Domestic Markets – 3Q21 Review

The U.S. equity market (defined as the S&P 500) kept its quarterly win streak alive – if only by the slimmest of margins. The S&P 500 eked out a gain of 0.58% for the third quarter – the sixth straight quarter of positive returns. September is historically known for being a more volatile period for equity returns, and the past month was no exception. After reaching new all-time highs, stocks caught a mild case of acrophobia and subsequently declined -4.7% for the month. On a market cap basis, large caps outpaced small caps, while performance was mixed on a style basis – as large growth bested large value, small cap value held up relatively better in the quarter vs. small cap growth.

Having hit 54 record highs thus far in 2021, perhaps the S&P 500 was due for a pullback. In addition to seasonality, the wall of worry in September included peaking economic growth concerns, containment of the Delta variant, ongoing supply chain disruptions and associated cost inflation, and further confirmation on the Fed’s taper timeline. Equity investors also had to contend with a rally in bond yields, as the 10-year Treasury yield moved from 1.27% to 1.52% over the final two weeks of the quarter. While not yet at a level where bonds become an attractive alternative vs. stocks, steepening yields are typically not conducive for longer-duration growth stocks (which comprise a sizable percentage of the S&P 500 Index).   

Given the strength in household balance sheets, consumer demand trends remain robust for industries such as retail, industrial, and semiconductors. The challenges continue on the supply side – where logistics bottleneck and shortages in labor and materials are hampering production output. Recall just-in-time (JIT) inventory management systems? The underpinning to JIT is to keep as little inventory on hand as possible, which should lower storage expenses and boost margins. The downside to JIT is the potential for stockouts should there be a backup in shipment times…which is the current situation for many businesses. The following chart on container shipping highlights the supply disruption:

As producer prices outpace consumer prices, the result is lower margins and profits. Companies are faced with the decision to pass on these higher input costs to their customers or defend market share at the expense of earnings. Taking a step back, companies would rather be faced with not having enough supply to meet demand vs. having excess inventory in light of weak demand; that said, some degree of equilibrium on the supply/demand front is needed. The expectation is for these constrained supply conditions to normalize in the coming quarters – but it has already gone on longer than expected and may extend into 2022 for more specialized needs such as semiconductors.