th, also materially outperforming stocks and bonds.
For Q3, numerous political risks dominated the headlines, including tax policy, spending bills and infrastructure deals. The contentious Congressional negotiations around raising the debt ceiling were the most impactful for the markets. A stop-gap solution has been reached, but it is very short term and will likely resurface as an issue again during Q4. There was also significant nervousness around the distress and expected default of Evergrande, the major property development and construction company in China. Though a systemic “Lehman moment” has not materialized thus far, there is still real risk that Evergrande and related China policy tightening will trigger a slowdown and recession with global ripple effects.
Market Outlook and Q3 Summary
Overall Asset Allocation
We retain a general recommendation of a small overweight to equities, a larger underweight to bonds, and modestly overweight cash, with some of that cash reallocated into gold and diversified commodities.
The biggest issue facing the market is how the inflation picture plays out. Inflation is not automatically a dire problem, and in fact, has been held down by the deflationary pressure of the advance of technology and globalization over recent decades. However, the current environment is experiencing hard asset shortages, supply chain bottlenecks and labor shortages above and beyond pre-COVID years.
A unique piece of the inflation puzzle is that much of the upward price pressure is arising from supply chain disruptions, materials shortages and labor shortages, which are not easily remedied with the traditional playbook of interest rate hikes. Rate increases are more for moderating excess demand or excess leveraged risk taking. In any case, the Federal Reserve will be hard pressed to resist its traditional tightening tools if inflation persists.
The equity market has benefited from the current excess liquidity and low-rate environment even more than the bond market. As a result, we think tapering of Federal Reserve bond purchases and rate hikes could eventually disrupt equity markets even more than the bond market. Further, on a secular basis, corporate profit margins (earnings) have benefited from cheap labor and cheap materials in ways that could also be ending. We are closely watching these factors for any softening in outlook that signals the US is moving to later (and less optimistic) phases of the business cycle and would require allocation changes.
Q3 was a bit of a round trip for the stock market. The quarter started on the upswing then retreated to finish nearly unchanged. International stocks lagged for Q3, returning -4%, with China’s -19% performance dragging down benchmarks. Year-to-date through September 30th still shows recovery of value and cyclical sectors relative to the technology sector’s dominance of trailing 3- and 5-year performance. As a result, the S&P 500 was up 16% versus Nasdaq up 13% for the year as of September 30th.
The dispersion across industry sectors has been quite pronounced so far this year with the energy sector being the top performer at +43% and utilities in last place at +4%. Technology remains strong yet is now more modestly in the middle of the pack at +15%. The financial sector has also enjoyed some revival at +29%.
Importantly, earnings have been strong and allowed stocks to grow into their elevated price-to-earnings (P/E) multiples from earlier this year. P/E ratios remain historically expensive, although somewhat less stretched than in prior months. The quarterly earnings season is well underway in the US. Results continue to come in quite strong, although this is largely “priced in” at this point. The news is not all good though, as profit margin pressure bears watching with input costs rising, both in terms of materials and labor.
In terms of sector exposures, any changes in corporate tax policy are potentially meaningful according to how they are structured. However, higher tax rates are largely expected. The larger issue is if/when material regulatory changes or anti-trust maneuvers are made against social media and big tech firms. We are monitoring these areas closely. As always, sectors such as energy, health care and financials bear close monitoring on the regulatory front.
Bonds were also largely unchanged for the quarter with the sole outliers being US TIPS (Treasury Inflation Protected Securities) being up +1% and emerging market debt being down -1%. For the year-to-date period, the bond themes are US Treasuries being under some pressure while risk appetite has supported high yield and lower rated credit sectors.
We have only modest expectations for bonds considering the already extremely low yields in the market. The one counterbalance to this pessimism is that bonds do come into play for global investors as yields increase. Similarly, if bonds come under further pressure from rate hikes, Fed tapering of bond purchases or persistent inflation, then growth and equity euphoria is ultimately choked off, which creates the paradox of bonds returning to favor as a safe haven. Therefore, we do think bonds retain some portfolio diversification benefit and some anti-correlation to equities in times of shock.
Other Asset Classes
The Bloomberg broad commodities index was up 7% for the quarter. Diversified commodity exposure remains appropriate to offset rising inflation risks and diversify beyond solely stocks and bonds.
We prefer a diversified basket beyond just the bellwethers of oil and gold because it is an effective way to capture the general uptrend as the flash point of the moment rotates across metals, agriculture and energy/heating needs as we have seen in 2021. We are also researching opportunities in renewable energy and electric vehicles.
There is always a two-sided list of pros and cons facing markets. That list feels longer-than-normal on both sides of the ledger currently. Political instability, tax policy, regulatory risk, COVID variants, peaking margins, and supply bottlenecks are just a few of the worries. Conversely, a generally healthy re-opening economy, businesses with good balance sheets, buyback programs, eventual infrastructure spending, and low rates lead the list of positives. Meanwhile, as these factors battle it out, the market has generally ground higher based on abundant liquidity and lack of attractive places for investors to park money.
We are very cognizant of these technical factors and look to participate in trends as they arise. We are nearly fully invested at this point in the cycle yet remain in liquid positions that can be rebalanced and tactically upgraded as market conditions change. Our overriding philosophy remains to be patient for attractive entry points to accumulate positions that we hope to own for multi-year holding periods. Interim volatility is to be expected, particularly as the Federal Reserve embarks on its tapering program, but we believe client portfolios are robust for the long term.
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