Quarterly Market Review and Outlook
Q3 2021 Market Re-Cap
The stock market often goes into a bit of a lull during the summer months. The U.S. stock market in the 3rd Quarter remained true to its historical trends and clawed out a small gain.[i] Additionally, the Global stock market remained true to its recent lagging and was down 3%.[ii] U.S. and Global bond markets essentially stayed flat during the 3rd Quarter.[iii][iv]
September is historically the worst month for S&P 500 performance, so for U.S. stocks to be slightly positive for the quarter is a good thing.[v] As we discussed in the previous newsletter, 2021 reminds us of 2013. The S&P 500 has yet to enter correction territory (i.e., a decline of at least 10% from a recent high) in 2021 as the strategy of “buying the dip” has squelched any short-term pullback.
Historically, the S&P 500 has a correction every 12 months or so.[vi] In case you forgot, global stock markets experienced a COVID induced pullback in the 1st Quarter of 2020. Generally, we prefer to experience a healthy restoring correction periodically. This offers the opportunity to potentially increase stock allocations at cheaper prices and allows for the stock market to blow off a little steam.
We are, from a historic perspective, in the timeframe of when a correction would be normal. Therefore, it seems logical to discuss a couple of the known reasons that a correction may occur in the short to medium-term.
2021 Q4 Outlook & Beyond
Politics, the Debt Ceiling, and the $5 Trillion Blowout
We don’t like to be political in our comments here. We figure that most folks want us to focus on economics and how it affects the stock, bond, and interest rate markets. It does seem, however, that some of the recent volatility can be blamed on various fights that are going on in Washington—namely the battle over the debt ceiling and the $3.5 trillion “infrastructure bill” (which is really more like $5.5 trillion).
The debt ceiling was suspended in August 2019 for a period of two years. Much like the opening line to Paul Simon and Art Garfunkel’s classic song, The Sound of Silence (“Hello darkness, my old friend I’ve come to talk with you again”), the dreaded debt ceiling has returned. In the event that you have forgotten what the debt ceiling is over the past two years, essentially the U.S. government has reached its maximum ability to borrow money. Or said more plainly, the U.S. government’s credit cards are maxed out. Since 1960 Congress has adjusted the debt ceiling 78 times.[vii]
The Democrats have been trying unsuccessfully to attach other things to the bill that would extend the current ceiling—the Republicans haven’t been cooperative. The Democrats, of course, control both houses of Congress. As of this writing, the Senate parliamentarian has ruled that a simple budget-resolution requiring only Democrat votes can extend the debt limit beyond the October 18 deadline. We expect this to get passed before or on that deadline.
If it doesn’t get passed that would likely increase volatility in the stock market substantially. Since 1980, there have been 14 instances when the debt ceiling was not increased right away and the U.S. government shutdown. The average length of a shutdown was 7 days and the average S&P 500 performance in the week before, during and the week after was about 0%.[viii] We would point out that the worst of those 14 iterations was in 1982 when the S&P 500 declined by roughly 8%.[ix] Also, we would recall back to 2011 when the U.S. government lost its AAA rating during another debt ceiling crisis. That debt ceiling debate lasted roughly 3 months.[x][xi] The S&P 500 declined about 16% over those three months.[xii]
The other issue that has financial markets spooked as of late is the debate over the Administration’s $3.5 trillion spending bill. To those that have studied it, it appears that the price tag is closer to $5.5 trillion. Either is a staggering sum of money. To put it in perspective, think of it this way—$1 million in $100 bills stacks 3.3 feet high, $1 billion in $100 bills stacks .63 miles high, and $1 trillion in $100 bills stacks 631 miles high!
The history of the modern world has been a battle between two competing ideologies of how resources should be distributed: Capitalism and Socialism. Without getting too deep in the weeds, Capitalism empowers people and Socialism empowers government. One of the problems with Socialism is the bigger the government gets, the slower the economy grows. Because the government doesn’t create wealth (it only redistributes it) the bigger it gets relative to the private sector, the harder it is to create more wealth in the economy. During the 20-years ending in the year 2000, non-defense, non-interest government spending averaged 13.2% of GDP, while U.S. real GDP grew an average of 3.4% per year. In the past twenty years (2000 to 2020) that same spending averaged 15.9% of GDP, while U.S. real GDP grew just 1.8% per year.[xiii]
The spending bill includes an incredible breadth of items to include health care, education, climate change, and housing and, generally speaking, increases the size and scope of the federal government substantially. The Internal Revenue Service budget would be increased by nearly $79 billion. We could go on, but you get the idea—government gets a lot bigger if this bill passes. The administration describes the bill as one that would “fundamentally change” how the U.S. economy operates and that it will cost “zero dollars.” We believe the first statement, but not the second.
The last election left the Democrats with a very thin majority—so thin the numbers are 50/50 in the Senate with a 4 vote majority in the House. We would argue this is not a mandate for radical change. At best, this is a mandate for moderate change. As of this writing, this bill doesn’t appear as though it will pass. If it does, it could uptick volatility in U.S. stocks as the market digests the implications of an increasingly bloated and growing federal government.
Stock Market Outlook
Despite the S&P 500 being in the doldrums over the last 3 months, the S&P 500 has been on a fantastic run since April of 2020. This has led to some market prognosticators to predict that a market crash is imminent. We tend to try to use math, history and our client’s unique financial circumstances as our guides. (DISCLAIMER: HISTORY IS NO GUARANTEE OF FUTURE PERFORMANCE).
First, the U.S. economy continues to heal from the COVID related shutdowns of 2020. The current Federal Reserve Bank of Atlanta estimate for 3rd Quarter GDP is 3.2% on an annualized basis.[xiv] Yes, this is a slower growth rate than the previous quarters, but it is still solid growth. Additionally, the exponential economic growth rate coming out of COVID must taper off at some point.
Second, the Federal Reserve Bank of New York has plotted the relationship between longer term treasury yields and short-term treasury yields since 1959. This refers to the inverted yield curve that we often discuss. Based upon this relationship, the Federal Bank of NY assigns a recession probability. The current probability of recession based upon this analysis is as low as it has been in about 3-4 years.[xv]
The relevance of the economic condition in the U.S. is that from a historical perspective, the most common cause of a stock market crash is an economic recession or depression. We are hard pressed to find a lot of tangible evidence of recessionary forces currently at play in the U.S.
This is not to say there is nothing but clear skies and calm winds ahead. We would expect increased stock market volatility as we look ahead over the next several months and quarters. However, it is probably unwise to shriek in fear over short-term news stories or daily market movements, especially if you have a long time horizon.
Federal Reserve and Interest Rate Update
We often tell clients that we probably spend as much, if not more, time reviewing and analyzing the bond market and interest rate movements than the stock market. Our economy is built on spending and borrowing. Interest rates are either fuel or an anchor of spending and borrowing.
The Federal Reserve has kept interest rates at historic lows since COVID began in 2020. This has enabled borrowing costs to remain extremely low and provide a psychological support system for the U.S. economy, the stock market and the bond market.
The trade off to low interest rates in the face of massive government spending and economic recovery is inflation. One of the Federal Reserve’s mandates is to keep inflation in check. Otherwise, if inflation takes too strong of a hold on the U.S. economy, then economic recession could occur.
As we have previously hinted, it appears that the Federal Reserve is about to start a multiyear normalization process. The first step will likely be to begin tapering their quantitative easing (“QE”) process later in 2021. We would anticipate some small increases in interest rates. Further, we expect this process to be slow, transparent and lengthy. The previous unwinding of QE took over a year.[xvi] Beyond QE, based upon Federal Fund Futures probabilities, it appears that the Federal Reserve is at least a year away from direct interest rate hikes.[xvii]
The Federal Reserve is betting that the current levels of inflation will moderate. If they are correct, then we would suggest that while interest rates are likely to begin moving higher, it is unlikely that we see major spikes or interest rates approaching late-1970s levels. If they are wrong, then they will either need to accelerate their hike timing or increase interest rates at a higher level. Faster hikes raise the chances of an economic slowdown.
In an effort to be prepared for either possibility, we have actively been reallocating fixed income/bond positions to less interest rate and inflation sensitive areas. As we do not have a crystal ball, it only seems logical to prudently take proactive steps in case the Federal Reserve is wrong.
It is our hope that as you read this, you do not focus solely on the potentially negative political climate, events and circumstances that can occur. Political whims, events and circumstances are ever changing. It would be a fool’s errand to attempt to react to every possibility.
Rather in is our hope that these newsletters provide you with context of the events and circumstances as well as a confirmation to discussions that we hold periodically. We are in fact optimistic that the economy and stock market, at least in the U.S., is still constructive for growth. The U.S. economy has a long history of overcoming a vast array of hurdles. While all good things may eventually come to an end, we remain confident that the sunset is far from setting on the U.S.’s growth prospect.
Bob Brinker recently wrote, “Since the end of World War II, there have been 22 years in which the S&P 500 Index increased over 10% in the first-half of the year. During those 22 years, the median gain during the second half was 10%, and 18 of the 22 years saw positive second-half returns.”[xviii]
Additionally, Brian Wesbury explained their mathematical approach in an article that we circulated in late August. In that article he stated that based upon First Trust’s fair value estimate, “we think it is prudent to raise our 2021 year-end forecast to 5,000 on the S&P 500.”[xix]
Both gentlemen could absolutely be wrong as neither they, us or anyone else has precognitive abilities. However, as we said earlier, we tend to use history, math and client’s unique circumstances as a guide. If you have tolerance for risk and/or have a lengthy timeframe for your goals, there could be an opportunity, especially if stock markets experience a correction. Just as a reminder, the S&P 500 experienced little gain in the 3rd quarter and is currently hovering around 4,380 on September 30th.[xx]
As always thank you for your continued trust and the opportunity to serve you. We hope that you and your family have a great end to 2021!
[vii] BlackRock. “Weekly Commentary: Debt Ceiling Showdown Redux”. BlackRock Investment Institute. 20 September 2021.
[viii] Stone, Bill. “The Market Impact of a Possible Government Shutdown and Reaching the Debt Ceiling.” Forbes. 26 September 2021.
[xiii] Monday Morning Outlook, August 16, 2021
[xvi] Board of Governors of the Federal Reserve System. “Federal Reserve Issues FOMC Statement.” 29 October 2014.
[xviii] Brinker, Bob. “Bob Brinker’s Marketimer.” Volume 36, Number 8. 3 August 2021.
[xix] Wesbury, Brian S. & Stein, Robert. “Monday Morning Outlook.” First Trust. 31 August 2021.
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.