Noisy Normalization

Market Commentary | Q3 2021

September marked the first monthly decline for stocks since January as investors focused on concerns about political uncertainty and the possibility of long-haul economic symptoms from the pandemic. The S&P 500 dropped more than 5% from its all-time high set on Sept 2. Prior to that, the index went 227 days without a 5% drop, the seventh-longest such streak on record, gaining 29.4% during that period.¹ As we head into October, a month with a reputation for volatility, investors are re-assessing the current market landscape.

For long-term investors, the benefits of staying invested in a diversified portfolio remain strongly in place. The path to normalization may be bumpy over the short term, as tax and fiscal policy remain in flux, the global supply chain remains snarled, and equities remain priced for perfection near all-time highs. Sentiment is slowly shifting from the optimism of early-2021, during which investors touted a narrative of ‘when this pandemic is over, things will be better’, to a more pragmatic outlook that acknowledges the pandemic is not over and may linger for a long time to come, albeit in a more manageable form.²

As we move into the fourth quarter, certain themes that are currently unfolding will add noise and volatility to the short-term, while others may have a lasting impact.

This week’s market consternation focused on the possibility of a government shutdown, as well as the US defaulting on its current debt if the debt ceiling is not increased. Congress extended government funding until December 3, averting the imminent shutdown, but has not yet dealt with the debt ceiling. To be clear, the idea of a US default is a nearly unfathomable scenario – except for the fact this isn’t the first time this debate has been politically weaponized.

For investors, the focus on congressional negotiations expands beyond the debt ceiling. A bipartisan infrastructure bill, a spending plan with accompanying tax reform, and a debt-ceiling increase all remain outstanding. We expect the near term will include plenty of noise and alarmist headlines emanating from Washington on all three fronts.

Barring the unlikely scenario of the US government defaulting on its debt, the most meaningful legislation for investors will be the tax provisions in the Democrats’ reconciliation bill. The market expects that Democrats will eventually pass a bill costing approximately $1.5 trillion, that includes spending for social programs combined with limited tax hikes. The market won’t be shocked if the corporate tax rate increases from 21% to 25%, and the top personal tax rate increases back to 39.6%. There is even a possibility the cap on SALT deductions would be repealed, allowing California residents to fully deduct property and state taxes again, which could partially offset the negative impact of any personal tax increases. As long as the economic recovery remains solid, these tax increases shouldn’t derail current growth, although they may cause short-term price volatility as investors adjust to the changes.

The widening political division that we’ve witnessed over recent years and the dramatic oscillation of policy between administrations is a more nuanced and bigger picture risk. While it doesn’t change the fact that the current noise from Washington is likely a temporary headwind, it is an area we will continue to monitor with regard to long-term market stability.

The Federal Reserve has maintained a policy of near-zero interest rates since the onset of the pandemic and has repeatedly assured market participants that rising inflation will ultimately be transitory. This week that message shifted slightly, with Federal Reserve Chairman Jerome Powell saying that the current bout of high inflation could be prolonged into early next year because “supply chain problems are not getting better, in fact they are probably getting worse.”³

Using the Fed’s preferred personal-consumption expenditures price index, the rate of inflation in the US rose by 4.2% for the 12 months ending in July. That is the fastest increase in 30 years.⁴ One minor but noteworthy sign of this inflationary pressure: the Dollar Store announced this week that prices are finally forcing them to raise their prices beyond the $1 price point, citing supply chain challenges and the rising price of goods.⁵

Consumers will feel inflationary pressures as we head into the holiday shopping season, but the larger risk for investors is the chance that inflation doesn’t subside in 2022. In that scenario, the Fed may be forced to accelerate the path to higher interest rates as a way to mitigate inflationary increases. For now, investors view inflation as a tolerable and transitory aspect of this extended cycle of economic normalization.

Since the onset of the pandemic, much has been written about the “new normal” and what that means for daily life. For financial markets, continuing to have interest rates pegged at zero percent is neither “normal” nor sustainable. Over the past fifty years, the Fed Funds rate has averaged 4.9%, compared to an average of 0.5% over the past ten years.⁶ A higher, more normalized interest rate environment would benefit savers and cautious investors looking for bond income, and importantly, it would give the Fed the ability to lower interest rates in response to future crises.

We’ve said for many years that the process of interest rate normalization will likely be volatile for markets. Technology stocks are often disproportionately impacted as rates rise, since much of their profitability is in the future. This has some investors concerned since 24% of the S&P 500 index is comprised of 6 tech companies: Apple, Microsoft, Amazon, Facebook, Google, and Tesla. That group of companies, excluding Tesla, is more profitable and stable than the broad technology sector. Nonetheless, if those companies see downward price pressure, the index will decline even if other sectors of the economy remain on solid footing.

History shows us that minor corrections are a normal part of price calibration in the market. On average, over the past 50 years, equity markets have experienced a decline of -10% at least every two years. These price corrections can be unnerving, especially in the moment when it is unknown how long the price decline will persist. For long-term investors, though, these declines often represent attractive opportunities to buy high-quality businesses at lower prices.

Despite the bumps, this process of price declines and incorporating new concerns is healthy for the market. Barring a quasi-unfathomable outcome on the debt ceiling, the current noise in Washington will not cause anything other than temporary market volatility. Similarly, the array of expected tax increases may get a lot of media attention but won’t materially alter the current growth cycle in the economy or the market.

As we head into the remainder of the year and look ahead toward 2022, we expect continued recovery in economic and global health. Yet, equity prices may be vulnerable to near-term swings. At North Berkeley, we will continue to emphasize disciplined rebalancing by trimming stock allocations as they grow beyond target levels and buying stocks if market prices hit an air pocket and drop from current levels. Our goal remains constant: stewarding our clients’ portfolios such that they feel confident in their long-term financial resiliency, as well as an alignment of their financial life with their values and vision of the future.

Resources

¹ The S&P 500 Went 227 Days Without a 5% Drop. Here’s Why It’s Suddenly Sliding. Barrons

² BioNTech Co-Founder Says Covid Will ‘Become Manageable’ and Be With Us for Years Barrons

³ Fed’s Powell says high U.S. inflation could last into early next year due to shortages Marketwatch

⁴ Professor who called Dow 20,000 says he’s nervous about trends in inflation that could spark a stock-market correction Marketwatch

⁵ Dollar Tree to raise prices in what it’s calling a “Multi-Price Evolution” for the company Dollar Tree Press Release

⁶ Federal Funds Rate – 62 Year Historical Chart MacroTrends