Following a prolonged period of subdued volatility and a steady climb higher in markets, the third quarter ended with a sell-off in September. An onslaught of market-moving events and seasonal factors contributed to the decreased monthly performance in September as prospects of rising taxes, and high inflation coupled with a more hawkish stance from the Federal Reserve dampened investor sentiment.
The large drawdown in September was not enough to bring Q3’s total return into negative territory, but it was the worst-performing quarter since Q1 of last year1. The S&P recorded its first pullback since last October and finished the month lower by 4.8%. As for the other indices, the Nasdaq Composite fared the worst in September with a 5.3% monthly decline, while the Dow Jones Industrial Average fell 4.3%1.
Exhibit 1. S&P 500 Quarterly Returns.
In the third quarter, financials and utilities recorded the largest increases of 2.7% and 1.8%, respectively, while the S&P 500 index returned 0.6%. Conversely, the industrials and materials sectors lagged the broader market’s return and fell 4.2% and 3.5%, respectively. The cyclical sectors of the market were the hardest hit as investors may have braced for a slowdown in economic activity. Meanwhile, financials continued to build on their strength as higher interest rates and increased investment banking and trading activity provided a boost to their top and bottom lines.
Exhibit 2. S&P 500 Sector Performance in Q31.
Growth stocks largely outperformed value stocks in the third quarter, likely due to a decrease in long-term interest rates and expectations for a year-end slowdown in the economy. The rise of the Delta variant reintroduced shutdowns and restrictions across the country, which adversely impacted consumer confidence and economic growth expectations globally. Despite these concerns, equity markets remained stable and continued their march higher due to strong Q2 earnings that came in 92% higher YoY1 and positive equity fund inflows totaling more than $350 billion so far, this year1.
However, in the final leg of the quarter, volatility returned after some uncertainties plagued investors' risk appetite. The inability of House Democrats and Republicans to come to an agreement over the size of the upcoming infrastructure and social wealth-care bills led to a standstill in raising the country's debt limit. This meant that the United States would be forced to default on its debt unless Congress increased the Treasury’s borrowing capacity by October 18th. The risk of default had some negative implications for markets and weighed down sentiment.
Coincidentally, the Federal Reserve indicated that it would likely announce the tapering of its
monthly asset purchases in November. Also, the Federal Reserve’s interest rate projections were revised to show a shorter rate-hiking timeline than previously shown, with the first increase in the Federal Funds rate expected in 2022 and three more subsequent rate hikes in 2023.
The less accommodative stance from the Fed and the possibility that a rise in interest rates may come sooner than expected triggered a sell-off in bonds, causing bond yields to spike higher. The resulting move in the 10-year Treasury yield from 1.27% at the end of August to 1.48% at the end of September likely led to a decline in equities, especially those with more aggressive valuation multiples.
Exhibit 3. Federal Reserve Dot Plot for Federal Funds Rate Expectations1.
As COVID-related restrictions are lifted and the vaccinated population grows, consumer spending should remain elevated given how robust household balance sheets are. Aggregate household net worth has climbed to $142 trillion in 2021 from $111 trillion in 2020. That means that household net worth has more than doubled since The Great Recession2.
Exhibit 4. US Household Net Worth as of Q2, 20211.
2020, to $20.8 trillion at the end of Q31. Monetary and fiscal stimulus seems to have boosted consumer demand and eased access to credit, but it has inevitably led to higher inflation.
Exhibit 5. M2 Money Supply.
Moderate levels of inflation are a typical byproduct of economic growth, but higher levels of inflation can be detrimental to the economy and can hurt investors’ returns. The impact on
For example, the real yields on Treasury securities have gone negative. With a nominal yield of 1.57%1 (as of October 15) on the 10-year note, the real yield an investor receives after accounting for inflation is -0.97%, which is calculated by subtracting the expected inflation rate on the 10- year breakeven from the nominal 10-year Treasury yield. In an environment where inflation is comfortably above 2%, there is a scarcity of asset classes to invest in that can adequately compensate investors.
In contrast, the equity market’s earnings yield (the inverse of the P/E ratio), which is calculated by dividing next year’s earnings per share by the current price per share, is now expected to yield about 4.5%1. Comparably, equity investments have the potential to be more attractive on a risk- adjusted basis.
Exhibit 6. S&P 500 Forward Earnings Yield VS. 10-year US Treasury Yield.
Buying Opportunities in the Market:
Optimistic economic growth expectations and historically low interest rates have pushed stock valuations towards the upper range of their historical valuations at roughly 21X forward earnings for the S&P 5001. For the faster-growing technology sector, valuations are higher at approximately 26X forward earnings1. The fundamental prospects of the broader market, however, are promising in our view.
Although the broader market is at a relatively elevated valuation on a price-to-earnings basis, there are still certain sectors, in our view, that can provide a lot of value moving forward. When looking at the technology sector from a price to free cash flow perspective, the technology sector trades at a slight discount to the overall market at 28X trailing-twelve-month free cash flow, as opposed to 30X for the S&P 5001. Free cash flow measures the amount of cash a company generates from its operations less any capital expenditures needed to maintain and grow its business. In our opinion, this discount reflects an attractive opportunity to take advantage of a sector that is both growing revenues and earnings at a higher rate than the broader market.
Exhibit 7. S&P 500 VS. Technology Sector on a Forward P/E and P/FCF basis.
Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), Alphabet (NASDAQ: GOOG), Amazon (NASDAQ: AMZN), and Facebook (NASDAQ: FB) collectively make up approximately 23% of the S&P 500 in terms of market capitalization1. While that level of concentration is some of the highest on record, our opinion is that the fundamental outlook of these companies remains positive and has been resilient throughout the most recent economic downturn. In the second quarter of 2021 alone, these five companies collectively grew their revenues by 36% and generated $332 billion in sales1.
As the world continues to undergo a digital transformation, these companies could have significant tailwinds behind them. The explosive growth of emerging technologies such as 5G, artificial intelligence (AI), cloud computing, and augmented reality (Metaverse), are all reinventing the way we communicate and interact with one another. The government-imposed lockdowns that swept through the nation last year likely helped accelerate the growth of these technologies and pulled their adoption curves forward.
The implementation of 5G network connectivity can accelerate the further adoption of these technologies and is still only in its early stages. As more 5G compatible phones come to market, the usage of social networks and cloud-based applications have the potential to grow exponentially as internet speeds are expected to increase as much as ten-fold. It will enable emerging technologies such as autonomous driving, which will require vast amounts of real-time data and computing power to successfully navigate city streets.
In the most recent quarter, Google’s advertising business grew 69% on a year-over-year basis, and YouTube’s revenue increased by 84%. YouTube’s explosive growth is expected to increase sales at a pace that would put it ahead of Netflix by the end of the year. YouTube only makes up 11% of Google’s annual sales.
Google’s cloud segment reported revenue of $4.6 billion in the second quarter, up 54% year- over-year. At an annual run rate of $20 billion, Google’s cloud business on a standalone basis could be worth as much as $200 billion if it was assigned a common industry multiple of 10X sales.
Economic Data Recap:
During the second quarter, US GDP grew 6.7% on a seasonally adjusted annualized rate amid a reopening of the economy and a bounce back in economic activity. According to the Fed, this growth is expected to carry over for the full year, with the Federal Reserve providing estimates for GDP growth of 6% in 2021. However, many disruptions in supply chains globally and some friction in the labor market have caused prices to materially increase this year, which can have a significant impact on consumer demand moving forward. The continuation of labor shortages and elevated inflation can add to fears of a slowdown in economic activity next year.
Exhibit 9. US GDP Growth in the second quarter accelerated from Q1 to 6.7%1.
Job Market Progress Decelerated in September:
The US economy has added back more than 5 million jobs over the past 9 months, bringing the unemployment rate down from 6.7% at the start of the year to 4.8% as of September. The rollout of the vaccine has proved to be very successful with more than half of the adult population receiving both doses of the vaccine according to data from the CDC’s Covid Data Tracker. This may have made Americans more willing to go back to work and fill the void in many industries that were on the brink of collapse last year. Industries such as hospitality, leisure, and restaurants, have all added back millions of jobs this year and have been responsible for the bulk of the job gains1.
The most recent Nonfarm Payrolls report disappointed with only 194K jobs added in September; this number was well short of estimates of 500K. Job growth was the slowest of the year, complicating things for the Federal Reserve, which is likely set to decide on bond tapering next month. While September’s results were disappointing, a deeper look into the report reveals some positive indicators. The headline number was hurt by a larger-than-expected drop in government jobs (-123K), while private-sector jobs increased by 317K1.
August’s Nonfarm Payrolls were revised upward from 235K to 366K, and July’s NFP was revised upward from 943K to 1,091K. These increases along with strong gains over the summer brought the 4-month average through September to roughly 750K new jobs per month.
After two straight months of large misses on the job’s reports, investors are questioning why job openings remain vacant. With more than 10.4 million jobs available as of August, there are roughly 1.36 jobs for every unemployed person1. This conundrum is puzzling both economists and employers who are desperate to hire more people. This discrepancy can partially be explained by a drop in the labor force participation rate, which measures the share of Americans who are employed or looking for work, from 61.7% to 61.6%.
As vaccine mandates continue to roll out, churn in the job market is likely to stay elevated. On the other hand, as COVID-19 case counts continue to trend lower and as the immune population grows, we would expect that people should feel comfortable going back to work. Additionally, the expiration of expanded unemployment benefits could prompt many unemployed Americans to return to work.
Exhibit 10. Nonfarm Payrolls miss in September, adding to job market fears.
Inflation Could be Higher than the Data Suggests:
The disruptions in both the labor market and global supply chains were likely some of the factors that have driven up prices this year. These complications, in our view, are mostly to blame on rising commodity prices and material shortages around the world, leading to the highest price increases in more than a decade.
In September, the Consumer Price Index (CPI), which is a measure of inflation, rose 5.4% year- over-year to the highest level since 20081. Some of the biggest price increases this year have come from categories such as used cars, which are in high demand now due to a shortage of new cars on the market. A lack of semiconductor chips has halted the production of millions of cars around the world that need chips to operate basic functions in the car. The global chip shortage has impacted the nation's largest automakers and has forced them to prioritize and redirect chip production to their best-selling vehicles, and at times, completely shut down idle factories. The resulting impact has been a 24.4% year-over-year increase in the price of used cars in September1.
Exhibit 11. US Consumer Price Index (CPI).
In some areas, the CPI could be understating inflation. A major component of the CPI is housing and shelter costs, which make up roughly one-third of the index. However, the cost of shelter in the CPI is tracked from the renter’s perspective and not from the homeowners, because housing units are considered investments.
Over the past year, the CPI reported that the cost of shelter has increased by 3.2% year-over- year, while home prices rose 19.9% in August on a year-over-year basis, according to the S&P Case-Shiller National Home Price Index 1. This discrepancy is due in large part to the federal moratorium on rents, which prohibited landlords from evicting tenants for ceasing to pay rent.
Also, in many states and counties, landlords were restricted from increasing rent prices. These factors, in our opinion, could be the reason why the cost of housing reported in the CPI index does not accurately align with the price increases consumers and homeowners alike are experiencing.
Exhibit 12. S&P Case-Shiller Home Price Index rose 19.9% year-over-year in August.
Labor shortages have also had a profound impact on prices, as employers have had to lure new employees with large sign-on bonuses and higher wages. In the most recent Nonfarm Payrolls report released by the Bureau of Labor Statistics (BLS), it was reported that average hourly earnings increased by 4.6% year-over-year. The impact of higher wages and a lack of available workers has forced some employers and businesses to raise their prices to keep their profit margins intact.
Tightening Fed Policy:
In the eyes of the Federal Reserve, these price increases are mostly a consequence of
international supply chain disruptions and material shortages. The Fed’s view is that these issues will be resolved as economies around the world emerge from the pandemic.
Earlier in the year, the Fed expected the rate of inflation to moderate by year-end, but Federal Reserve Chairman, Jerome Powell, recently said that inflation has been stickier than initially expected. This forced the FOMC to raise their inflation expectations for the full year to 4.2% from 3.4% but maintained their 2022 inflation expectations at 2.2%1.
waiting to pull back their quantitative easing program until their criteria for “substantial further progress” was met. This meant that inflation had to moderately exceed a 2% long-term average, and for the job market to make meaningful progress toward their goal of maximum employment. Now that both of those parameters have seemingly been met, they will likely begin to discuss the specifics for tapering during their upcoming meeting in November.
After increasing their balance sheet by more than $4.3 trillion over the past year and a half, the Fed appears to be ready to slow down their asset purchases of $80 billion a month in Treasury securities and $40 billion in mortgage-backed securities. Those emergency measures have provided plenty of liquidity for markets and suppressed interest rates to record low levels while supporting the flow of credit to households and businesses at a very low cost.
Exhibit 13. The US Central Bank balance sheet swells to $8.5 trillion because of QE.
Bond Market Recap:
Bond yields seesawed during the third quarter as the Delta variant of COVID-19 reintroduced uncertainty regarding the economic recovery in the US. Reduced growth expectations for the second half of the year and renewed shutdowns and restrictions across the country prompted some investors to take some risk off and shift into Treasuries.
At the start of the quarter, the yield on the benchmark 10-year Treasury yield stood at 1.47%, then subsequently fell to a low of 1.13% a few weeks later1. Yields bounced back from their lows and consolidated before climbing back to 1.48% at the end of September.
In October, yields for intermediate maturities ranging from 2-10 years have all meaningfully moved higher. The largest increases have taken place between 3–5-year maturities, as these are heavily impacted by Federal Reserve policy and higher inflation expectations. At the start of the year, the yield on 5-year notes was as low as 0.35% and has since moved up to 1.13%1, which is an increase of more than three-fold.
Exhibit 14. The shift in the US Treasury Yield Curve from 06/30/2021 to 10/15/2021.
Increasing yields in short to medium-term maturities and decreasing yields in longer ones have led to a slight flattening of the curve since the peak in March of this year. The 2s10s curve, which measures the spread between the yield on the 2-year note and the 10-year note, has remained steady at around 120 basis points (bps). After rising to as high as 157 bps last March, the spread has tightened due to increases at the shorter end of the curve, indicating a shift in monetary policy expectations.
The 2s10s curve is closely watched as it is an accurate predictor of economic slowdowns. Generally, when investors are pessimistic about the economy, they buy long-dated maturities, which suppresses yields on the long end of the curve. This dynamic tends to tighten the spread and can possibly lead to an inverted yield curve whereby short-term bonds pay higher rates than long term bonds. This abnormal turn of events often indicates an imminent recession or economic slowdown. Currently, the US Treasury yield curve is upwards sloping, most likely indicating that investors believe we are still early in the economic cycle following last year’s recession.
Exhibit 15. The yield spread between the 2 and 10-year Treasury yield.
Increased Inflation Expectations:
The persistent increase in prices may be forcing investors to reconsider their long-term inflation expectations. This is evident by looking at the 10-year breakeven rate, which is the spread between nominal 10-year Treasury yields and TIPS (Treasury Inflation-Protected Securities).
This metric allows investors to get an estimated inflation rate based on bond market expectations.
The breakeven rate (10-year inflation expectations) has broken out of its months-long range between 2.3% and 2.4% and has reached 2.5%. This indicates that longer-term inflation expectations have been rising, which is one reason why the bond market has sold off as of late. Inflation erodes the value of bonds because the value of fixed interest payments diminishes in real terms. The breakeven rate now implies that the average inflation rate for the next 10 years is going to be approximately 2.55%. However, this is constantly subject to change.
Exhibit 16. US 10-year inflation expectations rose to multi-month highs in October.
A reduction in the Fed’s monthly bond purchases can also lead to lower bond prices, as their purchasing program has likely kept prices elevated and yields low. Bond yields rise when prices fall. Furthermore, now that inflation has remained consistently above 5% over the last few months, real yields on most bonds are now negative. Even speculative-grade, or “junk,” bonds are yielding negative real returns with the stated Bloomberg US Corporate High Yield Bond Index at 4.2%1.
Exhibit 17. Bloomberg US Corporate High Yield Bond Index.
Municipal Bond Market Update:
In the Municipal bond market, yields have considerably risen in the past few months. As of last June, AAA-rated tax-free municipal bonds were historically one of the most expensive on record. Tax Free Municipal bonds paid only 67.2% of an equivalent 30-year Treasury bond.
Currently, Municipal bonds trade at approximately 85% of their Treasury counterparts for 30- year maturities1. That said, the most recent and meaningful rise of 23 bps in Municipal yields took place in intermediate maturities, mostly between 7-12 years.
Exhibit 18. Municipal bond yields relative to Treasury yields of the same maturity
1. Bloomberg Finance L.P, 2021.
2. St. Louis Federal Reserve, 2021.
By: Amit Stavinsky, Managing Director, and Daniel Itzhaki, Financial Advisor - Analyst.
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