After a string of positive returns, the domestic equity market posted a relatively flat third quarter of 2021. After inching higher for the majority of the period, U.S. stocks gave back some gains in the quarter’s final weeks, with the S&P 500 Index hanging on to finish 0.58% higher. As always, COVID played a factor as investors monitored the path of the Delta variant, case counts, and reopening efforts. Politics reared its head as well, with debates over the debt ceiling and potential tax increases for high earners both making headlines. Labor and supply shortages for many sectors of the economy were a third concern, and widespread industries from personal electronics to automobiles are reworking their supply chains to adjust. Meanwhile, core market drivers keep chugging along, as corporate earnings continue to grow at a robust rate and individual demand trends and savings rates remain strong.
Overseas, Chinese real estate developer Evergrande made global headlines late in the quarter when it missed an interest payment to its bondholders. With over $300 billion in liabilities, the firm’s missed payment sparked fears of a broader default and raised concerns over some of the practices in China’s real estate sector. Chinese officials are also in the midst of a sweeping crackdown on specific industries like payment processing, video games, and cryptocurrencies. In developed markets, Japan significantly accelerated its domestic vaccine production and the European Union allowed members to reopen to vaccinated U.S. tourists, a massive move given the role of tourism in many European economies. As a result, emerging markets fell by just over 8%, weighed down by a 17.93% loss for the MSCI China Index, while Japan gained over 5% and Europe finished the period slightly negative.
Fixed income markets were generally flat to down in the third quarter, though high-yield corporate bonds led the pack. For the municipal bond market, rising uncertainty over increasing the debt ceiling was an additional headwind, as programs like the State & Local Government Series Securities program that states use to bolster their finances can be put on hold when federal funds get tight. The Federal Reserve remains a focal point here, and investors came away from the Fed’s September meeting taking special note of Chairman Jerome Powell’s comments that tapering “may soon be warranted,” perhaps in a matter of months. That said, the Fed remains tremendously accommodative, and the more impactful move of raising interest rates still appears far off.
Moving forward, we will continue to monitor the growing list of risks and opportunities in the current market. One cause for optimism is the state of corporate earnings. Companies across the board have exploded out of their COVID lows, and analysts are forecasting earnings for S&P 500 companies to grow 27.6% and 21.5% in the third and fourth quarters of this year, respectively. These forecasts take supply chain issues into account, showing just how durable firms’ bottom lines are right now.
Another positive trend is the setup in service industries. Demand for both durable and non-durable goods has long since recovered beyond pre-pandemic levels but spending on services has just started to come back to where it was in early 2020. This recent surge gives hope that a spending shift from goods towards services could fuel the next leg of the recovery. While services are not immune from inflationary pressures, and labor shortages are of particular concern for many service sectors, the end of extended unemployment benefits may help stem the tide here and consumers generally appear hungry and able to maintain demand even if companies have to pass on the cost of higher wages.
As for inflation, we have been in a disinflationary environment for so long now that any uptick can understandably be jarring. While many still question whether recent inflation readings are permanent or simply transitory as supply chains grasp to regain their equilibrium, the lumber market may serve as a harbinger. For example, the lumber market had severe supply and labor shortages in early 2021, with prices peaking at an astronomical $1,681 per 1,000 board feet in May. Yet the industry was able to iron out kinks in the supply chain and fill up staffing, and the price has now plummeted to back around $635 per unit. This is just one example, but it could be a leading indicator given the early timeline of lumber shortages. If other industries are able to smooth out idiosyncrasies in their own supply chains, many of the inflationary pressures felt today may abate in the coming year.
On the domestic political front, while we continue to believe that politics generally play a minor role in investing, especially when gridlock can help stop proposals that would be more disruptive to markets, we are monitoring potential changes closely. There is a chance that some tax and estate policy changes will be passed, and our financial planning professionals are working to ensure that we can provide you with the optimal advice if and when anything changes.
We also continue to monitor the situation in China closely. One thing to note that has been highlighted by several China experts: both the Winter Olympics and the Chinese Communist Party National Congress take place in 2022. While we are beyond the point where we can confidently assess what the Chinese government will or will not do, China’s leadership will have a serious interest in bolstering their global image, and numerous experts expect that they will take steps to get their house in order and project growth and stability to the outside world sooner than later as the global spotlight approaches. For example, the Chinese government could maintain or expand policies like cash injections into its banking system and interest rate adjustments to assist their economy, and we maintain that any fallout to U.S. investors stands to be relatively tame. Within Condor’s portfolios, we have long favored domestic equities and are not overly exposed to China in the first place. As a result, your accounts are relatively insulated from some of these risks.
Overall, the market pause late in the quarter feels like a rational assessment of the above risks. Markets cannot go up in a straight line forever, and without periodic resets like this, the market only sets itself up for a harsher reckoning later. Furthermore, some of the worst days in recent weeks have come on relatively low trading volumes during a historically seasonally weak part of the year. All told, we appreciate your continued trust and will keep working hard to ensure your portfolios are positioned as effectively as possible to navigate this current environment.