Quarterly Commentary

September 30, 2021





Entering the Third Quarter of 2021, the U.S. economy continued its recovery from the pandemic recession.  Unfortunately, the exodus from the pandemic has not been smooth sailing and has hit a snag as the Delta variant of Covid-19 took hold, particularly of the unvaccinated, impacting “The Great Reopening” trade.  Additionally, supply chain bottlenecks and rising inflation continued to cause headaches for investors who wonder when the “transitory” or temporary nature will subside.  Fortunately, there are signs that the pandemic may soon be an Endemic, which can’t get here soon enough for EVERYONE, not just investors.


When reviewing the economy and market results of the third quarter one must begin that discussion with the pandemic.  While we reveled in the roll-out and rate of vaccinations in the prior quarter, that pace slowed in Q3 and coupled with the spread of the highly contagious Delta variant caused a resurgence in the pandemic.  The good news is that trend now seems to have peaked with more widespread immunity from vaccinations and prior infections.  Recent studies estimate that roughly 85% of the U.S has some sort of immunity to the Covid-19 virus, having either been infected by the virus or vaccinated.  The thought (hope) is that this should lead to a slowdown in cases and particularly deaths as we move forward into 2022. 


Economically, the first-half increase in GDP has moderated in the second half with the persistence of the pandemic and resulting Delta variant, as well as supply chain issues.  The GDPNow estimate for real GDP growth in the just ended quarter is 1.3%, dramatically lower from last quarters estimate of 7.8%.  However, entering the fourth quarter, real growth (GDP) has recovered from the pandemic recession to levels last seen prior to the onset and on track to return to the 20-year growth trend (2%) that preceded the Covid-19 induced recession.  Supply chain bottlenecks first thought to be a “labor shortage” issue is now believed to be more of a FED induced “demand issue” from the nearly $2.8 trillion in federal stimulus spending since December 2020.   Employment continues to improve having added 1.65 million non-farm payroll jobs during the quarter and dropping the unemployment rate to 4.8%.  While the trend is in the right direction the rate at which the labor supply continues to recover has been hampered by enhanced unemployment benefits, which are slowly expiring.  Lastly, inflation (CPI) has risen sharply this year as FED induced demand has dwarfed supply across many sectors of the economy, in addition to the historically low base numbers used from the shut-down a year ago.  Much of the rise in prices does seem to be transitory but the longer they are with us the greater the possibility they become permanent.  Year-over-year CPI in August was up 5.3% and 4.0% ex-food & energy.  Keep in mind, the FED’s inflation target, for when they would be expected to take initial action on curbing inflation is “an average of 2%.”.  Airfares, hotels, restaurants, housing/rents, and autos have all seen a general recovery in prices from their pandemic lows.  Additionally, the auto industry has been particularly hard hit with a semiconductor shortage that does appear to be directly a result of the pandemic.  So, no matter how you slice it prices are higher nearly everywhere you look but, for how long?  As fixed income investors, this is our #1 concern!  Stay tuned.


For the quarter, markets seemed to take a breather, as performance for most asset classes was around break-even, give or take a few percentage points.  This, after stocks had their worst month in September since March 2020, down -4.8%.  However, for the entire quarter, stocks did better than bonds, domestic stocks over international and large cap stocks over small.  Value underperformed growth in large cap stocks but outperformed growth in small cap stocks.  The S&P 500 was positive for the sixth straight quarter but, just barely +0.58%.  Year-to-date it still maintains an historically better-than-average return of 14.7%.  International developed stocks were down about -1%, with emerging market stocks down approximately -8%.  REITs for the second quarter in a row and with housing prices continuing to rise, was the top-performer outperforming all asset classes with the Dow Jones REIT Index up 1.25% in Q3.   For the quarter, the Barclays US Aggregate Index was basically break-even, albeit positive, +0.05%.


Interest rates in the US Treasury fixed income market generally increased during the third quarter. The yield on the 5-year Treasury note rose 12 basis points (bps), ending at 1.00%. The yield on the 10-year Treasury note increased 6 bps to 1.52%. The 30-year Treasury Bond yield rose 1 bp to finish at 2.05%.  In terms of performance, short-term corporate bonds returned 0.11%. Intermediate-term corporate bonds gained 0.08%.


We entered the third quarter with portfolio durations at 90% of their benchmarks with the expectation that once the Fed announced they were going to reduce the monthly purchases of US Treasuries and MBS securities that longer term interest rates would move higher.   Accordingly, we had the portion of our portfolios invested in the longest maturity securities below their benchmarks.  However, concerns about further outbreaks of the Delta variant, stubbornly low increases in monthly job gains, and comments from Fed Chairman Powell that the Fed was not in any hurry to remove accommodation, caused interest rates to move lower. We used this opportunity to fade the rally and reduced our durations to 70% of their benchmarks.  For the quarter, performance for all composites was ahead of their respective benchmarks.


As weeks passed, signs of inflationary pressures building in both labor and commodity prices and comments by other Fed members that they needed to start tapering sooner than markets expected, led Chairman Powell to announce in late September, that tapering will soon begin (Nov.?), caused long-term interest rates to move higher.  Ten-year yields ended the quarter at 1.52% with an expectation they will end the year closer to 2%.  We continue to maintain an underweight in MBS and a slight overweight in corporate securities.


On the equity side of the equation, much like most asset class performance for the quarter, sector performance was a mixed bag but, basically break-even give or take a few percentage points, from Finance +2.29% to Industrials -4.55%.  Other top-performing sectors included Communications +1.40%, Technology +1.13% and Health Care +1.02%.  Detractors included Materials -3.94%, Energy -2.82% and Consumer Staples -0.98%.  Looking forward and with earnings season getting ready to kick-off, 2021 is looking to close with an all-time high in year-over-year operating EPS growth north of 60%.  As many of the larger and more important sectors of the US economy, including Consumer Staples, Health Care and Technology withstood the effects of the pandemic, and in many cases have had stronger revenues.  Earnings continue to benefit from strong consumer demand, including the historical stimulus, as well as higher productivity as companies have been able to reduce costs given the virtual business climate, we still find ourselves in today.  However, looking down the road and into 2022, we believe things will get a little bumpier.  Slower economic growth is in the cards, while higher wages, higher interest rates and possible tax increases are likely.  Not the best environment for stocks but, for now – stay the course.


While the reopening hit a soft patch in the just concluded quarter, we believe that while the Delta variant and supply chain shortages have caused the economy to slow, the markets have certainly learned how to deal with a resurgence, in case it happens again, and earnings should continue to grow into the end of the year as businesses look to rebuild inventories and the recovery continues.  Moving into 2022, our hope is that it is an Endemic that we are dealing with, however we may still be dealing with many of the aftereffects, namely the supply chain, lack of workers, less fiscal and monetary stimulus, and potentially higher inflation, which will likely cause economic growth to slow to the long-term trend of 2% by year-end.


As always, we will remain diligent and disciplined in our approach, realizing that it is these principles that steer us to the VALUE capital markets have to offer long-term investors.