October and November.
While we are still optimistic that the U.S. economy will to continue to perform quite well, we do worry financial markets may be in for a bumpy ride for the balance of the year as recent tailwinds start to transition into headwinds.
As such, most Sequoia strategies remain broadly balanced (neutral) relative to equity/fixed income targets, with modest tilts toward U.S. higher quality equities and lower fixed income duration than broad indices. For example, our 70% equity/30% fixed income strategies are generally in line with these “neutral” points, i.e., not materially greater than or less than 70% equity. Also, within fixed income allocations, several strategies hold managers that have flexibility to adjust duration and search for sectors and bonds that are positioned relatively well and backed by well capitalized assets. This is the same positioning and conclusions we drew to start the year and each quarter since. In Q3, we maintained an overweight to U.S. smaller companies, which typically do well in rising inflationary environments. We also maintained exposure to equities in Europe and many developed nations that offer compelling valuations relative to the U.S. as they continue to reopen their economies. Generally, this positioning allowed us to perform reasonably well compared to our benchmarks net of fees, while not taking on excessive risk in an increasingly uncertain environment.
Our goal is to provide diversified, long-term focused strategies that fit well into investors’ financial plans and objectives. In the current environment, we think it is paramount to be patient and disciplined. As markets price how the pandemic continues to impact the economy, inflation and Fed policy, fiscal policy from Washington, China’s economic problems and commentary from executives during the Q3 earnings season, we think markets may be more volatile than we’ve experienced in quite some time. If so, we think opportunities to rebalance portfolios and find bargains may emerge as we move toward 2022.
Sources: 1. Bloomberg 2. Morningstar Direct 3. Treasury.gov 4. NY Times COVID Tracker 5. https://www.wsj.com/articles/chinas-evergrande-debt-crisis-sizing-up-a-big-mess-11633253402?mod=searchresults_pos4&page=1 6. FactSet Earnings Insight 10/8/21
Chad Roope is Vice President, Chief Investment Officer at Sequoia Financial Group, LLC. Contact him at email@example.com or visit www.sequoia-financial.com.
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