The third quarter ended with risk assets still firmly in favor, however, September proved to be a cautionary month for both equity and fixed income markets. U.S. valuations and macroeconomic factors led stock markets lower while inflation pressures pushed interest rates higher.
The bell-weather 10-year U.S. Treasury note began the month in a familiar trading range around a 1.3% yield. More signs of “stickier inflation” appeared, and the FOMC suggested “tapering” soon was warranted. Rates moved above 1.5% on September 27th for the first time since June.
Stocks experienced volatility and the worst quarter since the beginning of the pandemic (after six straight quarters of gains as Congress argued over the debt ceiling and the Fed prepared to “remove the punch bowl”. August was strongly led by gains in the NASDAQ and technology companies, but stocks reversed course and the value rotation reemerged in September.
The volatility in equity markets began in early September as “back to school” seemed somewhat normal despite stories of new Covid-19 variants. The Gulf Coast was dealing with the aftermath of Hurricane Ida, the west coast was managing various wildfires and the nation honored the 20th anniversary of September 11, 2001. Around this time, the sentiment seemed to shift in equity markets. Investors and strategists cited high valuations and a less enthusiastic “roaring 20’s” scenario.
Despite solid economic and strong consumer growth throughout the summer, the first Friday in September delivered a surprising jobs report. Non-farm payrolls came in at 235,000 much lower than the expected 733,000, and well off a revised July figure of 1,053,000 jobs added. Average hourly earnings jumped, as did the employment cost index, suggesting inflationary pressures are beginning to restrain economic growth and hiring. Economic growth continued to flourish in many sectors as both the manufacturing and service sectors continued to grow. Retail sales and housing reported strong figures for August. A September reading for Q2 GDP came in at 6.7%, mostly in line with economists’ expectations.
Inflation may have been the main catalyst of sub-par performance of major asset classes in September. While the monthly CPI and PPI readings were in line, they continue to report year-over-year numbers much higher than in recent history. 2Q Core PCE figures released at the end of September were up 6.1%, the highest reading since the 1980s. More important to investors are anecdotal reports of supply chain shortages, bottlenecks, a dearth of workers, and rising input costs from large corporations as well as small business owners. Certainly, the energy sector reacted as crude oil was up over 10% as demand outstripped supply.
On September 22nd, the FOMC released a statement after the conclusion of their two-day meeting. While there was no change to current policy, Chairman Powell suggested tapering “may soon be warranted”. It was clear that inflation goals have been met and exceeded, and continued economic strength will allow the Fed to announce and enact a pullback on bond purchases as soon as November. Fed tapering plans look to be swift and over by mid-year 2022. Investors are taking note of the committee’s “dot plots” which suggest a rate hike is possible next year. Many Fed watchers believe the Fed did not officially move forward in September due to the overhang of the upcoming debt ceiling, budget resolution, and potential for a government shutdown.
Treasury Secretary Janet Yellen implored Congress to raise the debt limit so the US does not default on its debts and create economic havoc globally. Democrats and Republicans remain locked in a conflict of having the responsibility for the debt ceiling while trying to pass an enormous $3.5 trillion spending package. Despite the severity of a negative outcome as the October deadline approaches, investors are somewhat cautious to react, as Washington has allowed this drama on numerous occasions. Tensions eased slightly on September 30th after the Senate passed a stop-gap spending bill to avoid a government shutdown.
During the same week of the September Fed meeting, China brought a crisis to global markets and risk markets took a hit. The China Evergrande Group, a large Chinese conglomerate including large real estate developments, missed loan payments. Shares fell rapidly, the S&P suggested default was likely, and correlations to China’s potential “Lehman moment” drove investors to safe-havens. As markets digested the news, reports of possible government assistance either directly from China or banks emerged. As the crisis continues to play out, global markets have calmed, fallout continues to be China-specific, and the risk of contagion has diminished. The company announced it would make a payment on a domestic bond, easing jitters of a messy default, but upcoming global debt and liabilities are coming due. China has not taken the tact that the company is too big to fail, but it has injected capital into the financial system to ensure the liquidity of short-term markets. While stocks tumbled, the bond market reacted modestly to the Evergrande problem.
The realization of less stimulus soon, and the potential for higher inflation expectations drove bond prices lower. Earlier in the month, Treasury auctions showed strength with many foreign buyers participating. In addition, corporate supply was in abundance. September was one of the biggest issuance periods for corporate bonds ever as companies scrambled to raise cheap capital. All of this contributed to a shift higher in the yield curve, and a 10-year U.S. Treasury yield of 1.50% on September 27th. As the 4th Quarter begins, it will be important to see if the upcoming supply is met with the same appetite and if global investors with $13 trillion of negative-yielding bonds look to invest chase higher yields and a stronger dollar.
Fixed income strategies saw higher yields, but negative performance in September. Government debt performance and corporate bond indices fell similarly with credit issues doing slightly better despite equity market sell-off. High-grade municipal bonds moved slightly lower but outperformed corporate counterparts. Bond market allocations have been noticeably lower in 2021 as equity indices have benefitted from the re-emerging economy and massive stimulus efforts.
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