Welcome, and thank you for joining us for our view of the global capital markets.
The contour of this quarter’s results were driven by growing concerns ranging from less accommodative central banks to continued concerns associated with COVID’s delta variant and its possible impact on global economic growth. For the quarter, equities posted negative returns, with the US being the exception where performance was slightly positive, while the fixed-income markets were mixed. However, year-to-date returns for risk assets have generally been strong. Meanwhile, government bonds have suffered this year from the risk on tone and increasing concerns over inflation and rising rates.
A closer look at the broad equity markets reveals that, year to date, it has delivered generally rising returns with some volatility interwoven in certain periods, which ultimately culminated in a material pullback in September due to concerns over Fed tapering and the prospect of chronic inflation. In turn, this has led to some debate at the Federal Reserve. They may start tapering in November, with the Fed funds rate rising in 2023, but they remain split as to the timing of any rate increase. And this decision will hinge on concerns ranging from the direction of the coronavirus to the unemployment and inflation landscapes.
Regarding core inflation, it is now running at a modern-day high of 4%, but a closer examination reveals an exorbitant rise in transportation goods. Higher automobile costs have been driven by supply-chain bottlenecks in the semiconductor industry, which over the long term will abate. And interestingly, if we strip away the effects of transportation goods from core CPI, this yields a meaningfully lower inflation number. Putting it all together, return expectations going forward for a traditional 60/40 stock/ bond portfolio have become more muted over time. So it’s critical to be very active and selective, whether choosing securities for fixed income or in the equity markets where valuations are elevated but earnings have been strong and are still expected to grow.
And if these forecasts are realized, this could lead to more reasonable valuations, which is always a positive. However, one concern that’s reemerged is the concentration of the largest stocks in key indices. We again advise being active and selective, because when you look beyond these top 10 names, the rest of the market trades at a substantial discount to them. In fact, the premium you pay for those top 10 names is roughly 57% versus the rest of the stocks in the S&P 500. While there’s no shortage of concerns for equity markets, we remain focused on quality, a resilient characteristic for both value and growth. And over the past 35 years, quality stocks have markedly outperformed the broad market.
Certain criteria we look for include high and stable profits for growth stocks, strong free cash flow for value equities, and pricing power for both. But we look to avoid such attributes as high-cost operators and companies having high debt balances. And an emphasis on quality is agnostic to style or market cap. With small caps, whether they be growth or value, we believe you can find select opportunities among our highest-conviction sectors, which currently have more of an economically sensitive tone.
The past four decades have seen many challenges to the stock market, but the long-term trend is up, and it all comes down to time in the market, not timing the market. Even looking at 2021 so far, had you missed the five best days in the S&P 500, you would have foregone a meaningful amount of appreciation in your portfolio. With fixed income today, concerns over the prospect of higher interest rates, possibly lingering inflation has been challenging for investors seeking income while not wanting to take on an undue level of risk. And it is difficult finding yields above the Fed’s desired average inflation target of 2%, let alone a current core CPI of 4%. So in this environment, we’re recommending a combination of government bonds and global credit, a barbell approach.
This structure lends itself to an efficient stream of income, where government bonds can provide a degree of safety in periods of market stress, while global credit enables a level of participation in rising markets. And casting a wider net is essential. While yields are historically low in developed markets, we are still finding fertile ground in sectors such as emerging-market corporate and dollar-denominated sovereign debt, as well as local currency sovereign bonds. Overall, we still advise a mix of global higher-income sources. This combination includes global high yield, securitized bonds and even select BB- and B-rated corporate bonds having the prospect of being upgraded. Now, clearly a lot has transpired this quarter and many concerns persist, yet our advice remains to be global, be selective and be active.
Thank you so much and wishing you all the best.
Capital Markets Outlook: 4Q:2021