As of October 18, 2021
Three of the four major U.S. stock indexes ended lower in the third quarter — particularly in September. However, the S&P 500® Index posted a slight gain in Q3 — its sixth straight quarter with a positive return.
Cyclical areas lost momentum as economic and reopening trends slowed. Stocks also faced headwinds from an uptick in COVID-19 cases and related pandemic concerns. In addition, supply chain disruptions, transportation bottlenecks, inflation pressures, increased regulations out of China and concerns over the Federal Reserve reducing its bond purchases were other factors that weighed on investor sentiment.
Dynamics in Washington also sapped buying enthusiasm in Q3, as the path forward for fiscal stimulus became more complicated throughout the quarter. Budget and spending debates and deep Congressional divisions on how to raise the debt ceiling contributed to the S&P 500 posting its worst September performance since 2011.
We believe the trajectory for growth and inflation as well as the fiscal environment are likely to play a leading role in how stock prices finish the year. Thus far, year-to-date gains across major global stock averages, including in the U.S., remain positive. In some cases, those gains are very robust versus historical averages.
Despite the slowdown in economic activity, elevated inflation pressures and uncertainty regarding fiscal matters, stocks have shown incredible resiliency. Investors could continue to look through the tension as long as corporate profit growth in Q3 meets or exceeds analyst estimates (hint: we believe it can). The earnings season over the next few weeks should provide more insights.
On the Washington front, Congress has pushed out to early December a longer-term solution on passing a budget and raising the debt ceiling. The short-term fixes essentially kick the can down the road and avoid a disruptive government shutdown and a financially disastrous U.S. default scenario, for the time being.
In addition, the reprieve in Washington should allow Democrats more time to work through the logistics of passing a bipartisan infrastructure bill and a likely smaller-than-proposed reconciliation bill. House Speaker Nancy Pelosi has expressed a desire to pass the bipartisan infrastructure package (already passed in the Senate) and find a path forward on a reconciliation bill by the end of October.
Over many weeks, progressive Democrats have attempted to pressure moderate Democrats into supporting a $3.5 trillion reconciliation bill focused on education, childcare, climate change and other spending priorities. However, both President Biden and progressive Democrats now concede the spending figure will likely need to come down significantly to pass in the Senate.
Some Democrats have floated the idea of scaling back social spending measures, eliminating some proposed programs or reducing the time some priorities are authorized to be funded (e.g., letting them expire instead of running indefinitely). We suspect the overall price tag of the reconciliation bill is likely to come down to $2 trillion or below and could see congressional tax-writers scale back or drop some of their proposed revenue sources. In our view, a smaller reconciliation bill with less tax increases on corporations and individuals would likely be viewed as a market positive.
Washington dynamics are likely to simmer in the background but, over the next several weeks, shouldn't be a significant disruption for markets. Our base case assumption is that Congress will pass a budget, raise the debt ceiling longer-term, and pass a bipartisan infrastructure bill and a smaller reconciliation bill. Outside of some potential volatility leading into December, we believe investors could eventually look through all the noise.
Turning to our outlook for the fourth quarter, we expect economic trends to remain largely positive but look uneven globally. This is due to pandemic effects, vaccine distribution, supply chain disruptions and transportation bottlenecks.
However, in the United States, we expect GDP to grow above longer-term trends through the rest of the year. Notably, a strong demand backdrop, healthy consumer balance sheets and slowly fading pandemic effects should support stock prices through the rest of the year and into 2022.
Inflation will likely remain a central focus for investors, businesses, asset prices, interest rates and monetary policy. If inflation pressures appear manageable during the quarter, we believe longer-term interest rates may see less upside from current levels. This could help buoy stock prices. However, price pressures that appear unchecked could contribute to additional investor anxiety, which would likely contribute to pressuring stock prices for a period of time.
Overall, economic and profit growth is likely to slow from elevated levels. Yet, investors should remain confident about reopening trends, better seasonal patterns in Q4 and easy monetary policies that could continue to provide tailwinds for risk assets, including stocks.
Data source for indices and sector graphs: Morningstar Direct, as of October 11, 2021.
These examples are shown for illustrative purposes only and are not guaranteed. Past performance is not a guarantee of future results.