After a series of monthly gains fueled in part by the re-opening of the U.S. economy, the stock market rally stalled in the third quarter, with most of the major indices recording losses. The Dow Jones Industrial average declined 1.5%, the Standard and Poor’s MidCap 400 index fell 1.8% and small cap stocks, as measured by the Russell 2000, fell 4.4%. Unfortunately, bonds offered no refuge as interest rates rose and bond prices fell, resulting in a decline of 1.6% for the U.S. Aggregate Bond index. As the market rally stalled, many began to ask if this was the top for this bull market or just the pause that refreshes and leads to a continuation of the rally. Sadly, this is an unknowable question and only time will tell. But as the year draws to a close, we are paying attention to several developments that may matter to financial markets.
The Federal Reserve (“the Fed”)
The Fed announced at their September meeting they are likely to begin to reduce the rate of their asset purchases in November if the U.S. economy continues to perform in-line with their expectations. As a reminder, the Fed is currently buying $80 billion of U.S. Treasury securities and $40 billion of mortgage-backed securities per MONTH. These extraordinary measures were put in place to fight the economic downturn caused by the pandemic. Now that the pandemic has begun to ease and economic activity is normalizing, the Fed wants to extricate itself from this monetary stimulus for fear of exacerbating inflationary pressures. This tailwind to financial markets will begin to become a headwind as we move through 2022.
Supply Chain Disruptions
The Fed had messaged its belief that inflationary pressures would largely be transitory as supply chain disruptions eased and inventory levels began to normalize. As we all know, this has not occurred. While the U.S. has largely re-opened, many parts of the far east, where many goods are manufactured, are still under partial lockdowns. It now appears supply chains may not normalize until the second half of 2022 at the earliest, with some expecting it could take until 2023. These critical supply chain issues may lead to inflationary pressures lasting longer than anticipated and impair the earnings power of certain businesses as they are unable to source enough product to meet consumer demand.
Gridlock in Washington D.C.
President Biden’s infrastructure bill remains trapped in Washington D.C. gridlock as a few Democrats appear reluctant to support the $3.5 trillion price tag. In addition, after much wrangling, Republican leaders agreed to temporarily raise the debt ceiling until December 3, 2021. If the debt ceiling isn’t raised by then, the U.S. Treasury will be unable to pay all its obligations. To state the obvious, this would likely be very destabilizing to financial markets. Our baseline expectation is that the debt ceiling is ultimately raised, and President Biden’s infrastructure bill passes but at a reduced-price tag closer to $2 trillion.
Depending upon when you measure the start of this bull market in stocks, it could be either early innings, if measured from the start date of April 2020, or long in the tooth, if measured from the summer of 2009. We tend to lean towards the latter interpretation. Our investment discipline, however, is not dependent upon macro forecasts. Rather, we spend our time focusing on what we can control—owning world-class businesses at a fair price. And while we think the overall market is fairly to richly valued, surprisingly we are still finding pockets of opportunity to deploy capital in undervalued businesses that offer compelling risk/reward setups. While we don’t control the distribution of the returns of these businesses, we are confident they provide the opportunity to compound capital at an acceptable rate while avoiding the risk of a permanent impairment of capital. Our focus will remain here, and we shall leave the forecasting to others.
As always, we remain committed to helping you achieve your financial goals and are grateful for the trust you place in us.