3rd Quarter 2021: Market and Economy

Market and Economy

After rising an average of 11.3% in each of the previous five quarters, the markets hit choppier waters in the third quarter. By September, markets had reached an inflection point as several major news stories were competing for investors’ attention. At month’s end, large-cap stocks were slightly higher for the quarter, with the S&P 500 up 0.6%, while small-cap stocks edged lower, with the Russell 2000 slipping 4.4%.

Such mixed results are common when the market is confronting several situations that could each significantly affect future earnings. On the negative side, a critical ongoing struggle over raising the national debt ceiling, a likely tapering of Federal Reserve support for the bond market, a possible hike in corporate taxes, and a threatened financial collapse in China all loom over the markets to trouble investors. On the positive side, an improving labor situation and strong earnings growth, a proposed $4.5 trillion in US government spending, and a slowing of the COVID Delta variant could all further boost the economy and send markets higher.

Debt ceiling dilemma

Despite some recent progress, perhaps the most immediate concern overhanging the market is the struggle to raise the national debt ceiling before it is breached on October 18. On September 30, the House of Representatives agreed to a short-term spending bill to avoid a partial government shutdown but a battle over the debt ceiling remains.

The debt limit has repeatedly been raised or suspended by both parties over the past couple of decades but doing so has become increasingly political. Republicans have vowed to block even a temporary measure in the Senate. If the ceiling is not raised, the US faces defaulting on its obligations for the first time, which will significantly harm our global reputation and could wreak havoc with the markets. As the fight plays out in Congress, the movement to permanently abolish the debt ceiling is drawing more attention.

More spending on tap

With more than $5.3 trillion in fiscal stimulus already injected into the economy since the start of the pandemic, Congress is debating another $1 trillion infrastructure bill and $3.5 trillion investment in social safety net and climate protection measures. Infrastructure has bipartisan support, but progressive Democrats want to tie both bills together to ensure passage of the second bill to achieve the Biden administration’s goals. To earn the full support needed among Democrats for passage, the scope of spending may be trimmed down. Passage of either or both bills would be another injection of cash into the US economy that may spur growth even beyond the market’s currently lofty expectations.

Tax increases on the way

Also looming over the markets are potential tax increases. To help pay for the proposed bills and previous stimulus bills passed by both administrations, Democrats are expecting to raise taxes. The most likely change is an increase to the corporate tax rate. The most recent proposal is to raise the rate from 21% to 26.5%. Also being considered are a 3% surcharge on any individual income over $5 million, and increasing the long-term capital gains rate from 20% to 25%.

Back to work

Fortunately, the US economic picture has continued to improve. After starting 2021 with an unemployment rate of 6.7%, the rate had dropped to 5.2% by August. Though the number of jobs added in August fell short of expectations, altogether an average of 586,000 new jobs have been added monthly in 2021. The additional $300 in monthly unemployment benefits provided by the federal government expired September 7, which could supply further incentive for some unemployed people to find work.

Most of the economy remains strong. Earnings for companies in the S&P 500 are at all-time highs, and earnings per share are forecast to rise 27% in the third quarter. Everywhere you look, companies are hiring. The number of job openings, at an all-time high of 10.9 million in July, continues to rise while the number of unemployed workers continues to fall. As more of the millions who left the job market during the pandemic return to work, companies will be able to produce more goods and services, creating even more profit growth. It is because of the improving US labor market, strong economic growth and inflationary pressures that the Federal Reserve is considering tapering its support for the bond markets.

Bonds struggle on expected tapering

Since the beginning of the pandemic, the Fed has pumped more than $4.3 trillion into the economy through bond purchases and various lending programs. These actions have pushed bond prices higher and kept interest rates low despite rising inflation. Extremely low interest rates help companies keep borrowing costs down and typically push stock prices higher.

As the economy continues to grow and strengthen, the Fed is expected to announce plans to begin tapering off these bond purchases in November. The US gross domestic product is expected to grow by a healthy 6% in 2021. If US GDP continues to grow by 3% or more as projected in 2022, the Fed’s monthly bond-buying programs will likely be phased out entirely by next summer.

In anticipation of fading support for bond prices, interest rates moved higher in the last days of the recent quarter. The 10-year Treasury yield rose from 1.27% on September 15 to 1.52% on September 30. That 20% rise weighed heavily on bond prices, erasing what had been a positive quarter. Though 2021 has been a difficult year for bonds, the Barclays Aggregate Bond Index is off just 1.6% for the year, showing that even in challenging times, bonds still maintain most of their value and remain an important part of investors’ portfolios.

Is Evergrande another Lehman Brothers?

Another shadow over the markets recently has been cast from China, where a major property developer called Evergrande has run into trouble. Evergrande, which owes more than $300 billion to bond investors and banks, has recently missed payments to its debt-holders due to underperforming operations and a resulting cash crunch. The prospect of its collapse has spurred speculation that the company is large enough to cause an escalating chain of failures that could threaten the Chinese economy, much as we saw in the US with Lehman Brothers in 2008. While the Chinese government hasn’t shown much willingness to bail out Evergrande itself, it’s expected the government will step in to protect the debt-holders eventually, which should help contain the situation.

Is inflation under control?

We spent a lot of time last quarter talking about inflation. Some of the supply shortages pushing up prices have continued. A limited supply of computer chips has held new car manufacturing to much lower levels than normal and kept car prices higher. But in other areas, many of the rising prices appear to be cooling off as summer comes to a close. For example, the S&P/Case Shiller US National Home Price Index rose just 1.6% in August, after rising by over 2% each month from April to July. Inflation, as measured by the Consumer Price Index, rose just 0.3% in August—the lowest monthly increase since January. While inflation is expected to rise by about 5% for all of 2021, the Fed is projecting inflation to fall back closer to 2% in 2022.

Persistent pandemic

On top of all this news, we’re still in the thick of a pandemic that continues to affect nearly every facet of our daily lives. As the vaccine rollout kicked into gear in the spring, we saw consumers emerge from hibernation and embark on spending sprees, buying up houses and cars and traveling once again. However, the surge caused by the Delta variant starting in July has brought back masks and has spurred many large-scale vaccination mandates. Delta has once again limited business travel and some restaurant dining.

While not uniform across the country, as of the end of September daily new cases appear to have peaked across much of the country. We’re not past dealing with Delta, but rising vaccination rates could help push down case numbers, and another spending wave could result. We’re definitely not medical experts, but a post-Delta bump is one scenario that could play out.

What next?

Though uncertainties may have stalled the market during this past quarter, it’s good news that worrisome developments are balanced by positive ones. Whatever happens, our plan remains in place: we invest in high-quality companies that generate cash year in and year out, and we rebalance regularly to remain diversified and appropriately allocated. Stock valuations improved marginally as underlying earnings grew and stock prices held relatively steady for the past quarter. Valuations are still higher than we would prefer to see but that has been the case for much of the past decade. Over that time, we have stayed invested and reaped the benefits. We will continue to stick to our plan.