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Source: JP Morgan

Markets in the third quarter have followed familiar patterns of response to the levels of optimism or pessimism around reopening and inflation. This has been the theme throughout 2021.  Increasing optimism around reopening leads to positive equity markets, value outperforming growth and small caps outperforming large cap with intermittent pessimism reversing those trends. In Q3, we saw markets get a little more negative about reopening as global COVID case counts rose as a result of the delta variant. Of late, we saw additional volatility around how Congress is handling the debt limit; those concerns have persisted into October.

On the inflation front, we saw a much more consistent narrative with the rest of 2021: rising inflation associated with increases in commodity prices and decreases in bond valuations. This continuation in the inflation trend alongside enough improvement in the labor market has pushed the Federal Reserve to indicate they are likely to begin tapering their asset purchasing program before the end of the year. The tapering decision was well within market expectations heading into the September meeting; however, their projections for future rate increases showed interest rates at 1.75% by the end of 2024, which was quicker than generally anticipated and resulted in treasury yields rising in the days following the announcement. Overall the FOMC’s forecast of future policy has lacked any substantive shock to the system.

Outlook and Risks:

Despite the third quarter’s reversal in some of the optimism around reopening, there are positive signals around the pandemic for the remainder of the year with COVID cases appearing to peak in September and positive early results from countries that have approved vaccine boosters. This positivity should be caveated with some uncertainty about how the Northern Hemisphere will navigate winter alongside the delta variant as well as the potential for new variants to emerge, but expectations are positive for the continued reopening of the global economy heading into the end of 2021.

Source: NY Times

In addition to some cautious optimism around the pandemic, there are significant reasons to believe that, even with the significant economic recovery post-lockdown, the global economy still has room to continue performing like it’s in a recovery phase. Global GDP growth is still behind its pre-pandemic peak in 2019 with Eurozone GDP over 2% below its peak, Japan over 3% below, and both the UK and Australia over 4% below.  Even in the US, where the economic recovery has been significantly more advanced than other developed economies, GDP is below consensus projections for 2021 from pre-pandemic. Even with the US’s more mature recovery, our employment-to-population ratio looks more in line with lows for recessions in the early 90s and early 2000s than a fully recovered economy. This implies continued opportunity for sizable economic and market growth as we move closer to normal levels of employment.

Source: Russel Investments

The major market risks have not changed drastically from Q2. Central banks still have ample opportunities for missteps as they attempt to balance working towards full employment, managing inflationary pressure, and keeping markets stable and functional. We see two primary differences in this market risk from where we started the third quarter: central bankers are starting to play a more active role in managing inflationary pressure and data increasingly points to a less transitory inflationary environment. On the first difference, the Fed has signaled it will likely begin tapering its asset purchasing program by the end of the year; on the second difference, we continue to see wage growth applying inflationary pressure. The Atlanta Fed’s Wage Growth Tracker is at 3.9%, only slightly below the 4% level threshold that tends to indicate overheating risk. Wage pressure continues to be a contradictory data point to the belief that inflation is transitory. Secondarily, the pandemic itself continues to be an unpredictable variable in the economic recovery with the potential for new variants always looming alongside fears that those variants will be increasingly vaccine resistant. On top of these risk factors, surprising decisions and headlines from China, global supply chain issues and the US political environment have managed to insert additional uncertainty related to the debt ceiling. While these risks should not be ignored, our expectations are that equity markets will finish the year ahead of current levels as the pandemic increasingly fades and the economy continues to reopen.

Portfolio Update

We have maintained our overall global stock market exposure over the past quarter.  In response to our view on continued inflationary pressures, we sold off a portion of our core bond allocation and added exposure to the M&A marketplace via the Merger Fund. This active manager focuses on publicly announced corporate reorganizations. They have demonstrated below average volatility and as a result fit nicely within our expectations for the defensive portion of portfolios. Two structured notes matured during the quarter and proceeds were reinvested in the World Stock Index while we wait for terms to improve for any future structured notes. We also sold a tactical manager as part of a tax loss harvesting strategy. The Brown International Small Company Fund was a key contributor to positive returns and once again performed in the top quartile compared to peers. Emerging market exposure and global small/mid cap tech detracted from returns as they were out of favor this quarter. We will continue to monitor holdings and adjust to conditions as they appear warranted.

We welcome questions as the content above may create some for you.  As always, we are grateful for your continued trust in all we do related to planning and investments.