Markets were growing nicely (and with little volatility) until we experienced a September slump that put a pause on the global equity bull market. The S&P 500 Index dropped 4.7% for the month, developed international equities (MSCI EAFE Index) fell 2.9%, and emerging-market stocks (MSCI EM Index) dropped 4.0%. Needless-to-say, September was a bit more concerning than the past year, but market valuations are high and any negative news can cause volatility. Supply-Chain difficulties caused by high consumer demand and labor shortages is a real concern (more on this below).
Overall markets are still positive for the year. For the year to date, the S&P 500 is up an impressive 15.9%, international equities are up 8.3%, and the emerging market Index is down 1.2%.
The culprit behind emerging-market stocks’ poor recent showing is China (more on this below). The China Index was by far the worst-performing stock market in the third quarter, down 18.2%. For the year to date it is down 16.7%. Chinese stocks comprise roughly 35% of the emerging market equity index.
Meanwhile, within the broad U.S. market, smaller-company stocks and growth stocks beat value stocks for the second straight quarter. We do see signs of investors becoming more conservative and favoring conservative blue-chip stocks. Most of the volatility is coming from large growth stocks as investors play tug-a-war with each other to determine if growth will continue to lead the way.
In the bond markets, core bond returns were essentially flat, and yields were little changed for the quarter. But it was a roller-coaster ride, with the 10-year Treasury yield plunging below 1.2% in early August, and then shooting back up in the last two weeks of September. Credit-sensitive bond segments outperformed core bonds, and for the year to date, core bonds are now down 1.6%, while high-yield bonds and floating-rate loans are up 4.6% and 4.4%, respectively.
In our conversations with clients, we want to remind everyone that stocks markets have delivered double digit returns for three straight years and a bit of turbulence is to be expected. We have always strived to deliver transparent and objective advice so we are alerting clients that a 15-20% correction can be anticipated at some point over the next year or two. This is not a frightening prospect as we realize setbacks are typically short lived and unfortunately are part of the process of receiving over-sized returns for multiple years. We wish we had 100% clarity as to exactly when setbacks would occur, but absence this insight we have learned to play the odds for positive returns in the long run.
We have been highlighting the projection that higher inflation is a concern. Right now, it appears to be more likely a transitory effect of COVID-19 and supply-chain disruptions versus the start of a new regime where higher wages and inflation create a damaging long-term inflationary spiral. However, the jury is out as to whether inflation will be temporary or the beginning of a trend. A lot will depend on workers returning to work and the supply-chain operating normally again. We will be researching more and perhaps making portfolio adjustments as we head into the new year.
In all, we are satisfied that our portfolios were positioned to take advantage of the growth we have experienced the past three years but allocated away from core bonds in favor of real estate and flexible credit strategies. Under an inflationary environment “cash is trash” is the operative phrase and you can nearly equate bonds with cash. We do need to hold some position in bonds as a liquid source of funds during down markets and for more conservative investors. We will continue to monitor inflation closely and adjust our views and positioning as needed.
Some of our clients (including myself) have elected to take a real estate heavy portfolio approach to play defense. Real estate cash distributions have far exceeded that of bonds and have experienced higher safety (Including the Covid market setbacks of 2020).
A new concern that emerged in the third quarter is around the excessive borrowing in China’s property sector and within Evergrande Group, one of the country’s largest property developers. Moreover, this has come amidst other regulatory crackdowns in China. We have followed these events closely as part of our ongoing research on China and emerging markets. Thus far we are of the view that these risks will be contained. Looking further ahead, the short-term pain could result in new opportunities for investors in China.
It is also the case that a lot of bearish sentiment has been priced into emerging-market stocks; in fact, some of our managers are seeing potential long-term return opportunities emerge in China. That said, we will continue with our analysis and if we conclude the impact is likely to be long term versus temporary, we will factor that into our portfolio positioning.
And finally, a comment on Supply-Chain problems. I can summarize the issue as the result of two factors. First there is a huge increase in demand as many consumers have excess cash from direct-to-family government funding (unemployment and child stimulus checks) coupled with consumer underspending during covid. Second factories lowered production during Covid, as there was an anticipated economic slowdown. Add on top of these event a shortage of labor in key industries and the supply of goods can’t keep up with demand. For example, a shortage of needed truckers is holding up the movement of goods from port cities. If you drive by any car dealership you are likely to see almost empty lots. Without cars to sell two dangerous things happen. The business and their employees are making less money, and prices increase as consumer demand stays strong. The supply-chain issues are projected to unbottle by next summer. If this plays out as projected, the economy will normalize. However, if the problem is persistent the outlook will be a disappointment to stock markets as higher inflation will eat away at any wage gains made by employees and economic growth will suffer.
Overall, our best estimate is that the next several years remains relatively positive, as we expect the economic and earnings growth cycle, interest rates, and government policy to remain broadly supportive of equities and other risk-asset markets. However, our analysis also suggests we should be prepared for an extended period of lower returns than we have experienced recently. Single digit portfolio returns are more likely than double digit returns. Stocks are sitting at historically high valuations vs. earnings. And low yielding bonds can be hurt by rising interest rates. We are still highly bullish on real estate investments as real estate typically does well during rising interest rates and our government preference currently is to support tenants. Of course, we would love to be wrong on the projection that returns will be lower and continue to position our portfolios with the highest quality managers available.
We thank you for your continued trust in us.
Ron Dickinson, CPA, CFP®, MPA-Tax
P.S. Once again, we appreciate the large number of referrals we have been receiving from our clients. We are honored that you consider us worthy of being introduced to your family, friends, and neighbors.