Q3 2021 Market Commentary

    After rising relatively uninterrupted since last November, US equities took an overdue breather in the third quarter. As shown in the table below, the S&P 500 was up a meager 0.6% in the quarter, with the Russell Midcap Index falling by 0.9% and the small-cap Russell 2000 Index faring worse with a negative 4.4% return. Commodities continued to do well this year, gaining 6.6% in the quarter, adding to its stellar year-to-date (YTD) return of 29.1% (as per the Bloomberg Commodity Index). In fact, the best performing asset classes YTD have been those that historically benefit from an inflationary environment, namely equities, real estate (REITs) and commodities. However, non-US equities remain laggards, in large part due to the buoyant US dollar and brewing concerns about China’s economic growth.

    As with equities, fixed-income securities also experienced a fairly disappointing quarter. The Barclays US Aggregate Bond Index was basically flat for the quarter, unable to attain any traction since Treasury yields declined in the first half of the third quarter only to then rise in the second half. International bonds did not fare well in the quarter, with the Barclays Global Aggregate Bond Index declining by 0.9%.

    Despite the pause in equity markets, the economic recovery remains strong. Cases of COVID appear to have peaked in both the US and globally, and currently 66% of the US population has received at least one vaccine dose and 57% have been fully vaccinated. Whereas earlier this year the spread of the Delta variant had investors worried that we may be headed for a significant setback in the economy’s recovery, such fears have abated considerably.

    In September, after much anticipation by investors, the Fed indicated it would begin a gradual tapering process, slowing the pace of its bond purchases that has worked to keep interest rates low during the pandemic. If signs of escalating inflation do not eventually dissipate, it increases the likelihood that the Fed will raise interest rates, most likely next year.

    However, it’s worth noting that, in our opinion, it has become the consensus view that inflation will remain a problem and in response the Fed will hike interest rates. But when it comes to investing, the consensus view is all too often wrong. Robert Farrell, a Wall Street legend who for decades was the chief market strategist for Merrill Lynch, maintained 10 rules for investing, one being: “When all the experts and forecasts agree – something else is going to happen.” In general, when something becomes a very commonly-held view, as if it’s almost a foregone conclusion that it will happen, then it very likely won’t happen. Investor sentiment is typically a contrary indicator. As an example, late last year it seemingly became the consensus view that the US dollar would weaken and decline, and yet this year the dollar has steadily appreciated. The point being it often pays to at least question and attempt to poke holes in outlooks deemed to be universally accepted.

    Assuming that indeed the consensus view is the Fed will eventually raise rates to combat inflation, what could possibly occur to prove this expectation incorrect? For one, inflation could be alleviated if economic growth were to slow from what has been an extraordinarily rapid pace. With no more COVID-related government fiscal aid in the cards, and the Fed signaling its asset repurchasing activity (QE) will begin to wind down, much of the collective stimulus that has been fueling economic growth will gradually run out. Mind you, we’re not suggesting such tempering of stimulus will result in a recession, but rather that the economy simply moderates from what was an unsustainably high growth rate.

    The following chart illustrates the close relationship between economic activity and prices (inflation):

    The Fed Reserve Bank of Dallas conducts monthly surveys to obtain assessments of business activity and pricing in Texas. The red line in the chart measures business activity and the white line reflects pricing on goods. The two lines are clearly correlated with declining or slowing business activity resulting in lower prices and vice versa, as business activity heats up or rises so also does pricing pressure (inflation). As it happens, recently the red line in the chart has been declining, indicating business activity is dropping, which should lead to the white line (pricing) eventually receding – similar to what occurred in 2007-2008 when the red line diverged from the white line (see yellow arrows).

    Another possible remedy for the rise in inflation is a resolution of the many supply chain bottlenecks that have existed since the onset of the pandemic. The significant increase in consumer demand during the recovery combined with supply shortages due to COVID-related disruptions has greatly contributed to the escalation in prices. But supply chain bottlenecks won’t last forever, eventually easing and returning to some semblance of normalcy, which in turn should serve to diminish pricing pressures.

    A key concern for investors is if inflation continues to heat up and the Fed finds itself behind the curve, that it will then be forced to abruptly start raising interest rates to lower inflation, perhaps leading to both escalating inflation and interest rates – an environment usually not accommodating for financial markets. The real fear is the Fed could eventually overshoot the raising of rates in its effort to steer off inflation and thus adversely affect economic growth.

    It’s for this reason that investors keep close watch on the 10-year Treasury yield as it tends to give timely clues about what the Fed may do with interest rates in the near future. A persistent, rising 10-year Treasury yield often infers that investors believe inflation could become a potential problem and the Fed will, in due time, raise interest rates. In our 2Q missive, we showed the following chart which helps us in assessing and anticipating interest rate direction.

    The red line in the chart represents the relative return of the Russell 1000 Value Index vs. the Russell 1000 Growth Index, and the green line is the 10-year Treasury yield. When the red line is rising or in an uptrend, meaning value stocks are outperforming growth stocks, the 10-year Treasury yield usually follows suit, rising as well. Notice in years 2012 and 2016, the red line was rising (as denoted by orange arrows) and the 10-year yield eventually spiked higher. In 2018, the red line was declining, as value stocks were underperforming growth stocks, and the 10-year Treasury yield stopped rising and declined over the next two years. For 2021, the 10-year yield has spiked higher and remains somewhat elevated, and yet notice the red line is languishing and not rising to confirm the rise in the 10-year Treasury yield. Until value stocks outperform growth stocks on a longer-term basis, breaking the multi-year downtrend for the red line, it remains to be seen if interest rates will head higher, along with inflation (what the consensus expects).

    Bottom line: we’re always questioning consensus views and exploring alternative scenarios or potential contrarian outcomes. As the ever-quotable Yogi Berra once said, “It's tough to make predictions, especially about the future.” But in our experience, forecasting can be greatly improved by avoiding the knee-jerk reaction to simply go along with whatever is being repeated in the financial media. More often than not, the crowd is incorrect and something else happens.

    The team at Measured Wealth wishes you all the best during the rest of 2021. As always, if you have any questions, feel free to call or email.

    Ed Miller, CFA, CMT
    Chief Investment Officer
    Measured Wealth Private Client Group

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