The stock market was essentially flat in the 3rd quarter with the S&P 500 rising just 0.58%; bond returns were slightly negative. The quarter started strong as corporate 2Q earnings reports pleased investors, by and large, with near-record numbers of reporting companies beating expectations, thus prompting positive earnings revisions. However, the market sold off hard in September as economic, political, and geopolitical tensions ramped up, impacting both stocks and bonds.
On the economic front, inflationary fears have gripped the market, which has driven interest rates back up. The 10-year Treasury yield is now almost 1.6%, after a rally from the early part of the 2nd quarter, bottoming at below 1.2% in early August (the all-time low was 0.5% during the summer of 2020). This move in rates is consistent with the expectations laid out in last quarter’s newsletter. The market is beginning to adjust to anticipated lower (but still historically high) levels of accommodation from the Federal Reserve (the “Fed”) on monetary policy and the potential impact of continued debt issuance by the Treasury to fund increased government expenditures.
On the monetary front, the Fed has signaled its willingness to soon taper the $120 billion in monthly bond purchases it has been making ($80 billion in U.S. Treasuries and $40 billion in mortgage related securities), likely before the end of the year. As detailed last quarter, these purchases add liquidity into the financial system because the dollars used to pay for the bonds remains in the economy, spurring economic growth. This effect will cease when tapering occurs, thus eliminating a significant source of demand for bonds, with higher rates possible if other investors do not pick up the slack (interest rates and bond prices are inversely related). The Fed has been clear to differentiate between bond purchase tapering (they will likely start gradually, by reducing the monthly amount by less than 15% initially, hoping to end by the end of next year) and the short-term Federal Funds Rate. The Fed currently does not expect to change its 0-0.25% target before 2023.
Fiscally, Congress is still trying to pass a $1.2 trillion bipartisan infrastructure bill, and battling over President Biden’s “social infrastructure” initiative, which is now expected to be $1.5-$2.5 trillion. The market has reacted harshly to the uncertainty over the amount of spending and how it will be paid for, especially with respect to potentially looming higher corporate and capital gains taxes, which could prove a headwind for corporate earnings and consumer spending and so a catalyst for selling securities.