Market Review: A weak September dragged down the equity market in a quarter where most asset classes generated middling returns. The Standard and Poor’s 500 Stock Index’s 5.1% decline during the month ended an uncommon streak of 211 trading days since a 5% pullback. The S&P managed a gain of 0.6% for the quarter when including dividends, breaking a remarkable five-quarter string of 6% returns or greater. Small caps underperformed as the Russell 2000 Index declined 4.4%. The MSCI World ex-US International Index fell 2.9% reflecting weakness in China and other emerging markets. Despite dropping 0.9% in September, the Bloomberg Aggregate Bond Index edged up 0.05% in the quarter and gold fell 0.7%. Commodities represented one bright spot as the Bloomberg Commodity Index gained 6.6%, continuing its strong trend.
Is the Fed Behind the Curve? The Consumer Price Index remained above 5% annualized throughout the third quarter while Core CPI, excluding food and energy, remained above 4%. While the Federal Reserve’s long-term inflation target is 2%, they have made clear their comfort with inflation running hotter for a period and their hope has been that this inflationary surge is a temporary reaction to pandemic induced supply shocks. However, supply chain disruptions could continue for quite some time and housing costs, rising energy prices and worker shortages portend sustained inflationary pressures. The Fed intends to soon wind down (“taper”) their open market purchases of bonds from $120 billion per month all the way to zero before they begin to raise their Fed Funds target. If inflation data remains on its current trend and proves to not be as “transitory” as hoped, the Fed will be forced to accelerate this process to a pace not likely anticipated by the market. The upward pressure on market interest rates in September was likely a significant factor in the equity market weakness.
Changing Tenor: Given the current backdrop, it seems prudent to expect an end to the long-standing wave of liquidity and monetary support. If past market dynamics hold, this will particularly hold back the performance of the mega-cap FAANG stocks which, in turn, have an outsized impact on the broad stock indices. The FAANG group underperformed materially in September as rising interest rates helped to drive the sell-off. Conversely, history suggests higher rates should support the rotation to value-oriented sectors. Blanket assessments are not wise, however, as companies across industries face highly unique challenges and margin pressures from factors such as shortages, associated elevated costs of goods, and higher employee compensation. This monetary environment also implies a continued poor return profile for bond investments. The trailing one-year return for the Bloomberg Aggregate Bond Index is -0.9% with little opportunity for improvement given an upward bias to yields across the curve. Additionally, equity and fixed income investments have become more positively correlated so bonds have diminished utility as portfolio diversifiers. Diversification will therefore continue to be derived from low-correlated equities, such as owning both energy and technology, along with cash or short-term instruments, and alternatives as appropriate.
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