By Matthew McKee
October 16, 2021
Third quarter earnings season began this week with the major banks reporting strong results. JP Morgan, Bank of America, Morgan Stanley, Citigroup, and Wells Fargo all topped analyst expectations. Adding to the good news, jobless claims came in below 300,000 for the first time since the pandemic began and wholesale inflation of 0.5% month-over-month vs consensus expectations of 0.6% and 0.7% in the prior month.
Market performance during the third quarter was a wrestle between economic recovery and the Delta variant, and after a 4.7% pullback in September, the S&P 500 ended the quarter essentially flat. This “September Swoon” is not surprising – high valuations, “persistently transitory” inflation, the FOMC discussing tapering its asset purchase program, and concern of contagion from the fallout in Chinese markets was certainly a lot for the markets to digest.
And while we have seen only a modest pullback from record highs in the overall indices and are up on the year, there has been considerable rotations beneath the surface, and we are seeing weaker market breadth. Surprisingly, 90% of the stocks in the S&P 500 and 98% of the stocks in the Russell 2000 have experienced a correction of 10% or more with an average drawdown of -18% for S&P 500 stocks and -34% for small caps.
On a style basis, value (Russell 1000 Value) has outperformed growth (Russell 1000 Growth) on a YTD and trailing 1-year basis, although growth rebounded midyear as the Delta variant emerged and investors returned to their pandemic playbook.
Despite the beginning uptick in interest rates and a slight pullback in September, valuations remain elevated, particularly in large cap growth. According to Morningstar, growth is trading 8% above its intrinsic value while large cap value is trading 6% below its intrinsic value. Our portfolios have benefited from the higher tilt towards value, and we are maintaining that allocation tilt in Q4 due to the lower valuations and higher margin of safety.
Regarding economic fundamentals, GDP has surpassed pre-pandemic levels, yet its composition is quite different. While growth in consumer goods has reached multi-decade highs, consumer services, which makes up 50% of U.S. GDP, is still down considerably. Higher demand for consumer goods and supply constraints has pushed inflation higher yet it appears as though this is in process of resolving itself. Demand is cooling (Q3 and Q4 growth estimates have been revised lower) and inflation is showing signs of easing. Inflationary pressures should also abate as consumers shift spending back towards services and supply chains have time to adjust.
In monetary policy, the Fed will likely announce tapering to its bond buying program at its November meeting and begin reducing asset purchases shortly thereafter. Chairman Powell indicated that he expected tapering to be completed by mid-2022 and then the Fed will likely turn its focus to the federal funds rate. Median estimate shown in Fed’s dot plot suggests a rate hike in 2022 is likely with several more within the following two years. While there has been much talk about “persistently transient” inflation, as discussed above and is supported by yield curves, we don’t see a significant concern for a surge in rates.
Globally, the OECD forecasts every one of the 45 major economies to grow in 2022. The IMF projects global growth of 6.0% and 4.9% for 2011 and 2022, respectively. The MSCI EAFE Index has historically performed well in periods of strong global growth due to high proportion of cyclical stocks. In addition, their valuations are also more favorable (MSCI EAFE at 15.3x forward P/E as of 9/30/21). As such, we are maintaining a sizable exposure to this area of the global market.
Chinese stocks have fallen into bear territory due to the Evergrande fallout and China’s regulatory crackdown. However, this is to be expected from an emerging market, China’s regulatory regime is nothing new, and the higher volatility comes alongside the prospects for higher long-term growth.
While the debt ceiling was avoided, it will be revisited in December, potentially creating volatility. Also on the political front, we have two large bills that include trillions in spending alongside increase in taxes. The House version increases the top marginal tax rate, imposes a surtax on income over $5 million, increases capital gains rates on the wealthy, and reduces exemptions for inherited assets. However, there will likely be much haggling by Democrats over the details, and much will change as it advances through the process. We will keep you informed to the changes and how they may impact you and your portfolio.
In sum, in this environment we are focusing on quality, remain diversified within and across asset classes, and monitor and adjust accordingly. The last point is particularly timely as we go into Q4. As always, we will keep you informed as to any pertinent financial or policy changes that may affect you and your portfolio. Please feel free to reach out if you have any questions or would like to discuss in more detail.