Third Quarter Ups and Downs

The S&P 500 Index is consolidating as Washington policymakers postpone important decisions on the budget ceiling and the infrastructure bills. The S&P 500 Index has grown this year as earnings and growth have supported valuations, but now, as fiscal and monetary policies change, we are seeing investor concerns. With fiscal policy, there are many supportive benefits of spending $500 billion on actual bridge and road infrastructure. However, the massive $3.5-trillion “human” infrastructure package is concerning due to higher taxes and escalating inflation. This plan is likely to be debated and downsized before passage – if at all.

On the monetary side, the Federal Reserve is discussing tapering its bond purchasing program, and the 10-Year U.S. Treasury Note has risen to 1.53% from 1.17% during the third quarter. The market is just beginning to recognize the implications of a higher interest rate environment and a more normal economy. Higher interest rates are usually a sign of economic strength, because when confidence, speed, and momentum are sustainable, like child’s bicycle, the training wheels of highly accommodative Federal Reserve policy need to come off. The Federal Reserve is unlikely to actively raise interest rates, however, so supportive monetary policy continues.

As interest rates rise, the assumption is that higher multiple growth stocks in technology are more susceptible to valuation declines. As rates rise, there is usually a rotation into value stocks with lower multiples. These tend to be in more cyclical sectors like financial, industrial, and basic materials. The problem is that these are some of the sectors most affected by parts shortages, higher energy prices, and increased labor costs. The cost to produce and ship goods has escalated dramatically, and the shipping container unloading bottleneck at California ports is causing delivery delays and sales declines for all manufactured goods. This is likely to persist, so inflation concerns are real and even Federal Reserve Chairman Powell, who has said that it is temporary and transitory, is now saying inflation is likely to go on for months.

The U.S. equity market is leading global markets higher this year and performing better than most international markets. The leading sectors of the U.S. market have been energy and financials, while the worst performing sectors are utilities and consumer staples. High quality small caps have generally done better than mid-cap and large cap companies, because earnings are expected to grow faster. We remain underweighted in international equities and focused on higher quality companies with stable or growing earnings.

The markets are likely to remain volatile as we monitor the economic indicators and corporate earnings releases in the next few weeks. Third-quarter corporate revenues should be strong, but any temporary cost increases may reduce corporate profit margins and earnings. High-quality companies in our portfolios that can raise prices as fast as inflation will be able to preserve their profit margins. The earnings shortfalls will most likely be in selective industrial and consumer discretionary sectors, while information technology and energy earnings should be strong. Once we see the Washington policy drama subside and a diminishing number of COVID cases this quarter, the equity market should resume its economic mid-cycle strength and move higher through year-end.

Index Total Return through 9/30/21
S&P 500 Index.............................................14.7%
Mid Cap 400 Index......................................14.5%
S&P Small Cap 600 Index...........................19.0%
MSCI All-World Cap International Index..9.8%

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