Market Commentary - Q4 2021

The biggest “Grand Reopening” ever was put on hold this past summer thanks to an unexpected resurgence of COVID cases despite the broad deployment of vaccines. Beginning last November, when the first successful vaccine trials were announced, it appeared a return to normalcy was right around the bend, and banners could be hung on every street corner letting consumers know the economy would soon be fully open for business once again.

With vaccine distribution in full swing by spring, this summer was shaping up to feel a lot like the famous summer of 1969. While not exactly on the same scale, the prospect of resuming normal activities that we all once took for granted, like taking vacations and hugging loved ones, after a long hiatus felt like a moon landing event. Unfortunately, expectations that vaccines would offer fortress-like immunity and receive ubiquitous uptake among the eligible quickly gave way to a reality that both assumptions would prove overly optimistic and the pandemic would remain a dark cloud hanging over the economy for longer than most anticipated.

As case counts and hospitalizations grew over the summer, so did restrictions to slow the spread. In turn, the momentum of global economic growth naturally slowed. High frequency data that tracks mobility in places like airports, hotels and restaurants quickly reflected the pivot in pandemic-related concern. Perhaps most importantly, snarled supply chains, already putting heavy upward pressure on inflation, intensified over the third quarter. The bottleneck has become so pronounced that the ever-growing count of container ships waiting to be off-loaded at U.S. ports has become a regular news story.

Disappointing economic data as the second quarter progressed led to significant declines in estimates of third quarter U.S. real Gross Domestic Product (GDP). After initially estimating a 6 percent annualized growth rate for most of August, the Atlanta Federal Reserve’s (Fed) measure of GDP steadily plummeted to just 1.3 percent in early October.

Equity markets initially took the economic setback in stride, instead focusing on third-quarter corporate profits reports that continued to inspire confidence. Nowhere was this more apparent than domestic large cap stocks. Entering second quarter earnings season, consensus analyst estimates for the S&P 500 Index were expecting an already stellar year-over-year profit increase of 64 percent according to FactSet. By the end of the reporting season, FactSet noted, the Index would see actual earnings increase by over 90 percent -- the largest year-over-year increase since the fourth quarter of 2009.

In September, as the earnings season wound down, investors began to refocus on deteriorating economic data and negative headlines. The tape of bad news flowed freely with increasing attention being paid to the regulatory crackdown in China and gridlock in Washington. By the end of the month, the S&P 500 Index would register its worst monthly return since March of 2020, falling 4.7 percent.

Heading into next year’s National Party Congress, where he will be looking to secure a third term, Chinese President Xi Jinping has sought to address a number of structural issues that are seen as obstacles to growing a robust middle-class population and continued economic development. Under the banner of a “common prosperity” campaign and other initiatives, China’s government has taken aggressive regulatory action to rein in what it views as an unacceptable wealth gap. Targets of these restrictive measures have ranged broadly across the economy from China’s tech giants to private tutoring firms to insurance companies.

As Brookings Institute Senior Fellow Ryan Hass explains, “In launching a recent wave of actions to redress social inequality and economic disparity, China’s leaders may view themselves as correcting some of the excesses of Deng’s [Xiaoping] decision to ‘let some people get rich first’. Such efforts align with Xi’s efforts to recast himself from a princeling to a populist leader.”

China’s multi-pronged policy shifts have stirred uncertainty in the world’s second largest economy and sent domestic stocks well into bear market territory from February highs. Given the significance of China’s role in the broader economy, investors are naturally concerned about ripple effects across the global economy.

Compounding the market’s jitters over China, financially distressed property developer Evergrande has emerged as one of the larger casualties of a regulatory crackdown focusing on curbing speculation and leverage in China’s property market. With a reported $300 billion in liabilities, some have speculated that Evergrande could become China’s equivalent of Lehman Brothers. Facing a massive restructuring, Chinese authorities have aimed to limit Evergrande’s impact on the broader economy by signaling it intends to support the real estate market.

Washington’s penchant for political brinksmanship has once again found its way into the narrative of financial markets. Lawmakers have set themselves up for a down-to-the-wire stalemate over how to raise the debt ceiling in a standoff reminiscent of the same scenario that played out in 2011. According to U.S. Treasury Secretary Janet Yellen, the U.S. government can only afford to pay its bills until December 3 without additional borrowing. The devastating fallout of a default on U.S. government debt could not be understated. Secretary Yellen underscored this point in a recent television interview saying, “I think it would be catastrophic for the economy and for individual families”.

Aside from addressing the debt ceiling, Congress will have a packed agenda in October as it seeks to move the bipartisan infrastructure bill and President Biden’s Build Back Better budget plan across the finish line. Both pieces of legislation have important implications for fiscal policy over the long term and will also be closely followed by investors. As expected, the Build Back Better plan will increase taxes to pay for spending on social and climate programs and is likely to be significantly scaled back from the original $3.5 trillion price tag to meet the demands of moderate Democrats.

Since March of 2020, highly accommodative and globally coordinated fiscal and monetary policies have supported a ”glass half full” investor mindset towards the majority of risk assets whenever sources of uncertainty emerged. However, as accommodative policy is weaned over time, we expect that maintaining this sanguine disposition will become more challenging.

Global equity markets, led by domestic stocks, have enjoyed an unusually smooth and rapid ascent over the past eighteen months – a pattern we do not expect to continue going forward. Rather, we expect further price appreciation but at a more modest pace, accompanied by a normalization in volatility reflecting a growing number of risks as the recovery cycle matures.

For now, we expect the current headwinds to economic momentum as delaying, but not derailing, the recovery. Therefore, we remain constructive on the more economically sensitive areas of the equity market that have been out of favor relative to more defensive sectors.

The third quarter was characterized by increased COVID concerns, a strong but decelerating U.S. economic recovery, persistent inflation, Congress’s inability to pass an infrastructure bill and a move toward less accommodative global central bank policies. Given these drawbacks, volatility significantly increased, interest rates fell substantially, and credit spreads widened. By the end of the quarter, however, the impact of these moves in fixed income markets reversed. Long maturity U.S. government bond rates ended the quarter marginally lower while intermediate rates and credit spreads in general ended the quarter slightly higher.

This basketful of risks worrying markets has weighed on forecasts for economic growth. In fact, the Federal Reserve Open Market Committee’s (FOMC) median 2021 economic growth forecast fell from 7 percent in June to 5.9 percent in September. Downward revisions to growth forecasts, along with concerns over a potential Evergrande default, contributed to a short-lived decline in U.S. Treasury interest rates and a widening in credit spreads during the quarter.

Inflation readings remained stubbornly high due to global supply chain disruptions, rising oil and natural gas prices, increasing shelter costs, wage pressures within some industries, and low-base price comparisons versus prior periods. There are, however, some early signs of easing price pressures, including recent declines in the Manheim Used Vehicle Value Index as well as prices for airfare and lodging away from home. These data points, however, have not sufficed to resolve the debate among market participants and central bankers over questions such as whether current inflationary pressures are transitory, how long “transitory” might last or the prospect that we could be entering a new inflation paradigm. For the time being though, the markets cautiously agree with Fed Chairman Powell’s transitory inflation stance.

On the monetary policy front, the Fed began preparing markets for a potential tapering of its quantitative easing (QE) asset purchase program. If the recovery remains on track, QE tapering is expected to begin at the end of the year and conclude by mid-2022. The tapering timeline was telegraphed by the Fed during its September policy meeting and the tapering pace was faster than markets originally anticipated, contributing to the increase in interest rates near the end of the quarter.

QE asset purchases are synonymous with a monetary policy that pushes the gas pedal on economic growth, while changes to the Fed Funds rate are synonymous with pushing the brakes on economic growth. The Fed has been clear that there is no predetermined timeline between tapering QE and increasing the Fed Funds rate, but has noted that the latter will require much more progress toward meeting their policy goalposts. These goalposts were changed in August 2020 under the Fed’s new policymaking framework which seeks to achieve strong and broad-based employment outcomes, while also allowing average inflation to exceed its long-term inflation target over an unspecified period of time prior to triggering rate hikes.

The Central Tendency Forecast released from the September FOMC meeting highlights the vast difficulty in forecasting economic and monetary policy during the pandemic and the significant dispersion in forecasts among FOMC members. The median forecast for the first rate hike moved from 2023 to 2022 with the median forecast of one hike in 2022 and a few in each of 2023 and 2024. However, forecast dispersion as reflected in the Fed’s “Dot Plot” shows a 50 basis points Fed Funds policy range for 2022 and a 150 basis points range for 2023.

Ultimately, we believe the Fed leadership (the Chairman, Vice Chairman, and Head of the New York Fed), all of whom remain dovish in terms of rate hikes, will have the largest influence on the Fed Funds policy rate.

As a result, this median policy forecast may be more aggressive than what actually occurs in the quarters and years ahead. Regardless, the forecast helped reprice short maturity interest rates in three- and five-year U.S. Treasuries higher due to more aggressive Fed policy assumptions.

Rapidly improving corporate credit fundamentals remained a bright spot across both the investment grade and high yield bond markets. Debt leverage in general has fallen back to pre-pandemic levels given strong corporate revenue and earnings growth as well some debt repayments. Further, near-term debt maturities have largely been refinanced, reducing concerns of a looming maturity wall while corporate cash levels remain elevated.

Despite these improvements, there are concerns over margin compression going forward given higher input costs, as well as credit concerns regarding the potential use of the corporate cash stockpile. Consumer-related Asset Backed Securities’ fundamentals remain a bright spot given strong consumer balance sheets, while Agency Mortgage-Backed Securities remain under pressure given the increase in interest rate volatility as well as the negative effect QE tapering will have from a supply-demand perspective.

The recent uptick in intermediate and long maturity U.S. Government bond rates did not occur in isolation. Interest rates across developed market Government bonds have increased in tandem with the U.S., thereby raising the effective ceiling on U.S. bond rates. Increasing non-U.S. interest rates have been driven by rising inflation expectations due to higher energy prices as well as the potential for reduced monetary policy accommodation by global central banks.

Heading into the final quarter of 2021 and beyond into 2022, we expect a near-term resolution to the Federal budget and debt ceiling impasse, the passage of a slimmed down infrastructure stimulus package, decelerating yet reasonable U.S. economic growth, the beginning of QE tapering, modestly easing core inflation pressures, and continued improvement in corporate credit fundamentals within select industries.

We expect intermediate to longer maturity interest rates to resume their trend higher across developed market economies as the global glut of liquidity slowly declines. Further, we believe short- maturity interest rates in the U.S. will remain relatively stable given our expectation that the Fed will be slower to increase short-term rates than what is currently priced into the market.

Despite continued improvement in corporate credit fundamentals, select industries and issuers may face declining margins and increased pressure to partake in mergers and acquisitions or to prioritize equity holders at the expense of debt holders. With corporate credit-spread risk premiums near their lowest level since the financial crisis, we see limited opportunity for additional spread compression. However, opportunities exist within select industries and issuers. Further, higher U.S. Treasury interest rates should keep credit-spread premiums contained within a low range as yield-sensitive buyers increase purchase activity. As such, we advocate fixed-income strategies that focus on security selection, yield carry, and minimizing interest rate risk.

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