The last few days of the third quarter had a substantial impact on quarterly index returns. For the majority of the third quarter, the Nasdaq had solidly outperformed both the S&P 500 and the Dow Jones Industrial Average as investors continued a trend from the second quarter by moving to less economically sensitive large-cap tech shares. However, during the last week of the quarter, as global bond yields rose, there was heavy selling in tech shares as investors rotated into other market sectors. The Nasdaq still slightly outperformed the S&P 500 while the Dow Jones Industrial Average produced a negative return for the third quarter thanks to the late September sell-off.
By market capitalization, large-cap stocks outperformed small-cap stocks in the third quarter. In fact, small-cap stocks had a negative return for the quarter as rising COVID-19 cases, mixed economic data, and the prospects of eventually higher interest rates caused investors to favor large-cap stocks as the outlook for future economic growth became less certain.
From an investment-style standpoint, growth outperformed value in the third quarter, thanks to tech sector gains, although the amount of that outperformance shrunk considerably during the final week of the quarter as tech shares declined.
On a sector level, performance was more mixed than the previous two quarters as six of the 11 S&P 500 sectors realized positive returns in the third quarter, with financials leading the way higher. For much of the third quarter, the tech sector outperformed, but as bond yields rose in late September, financial stocks rallied on the prospect of higher interest rates and overtook tech as the best performing sector in the quarter. Healthcare also performed well, bolstered by strength in pharmaceutical stocks following more COVID-19 vaccine mandates and booster shot approvals.
Sector laggards included the industrials and the materials sectors, both of which finished with negative returns for the third quarter. Uncertainty surrounding the strength of the ongoing economic recovery in the face of higher COVID cases pressured industrials initially in the third
quarter, as did a lack of passage of the $1 trillion bipartisan infrastructure bill. Meanwhile, the materials sector declined late in the third quarter on Chinese economic growth concerns following the Evergrande debt drama. Broadly speaking, cyclical sectors, those most sensitive to changes in economic growth, lagged more defensive sectors in the third quarter due to the uncertainty of the economic recovery in the face of the COVID wave in July and August.
Internationally, foreign markets declined in the third quarter. Emerging markets dropped sharply, initially on concerns that rising COVID-19 cases would derail the global recovery, but late in the quarter, emerging markets fell even further on Chinese growth worries that stemmed from the Evergrande debt issues. Foreign developed markets, meanwhile, declined modestly during the final few weeks of the quarter on general global growth concerns combined with potentially higher global interest rates.
Commodities posted strong gains for the fourth quarter in a row and again outperformed the S&P 500 over the past three months. Major commodity indices were led higher by a late-quarter rally in oil prices as members of “OPEC+” maintained a historically high compliance rate to self-imposed production targets while easing COVID-19 cases around the globe in September bolstered the demand outlook for refined petroleum products. Additionally, there was no progress on nuclear negotiations between the U.S. and Iran, and sanctions remained in place preventing Iran from selling oil on the global market. Meanwhile, gold posted a small loss in the third quarter as a firming dollar and rising interest rates helped offset still stubbornly elevated inflation metrics.
Switching to fixed income markets, most bond classes were little changed in the third quarter. The majority of bond indices were solidly higher through mid-September as investors rotated to safety following the rise in COVID-19 cases in July and August. But in late September, the Federal Reserve confirmed tapering of Quantitative Easing will begin this year. That, combined with still-high inflation statistics, weighed on fixed income markets during the final few days of the third quarter which erased most of the quarter-to-date returns for many bond indices.
Looking deeper into the bond markets, longer-duration bonds and shorter duration bonds had very similar returns in the third quarter. For most of the quarter, longer-term bonds outperformed shorter-term bonds on the growing expectation that the Fed would begin to taper QE late in 2021, and that interest rates would start to rise in late 2022. But the late-September rise in global bond yields resulted in a moderate drop in longer-dated bonds, which erased the earlier outperformance over short-duration bonds.
In the corporate debt markets, higher-yielding, lower-quality bonds outperformed investment-grade bonds thanks to a late September drop in investment-grade following the rise in global bond yields, as investors rotated out of lower-yielding, yet higher-credit quality corporate debt as global yields rose.
Stock market corrections and rebounds
There have been 26 market corrections since World War II with an average decline of 13.7%. Volatility returned to equity markets during September, with the benchmark S&P 500 Index registering the worst month since March 2020. While the issue surrounding China’s largest real estate company was probably a catalyst, equity investors have also been concerned about future Federal Reserve (Fed) policy and decelerating economic data due to the highly contagious Delta variant and supply-chain bottlenecks worldwide.
The U.S. stock market fell into a correction recently as investors punished equities in favor of safer assets as anxiety over the spread and potential impact of the virulent coronavirus. Historical analysis shows these corrections result in a 13% decline and take about four months to recover to prior levels, on average. These moves are typically met with higher volatility. Corrections can be violent as investors’ fear levels rise and panic selling may hit the market.
Comparatively, a pullback was inescapable given the unusual tranquility of markets; the S&P 500 Index had not experienced a decline of 5% in nearly a year, and major U.S. stock indices were producing record highs on a regular basis. The CBOE Volatility Index (VIX) has been hovering at very low levels of around 15 to 25. However, the recent stock market drop coupled with the likelihood of additional volatility heading into 2022 provides a good opportunity to review the history of stock market plunges, rebounds, and how they relate to corrections, bear markets, and the economy.
Correction versus Bear Market
Signs of market weakness are starting to emerge, stemming from expected changes in U.S. monetary and fiscal policies to ongoing business challenges from the pandemic. After hitting a new high earlier this month, the S&P 500 fell 4% below that peak on Sept. 20, stoking concerns of a further fall. What is significant to investors is how quickly stocks rebounded after the market bottomed. On average, the S&P 500 recaptured all of the lost ground in approximately 10 months. “Buying on the dips” can be advantageous to investors during equity
market corrections in this situation.
The average length of a bear market is 289 days, or about 9.6 months. That is significantly shorter than the average length of a bull market, which is 973 days or 2.7 years. Every 3.6 years: That is the long-term average frequency between bear markets. The US bear market of 2007–2009 was a 17-month bear market that lasted from October 9, 2007 to March 9, 2009, during the financial crisis of 2007–2009. The most recent U.S. bear market started in 2020. The stock market crashed in March, with the Dow Jones Industrial Average and the S&P 500 Index both falling more than 20% from their 52-week highs in February with the COVID pandemic.
Corrections are common and are considered normal and even healthy. They allow markets to remove speculative froth after a big run-up and give investors a chance to buy stocks at lower prices.
The major U.S. stock indexes entered a correction this month amid mounting fears about the impact that the coronavirus outbreak could have on the global economy and company earnings growth. An oil market price war this week that led analysts to lower their profit forecasts for energy companies fueled more selling on Wall Street.
WHAT IS BOTHERING INVESTORS?
The outbreak of the coronavirus that originated in China has quickly grown into a pandemic that is threatening major sectors of the global economy, stoking fear that the U.S. and other economies could be tipped into a recession. Many companies, including airlines, cruise operators and big consumer technology manufacturers, have warned their earnings will take a hit this year due to the economic fallout from the outbreak.
While the Fed is expected to begin raising short-term interest rates in 2023 or earlier, market-implied indicators suggest that interest rate normalization will be very gradual and take years to complete.
Global interest rates
As inflationary pressures mount worldwide, money markets are charging ahead with pricing aggressive interest rate rises, in most cases betting that policy will be tightened far sooner and at a much faster pace than rate-setters are signaling.
The Fed also cut its forecast for 2021 growth in the nation’s gross domestic product from the 7% it projected in June to 5.9% while boosting its 2022 forecast to 3.8% from 3.3% previously, reflecting an economy that has slowed as the delta variant of the coronavirus has forced new restrictions on businesses.
Officials also raised their projections for inflation with overall inflation running 4.2% this year, up from 3.4% in June. Core inflation, which excludes volatile food and energy costs, is forecasted at 3.7% for 2021, compared to 3% previously, and 2.3% in 2022, closer to the Fed’s 2% annual target. The European Central Bank (ECB) has already slowed the pace of purchases, and will soon discuss whether to end its Pandemic Emergency Purchase Program (PEPP).
Bond markets have been shaken by central bank signals that interest rate rises are drawing closer, sparking the steepest price declines since a global debt slide at the start of the year. Investors have dumped government bonds in the wake of the latest policy meetings at the US Federal Reserve and the Bank of England last week, at which both indicated a willingness to respond to growing inflationary pressures by lifting short-term borrowing costs. Economic recovery in emerging markets has lagged that of developed markets, which may make emerging-market bonds more attractive amid expectations of a global economic rebound. As the Federal Reserve continues to purchase government securities and corporate bonds, while holding its key interest rates near zero, the value of the dollar is expected to decline against other major reserve currencies, such as the euro or yen. Late last year the International Monetary Fund estimated that the dollar may be overvalued by 15%-20%. Investors might consider increasing their weighting in emerging-market corporate debt and currencies via carry trades, borrow in a low-yielding currency and invest in higher-yielding emerging-market assets.
Hedge Funds
The hedge-fund community gained about 10% in 2021 through the end of August, according to HFR. Hedge funds posted broad-based gains in September across fixed income, commodity and event driven strategies, which were inversely-correlated to steep declines across global equity and fixed income markets. Emerging market hedge funds were up 4.32% over the first seven months of 2021, trailing behind their developed market counterparts in North America, Japan and Europe which returned 10.99%, 6.71% and 6.68% respectively. The economic recovery in the emerging markets has lagged their developed market counterparts due to delays in vaccine rollouts that had necessitated the imposition of harsh lockdown measures
Macro hedge funds which trade broader macroeconomic and geopolitical trends using equities, bonds, currencies, and commodities, among other assets – returned 0.54 per cent last month, aided by rising rates, spiraling energy prices and falling equities. Overall, the sector is up more than 8 per cent in the nine months since the start of the year.
Commodities-based macro funds were the standout performer, up 5.18 per cent in September, bringing YTD returns to more than 21 per cent. Currency macro funds were up 1 per cent, while discretionary thematic macro funds dropped slightly into the red, losing 0.40 per cent in September.
Equity Hedge Returns are hovering near the cycle peak
Investment Strategy
Global equities have rallied to new highs in the third quarter of 2021, powered by strong economic and corporate earnings growth, particularly in the US and Europe. Unusually, this has coincided with a sharp fall in bond yields, with the US 10-year yield dropping as low as 1.2%, and US high yield bonds now trading at around 4.4%.
In the near term, we expect growth to remain strong—we forecast global growth of 6.2% in 2021 and 5.1% in 2022—and monetary policy to remain loose. The Federal Reserve, which is likely to announce its plans to taper quantitative easing in the fourth quarter, has been at pains to stress it will remain data dependent, and that the start of tapering does not imply any particular timeframe for interest rate increases.
This creates a supportive fundamental backdrop for equities, and we continue to recommend investors to buy into markets and sectors best positioned to win from this period of high global growth, such as Japanese equities, energy, and financials. At the same time, with interest rates and bond yields at low levels, fixed income investors face a dearth of yield, and higher levels of potential return are only available in alternative areas such as private credit and real estate, through volatility-selling strategies, or through more active approaches to the asset class.
Of course, a backdrop of global equities at record highs and interest rates at record lows is an uneasy one for many investors, and debates about the path by which the global economy returns to “normal” will contribute to volatility, even if the Fed has committed to managing this process carefully. The spread of the coronavirus delta variant, China’s regulatory crackdown, and geopolitical uncertainties all present additional risks. With this in mind, investors should review the potential benefits of diversifying portfolios to include alternatives such as hedge funds, private markets, and structured investment strategies. All have alternative payoff structures and so can help improve diversification and overall risk-return profiles.