Quarterly Review: Markets Encountered a Detour, Not A Derailment, During Q3 2021

SUMMARY

• Slower economic growth is a detour not a derailment, in our view.
• Headline headwinds impacted third quarter results, but we believe the recovery remains on track.
• We believe utilizing a barbell approach to manage portfolios is useful to navigate volatile markets.

A flat quarter for Stocks and Bonds. The third quarter of 2021 began with optimism around strong corporate earnings, positive economic momentum, and consumers with cash to spend and places to go. Negative headlines received scant attention. More economically sensitive ‘value’ stocks seemed to be taking the reins from less cyclical ‘growth’ stocks as confidence increased that COVID-19 had loosened its grip on our daily lives. By mid-August, however, the Delta variant had crashed the recovery party and worrisome headlines garnered more attention from anxious investors. Some Wall Street strategists grew cautious and lowered growth forecasts, and some companies lowered future earnings guidance owing to higher costs associated with supply chain disruptions and labor shortages. Despite these short-term issues, we believe the recovery from the pandemic remains on track, acknowledging the road ahead could be bumpy as headline headwinds persist.

A September correction. A review of the trailing twelve-month (TTM) data reveals that investors have remained positive with all equity asset classes rising with the reopening of the global economy. However, the quarter ended on a sour note as the S&P fell almost 5% in September, eliminating the earlier gains from July and August. This illustrates the impact of headline damage as US small/mid-cap and emerging markets equities were the worst performing asset classes during the period. The slump in emerging market equities began in July as concerns grew over headlines around the Chinese government’s regulatory crackdown on multiple industries. Small and mid-cap stocks seemed to be most vulnerable to anxieties over the potential for slowing growth as supply chain disruptions and labor shortages dominated the news. The fact that high yield was the strongest performer of all asset classes during the quarter underscored investors’ continued search for yield as rates remained relatively low and equities became more volatile.

The table below shows the performance of asset classes on the left and US equity sectors on the right. Returns for both the third quarter and past twelve months are shown. The table is anchored by US Large-Cap equities, which are shaded, and allows for easier comparison to see higher and lower relative performance by each asset class and sector.

Heightened anxieties also impacted sector returns as performance zigzagged from week to week from those considered more ‘defensive’ back to those associated with a pro-growth environment. An examination of the returns for the eleven sectors in the S&P 500 also reveals the impact of headline anxieties as cyclical sectors were among the worst performers during the quarter. The supply chain disruptions have resulted in some high-profile companies lowering guidance in the Industrials sector which had a negative impact on performance during the quarter. Other cyclicals such as Energy and Materials also fell victim to worries over slowing growth during the third quarter.

Turning to some positive performers, strong balance sheets and expectations for higher interest rates kept the Financials sector at the top of the leaderboard for the period. Perhaps the most noteworthy performance came from the Utilities sector which has been out of favor throughout the recovery phase. We believe the strength in Utilities was a signal that nervous investors sought greater diversification into more defensive segments of the market until the growth path becomes clearer.

The Divergence in Performance During the Quarter Strengthened Our Belief in the Barbell Approach

At RiverFront, our process is grounded in active management and the ability to be flexible, helping us navigate through periods of uncertainty. Throughout much of 2021, our asset allocation process has favored US equities over international and we have taken a barbell approach to selection. In the US, one side of the barbell consists of a mix of growth industries that benefit from the work-from-home environment and the other side of the barbell is comprised of value stocks that stand to benefit from high levels of government stimulus. We also have exposure to quality branded consumer companies whose near-term prospects have been dampened by the pandemic.

Within International equities, we prefer developed markets where we find relative valuations attractive but continue to take a “show-me” approach as growth remains slower than that of the US. We are cautious on Emerging Market equities given the increased scrutiny and regulation of the corporate sector on the part of the Chinese government.

Turning to fixed income, we remain underweight in our balanced portfolios. We are also using a barbell approach to security selection, owning short and intermediate maturity corporate bonds on one side and long maturity Treasuries on the other, to act as a shock absorber in case of equity market weakness.

Process over Prediction

September was the worst month for equities since the spring of 2020 and it served as a stark reminder of what happens when uncertainties intersect with a bull market. Our mantra of “Process Over Prediction” helped us remain overweight stocks despite these negative headlines since our three tactical rules remained positive (as noted in the September 20, 2021 edition of the Weekly View: The Three Tactical Rules Remain Bullish, but Proceed with Caution). We expect this period of consolidation can continue, but ultimately, we believe the US economic recovery remains on track and equity markets will move higher over course of the next twelve months.

Given this, our message for the three types of investors is:

• Accumulate: Market consolidations are not tradeable events, in our view, for long-term investors.
• Sustain and Distribute: An unbalanced portfolio can make it more difficult to endure rising volatility. In keeping with this, we reduced our equity allocations earlier in the summer to bring our balanced portfolios closer to alignment with their long-term strategic allocations. We continue to prefer equities to fixed income in our balanced strategies.