Following a remarkable run of positive market performance in the first half of this year, the third quarter provided very high volatility- with minimal results. The S&P 500 index finished the period just barely positive, but most other major stock indexes finished with modest losses. The year-to-date numbers are still very strong, but over the summer the combination of Delta case concerns, inflation worries, supply chain issues, spending bill uncertainties, and ensuing drops in GDP projections were too much to sustain a market rally. In Cutler’s view, this period of consolidation is a positive result, as earnings need time to “catch up” to the high stock valuations in the markets. With a more tepid virus outlook (of late), Cutler believes the bull market of the past year can remain intact.

Of course, inflation continues to be a concern. Everything seems more expensive, and Headline Consumer Price Index (CPI) readings remain above 5%. With much of this inflation related to pandemic challenges, we do not expect this heightened level to remain ongoing. After all, the pandemic has caused inflation stresses that should abate as conditions normalize. But, the above average readings have forced the Federal Reserve to (reluctantly) adjust some of their own projections on the premise that elevated levels could linger. The Fed remains concerned, as do all investors, in the continued impact of the Delta variant and its potential drag on growth prospects. While case numbers do appear to have turned a corner and begun to come down in the US, the virus has still had an outsized impact both on domestic productivity and supply chains linked to countries still dealing with ongoing case increases. As a result, third quarter GDP estimates have come down from roughly 6% to just over 1%. Much of that impact is related to supply issues and a slight drop in consumer sentiment. Equity markets would enjoy a return of confidence and demand as we head into the end of the year. 

Bond markets, however, continue to defy expectations. How does one explain the continued very low rates, despite the increasingly sticky inflation data?  The 10-year Treasury yield even dipped down below 1.2% in August when it seemed inflation concerns may be overdone, but rates rose back up to 1.5% by quarter end with the Fed acknowledging that readings may stay elevated. As of now, the expectation remains for no interest rate rise until late 2022- but the Fed appears ready to begin tapering their monthly bond purchases, which will surely impact bond pricing. Current estimates have the Fed reducing their open market purchases by $15 billion per month. One might be left asking, “If the Fed isn’t buying bonds, who’s left?”

One potential answer is equity investors. Investors have been biased toward risk assets, and equities have been the beneficiary. However, if rates were to rise considerably, equity and cash investors would accept the safer returns of fixed income and markets would stabilize. The likelihood of higher rates is largely why Cutler continues to favor short-to-medium term bond positioning, as short-term bonds carry less price risk. At this time, with inflation still running rather hot, Cutler believes a strong case can be made for stocks as the preferred method to meet or beat inflation pressures. Keeping up with inflation is difficult to do with fixed income while rates remain so depressed.

Looking forward, an array of factors will determine the sustainability of elevated inflation, as well as a return of accelerated growth. Our consumer-driven society can benefit from fulfillment of the massive pent up demand, but things are not that simple. Growth expectations should be tempered by recognition of supply issues, as well as the possible impact of tax policy, interest rate policy, variant cases/ potential policies aimed to contain case growth, and the general ability of consumers to continue being the driving force of the US economic engine. These uncertainties led to notable increases in the VIX Volatility index during the third quarter. While well off the highs of last year, Cutler will be watchful for any sizable peaks or valleys in this measure, which may represent attractive opportunities for repositioning.

We have identified key data points in recent market commentaries. While these metrics may vary widely by quarter as we continue to come out of the Pandemic period, here is where they currently stand:

• Valuations. Valuations remain fairly high by historical standards, but earnings have grown to help alleviate some of that elevation.  The S&P 500 index ended the quarter at roughly 20.5 times earnings (source: JPMorgan).  This remains above long-term averages, but with bond yields remaining depressed that can help to justify these figures. 
• Economic growth. GDP measures have been well above average as we recover from the severe 2020 restrictions, but Q3 growth expectations have been guided lower with strain from Delta and supply issues. The GDPNow Q3 2021 estimate is just over 1% growth (source: Atlanta Fed), down from an estimated 6% reading just a month earlier. Looking forward, a key question will be whether that means the previous expected growth has been “punted” to future periods, or just will not materialize to that level.
• Interest rates. The Federal Open Markets Committee continues to hold the line on not increasing rates until at least late 2022, even with ongoing elevated inflation.  Bond markets initially took this as a sign to buy bonds, but lately bonds have seen increased selling pressure. The Fed does seem likely to begin tapering their monthly bond purchases this year.
• Currency. The dollar continued the trend of modest softening, which has been the case for multiple quarters in a row now.  This has somewhat helped the relative returns of non-domestic securities.

All opinions and data included in this commentary are as of September 30, 2021 and are subject to change.  The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision.  The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.  Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.