Markets rose each of the first eight months this year, then the rollercoaster started.
The third quarter began with concerns over the Delta variant, a lack of workers, continuing supply chain disruptions, inflation fears, and the Federal Reserve “tapering” their monthly bond purchases.
It ended with major concerns oversupply and labor shortages, rising energy prices, and the Fed, which started tapering this month. The S&P 500 Index® fell sharply in July, set new records in August, then fell in September to end the quarter almost flat (+0.3%).
The Dow Jones Industrial Average fell 1.9%, and the Nasdaq Composite dropped 0.4%. (As of this writing, they are setting new highs again.) 10-Year Treasury Note yields moved from 1.45% to 1.12%, ending the quarter slightly higher as acceptance of Fed tapering took hold.
While interest rates will rise with Fed policy, inflation is also a concern. Besides gas, we’re seeing prices climb for staples, cars, and housing. Producer input prices are rising (primarily from energy costs along with materials and labor) and these increases are flowing to consumers more readily than in the past decade. Underinvestment in energy development, while prices were low, is now a factor. Widespread shortages and skyrocketing costs are a major issue in Europe as efforts to concentrate on green energy were constrained by bad weather. China has the same problem as it mandated a speedy conversion from coal to renewables and now faces similar shortages, causing some companies to curtail normal operations – and exacerbating supply issues.
Fortunately, the U.S. is in a better position.
While energy prices quickly doubled and wages are rising (after being relatively stagnant for 20 years), materials costs will level as the supply chain heals and energy costs will moderate as supply comes to market. Higher wages will remain and feed into a healthy consumer sector, which is a major growth engine. We expect inflation will moderate to historical averages between 2%-3% in the next few years.
Higher inflation coupled with declining Federal Reserve bond purchases means the market will adjust to higher interest rates going forward. This will disproportionately affect technology stocks, which are now almost 28%of the S&P 500. So as the supply chain heals, employment growth resumes and economic recovery gets back on track, we expect our overweighting cyclical value stocks will resume their outperformance of earlier in the year.
We wrote last quarter that US markets were overpriced, due to a decade of Fed cash injections that also suppressed interest rates. The average P/E ratio (price to earnings) of the S&P 500 is 16 times earnings. Today, it trades at 26x the current year and 21 times next year’s projected earnings. As interest rates rise and the 2021 economic rebound plays out, we don’t see how earnings can grow enough to support these elevated valuations. Especially given higher wages, inflation, and the prospect of higher taxes.
So, what to do?
The rationale to increase foreign stock exposure is convincing, as international markets are now 30% cheaper than the U.S. and sport dividends double that of US stocks. They are statistically 2½ standard deviations below their historical mean, which will correct itself eventually. U.S. markets are expected to generate returns in the mid-single digits over the next decade, while foreign markets are expected to produce returns 20%-50%higher. We have gradually increased international exposure in our Growth Strategies, and as we see further evidence of the tide shifting, we will migrate more stock exposure to overseas.
We expect European economic growth to accelerate as the energy crunch and supply chain issues abate. China will add to global growth but its role as a primary investment destination fades as recent socialist mandates force private companies to serve the state before shareholders. They may be sowing the seeds of a capital drain as investors decipher the potential investment returns available in Chinese enterprises. We will monitor this dynamic closely, as China is the world’s largest emerging market and has a heavy weighting in most passive indexes. In the meantime, we remain invested with our sector overweights to cyclical stocks and a general favoring of value overgrowth.
We predicted that stock prices would “grind higher” and clients have enjoyed strong performance over the past few years and certainly over the past decade. We believe the time is right to begin reducing equity exposure. For starters, we are executing our paradigm of flowing excess gains down to more conservative strategies. We will increase the percentage of holdings in shorter horizon strategies to provide stable income during market volatility.
We will also capture the safer returns available in commercial real estate. Each client’s allocation will be different, and we will employ additional holdings at the strategy level and indirect real estate offerings. Look for further communications from us as to how we will address these and other factors going forward.
Much is about to change as the economy continues its lumpy recovery from the Covid crisis and the landscape shifts to less help from the federal stimulus. It is a challenging investment environment, to say the least.
One thing that remains sacrosanct is our continued commitment to each of our clients and their financial assets’ purpose in their lives.