Cross-Currents Headed into the Fourth Quarter
In the third quarter, we saw markets try to digest multiple risk factors while simultaneously hitting new highs. Strong earnings expectations buoyed stock prices heading into the quarter and were confirmed when numbers were released in July. Year-over-year earnings increases were in excess of 89%, the second highest gain on record. In August, we witnessed a slow grind higher on the back of those robust numbers, but the market peaked on September 2 as supply chain issues and higher inflation weighed on indices in the final month of the quarter. The combined pressure of increased Delta variant COVID cases and higher consumer prices were too much for the market to bear as we witnessed our first 5% correction in almost a year. As a result of these cross currents, the S&P 500 Index finished the quarter a paltry 0.58% higher.
Where we go from here depends on the strength of the third quarter earnings and forward guidance, in addition to any further news on the timing of the Federal Reserve (Fed) taper. If inflation remains persistent, the Central Bank will have to react more aggressively than the markets are anticipating. As of now, the planned taper should be very gradual, but interest rates are already spiking in anticipation of the Fed’s hand being forced. Concerns of a slowdown in China could also have a negative impact, as well as new tax and spending policies out of Washington. These headwinds are converging while the third wave of COVID recedes, offering a renewed “reopening” tailwind.
There are several scenarios to keep an eye on. The most damaging would be stagflation caused by persistent supply chain issues and a slower than expected recovery due to the factors listed above. Rolling Consumer Price Index numbers have been significantly higher than the Fed’s target of 2%, while the three most recent employment reports have been disappointing. We need time to see how this unfolds, but unfortunately, the market may react first. Keep in mind that if the stagflation scenario plays out, global central banks will be handcuffed in their ability to provide accommodation. Under a rosier scenario, we could see supply chain issues loosen up at the same time we rebound from the recent Delta-induced slowdown.
At the moment, it is difficult to handicap how things will play out. In general, stocks will do better than bonds under both outcomes, and that is driving our continued overweight in equities. In addition, broad diversification is critical to ameliorate any negative impact from such a broad scope of outcomes.
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