Q3 2021 Market Perspective
For the past 18 months, investors have been navigating the equity markets buoyed by strong stimulus tailwinds, and have been rewarded with solid returns since the lows of March 2020. Foreseeing a change in currents, investors are expressing concern for the pending headwinds facing the equity markets, which could result in increased market volatility relative to the past 18 months.
Rising inflation and the Fed’s anticipated move towards a less accommodative stance are viewed as significant impediments to economic growth. Factoring in the current state of politics in our country and with major equity indices near their all-time highs, this can create additional headwinds for the market in the near term. In this note we will outline many of these headline events that have investors concerned about pending market volatility. We will also offer some insight into why we believe the economy can resume its course on a multi-year expansion. Most importantly, we remind investors that they have navigated through volatility in the past and the goal is always to stay committed to your long-term investment strategy.
2021 Third Quarter Market Highlights
· Index returns: 
Major Asset Class Returns in Q3 2021
Source: 2021 Total Return as of 9/30/21, Bloomberg; See Chart A in Appendix
· U.S. equities had mixed results during the 3rd quarter. Returns have been strong this year, with small-cap stocks leading performance year-to-date, up 20%. Large-Cap stocks and mid-cap stocks are up 15.9% and 15.5%, respectively for the year. 
· International developed market stocks were down slightly during the quarter, yet remain up nearly 8.3% for the year. Emerging market stocks suffered the most during the quarter and are down roughly 1.2% for the year. 
· Fixed income returns were muted during the quarter while most segments of the fixed income markets remain in negative territory for the year. The Bloomberg Barclays US Aggregate Bond Index, while basically flat for the third quarter, remains down 1.55% year to date through September. Investment Grade Corporate bonds and Treasury bonds are also both negative for the year. National Municipal securities remain positive at 0.79% year to date due to continued demand for tax free income, yet the asset class looks fully valued and vulnerable to higher interest rates. High Yield bonds continue to perform well as investors reach for yield and corporate balance sheets remain strong. 
What to Watch in Q4
Debt ceiling, and infrastructure and social spending bill
This is a fluid situation but as of Tuesday, 10/12, the House had passed a bill to temporarily increase the government’s borrowing limit through early December. This stopgap bill came after weeks of political fighting and after Treasury Secretary Janet Yellen’s comments, stating that defaulting on paying our bills would be a catastrophic outcome and lead to a recession. Regarding the spending bills, moderate Democratic Senators (along with all Republican Senators) are pushing to drastically shrink the size of spending. One potential way to do this is to reduce the duration of some of the benefits in the plan, yet we can count on many rounds of negotiations before we have a final bill to analyze. This cloud of uncertainty will add to market volatility between now and the end of the year.
Inflationary pressures have increased as a surge in consumer spending continues to be met with supply shortages across major sectors of the economy. Some drivers of higher inflation are beginning to fade and we expect inflation to moderate in 2022 as supply chain disruptions are ironed out and demand growth cools. However, strong wage growth, higher inflation expectations and the lagged effect that increasing home prices will have on rental costs could keep inflation more elevated than at the end of the last expansion. Energy prices are a swing factor in inflation and higher costs for common goods and products are destructive to the consumer. Rising oil and gas prices, for example, could dampen growth expectations during the fourth quarter and into next year.
Strength of consumer spending and consumer confidence
With the enhanced unemployment programs having now expired, unemployment results are back in focus. The unemployment rate has slowly declined over the past three months, reporting at 4.8% for September. However, the labor force participation rate has remained stuck near 61.6%. Prior to the pandemic, the participation rate was closer to 63%. (The participate rate refers to the percentage of eligible employees who are employed or actively seeking employment). Despite a slow return to work, household balance sheets are still historically strong and savings rates remain above average. One possible headwind to economic growth would be any slowdown in consumer spending and consumer confidence due to rising prices and the inability to get people back to work. 
Equity market valuations
The prospect of increasing interest rates has added volatility to higher valuation sectors, namely information technology, communication services and consumer discretionary, which make up more than half of the S&P 500 by market capitalization. While the Fed’s open market activity and the sustained low interest rates support expanded stock price valuations, investors should not completely ignore valuation. As we said last quarter, investors should avoid taking excessive risks. Low quality, speculative assets have continued to weaken, while a bias towards higher quality companies has strengthened. Many stocks have far exceeded what have historically been high valuation levels and we would exercise caution in concentrated exposures.
Fed Chair Jerome Powell’s renomination
Powell’s renomination odds have taken a hit recently with the stock trading scandals reported on a few Fed officials. Powell was originally appointed as Chairman in 2018 by former President Trump (the lone dissenting vote on his nomination at that time was Senator Elizabeth Warren). Powell has been consistent and reliable during this pandemic and we expect the odds remain in his favor to receive another term from President Biden come February. However, we would expect any uncertainty concerning the future of monetary policy to be a headwind for the market.
Transition from accommodative policy to less-accommodative policy
The Fed has been transparent with regard to its intentions to start tapering its large-scale asset purchases. Fed chairman Powell has said the inflation test for scaling back bond purchases has been met.At this point, policy makers will be focused on improvements in U.S. employment data and will be monitoring jobless claims and change in payrolls. The details of the tapering are expected to be announced in November or December and once they start, it is expected they will be done with this form of quantitative easing in 8-10 months. The Fed is then expected to wait a few quarters before announcing an initial rate hike, which the market anticipates sometime late in 2022 to early 2023. While this policy is still accommodative, the market is anticipating the eventual inflection point.
Estate and tax law changes
House Democrats have released details of their tax legislation proposal from the House Ways and Means Committee. While this bill will face challenges in moving through the House and Senate we wanted to point out some of the proposals that could be perceived as headwinds for the market. Notably: increases in the top long-term capital gains rate and top marginal income tax rate, reduced Roth conversion benefits for high earners, forced distributions from large IRAs, increased holding periods for long-term capital gains treatment of carried interest, significant cuts to the lifetime estate tax exemption, reduced tax advantages for certain trust vehicles, and an increase to corporate tax rates. These are only a few of the recommendation and many will never become law in their proposed form, however, the headline risk may be another headwind for the market.
It has been a relatively smooth ride for equity investors thus far in 2021, notwithstanding a few days of turbulence during September. We are mindful of the shifting currents in the market, specifically, the eventual transition away from easy monetary policy and rising inflation concerns. However, investors have navigated through changing market dynamics in the past and while we may be in uncharted territory due to COVID and the unprecedented amount of stimulus, we would not deviate from a long-term strategy.
We have stated numerous times these past few quarters, the importance of removing emotional biases from the decision-making process. While we anticipate an uptick in market volatility towards the end of the year and into 2022, we do not expect anything out of the ordinary. We reiterate the importance of updating your advisor with any changes that may impact your financial situation. Maintaining an up to date investment policy statement and risk budget allows us to continually take advantage of efficient portfolio rebalancing and tax motivated trading opportunities, which can be especially beneficial during periods of enhanced volatility.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A: 2021 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2021 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes
1 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 - https://tradingeconomics.com/united-states/USinflation
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