Resilient Markets Hit New Highs in the Third Quarter

The S&P 500 hit new all-time highs again in the third quarter as investors looked past a resurgence of COVID-19 cases in the U.S. and instead focused on the positive combination of a resilient economic recovery, ongoing historic support from the Federal Reserve, and strong corporate earnings. Market volatility picked up during the final few weeks of September, however, reminding investors that the transition to a post-pandemic “new normal” isn’t always going to be smooth.

Stocks moved steadily higher to start the third quarter as the U.S. economy continued to return to pre-pandemic levels of activity while corporate earnings remained solid. Second quarter earnings results, which were released in mid-to-late July, were stronger than expected and broadly did not show signs of the margin compression that some analysts feared might hurt corporate profitability. Then, at the July FOMC meeting, Fed Chair Powell reiterated that, despite economic progress, it was not yet time for the Fed to begin to reduce Quantitative Easing (QE), thereby ensuring the economy and markets would continue to enjoy full Fed support until late 2021.

That positive momentum for markets continued in August, powered by similar factors: Positive corporate commentary, solid economic activity, and continued supportive Fed rhetoric. Those forces again combined to help markets look past a further increase in COVID-19 cases. Unlike during the COVID-19 waves of 2020 and early 2021, government authorities did not re-impose economic restrictions or lock-downs in response to rising case counts. Instead, most policy responses centered around mask mandates, and as such, the economic headwinds from rising COVID-19 cases were mild compared to previous episodes.

The market tone changed in September, however, as many of the factors that supported stocks earlier in the quarter began to fade. First, corporate commentary turned more cautious last month. Profit warnings cited supply chain constraints and margin compression came from multiple industries, and that caused concern about the outlook for corporate earnings. Then, economic data from August showed the rise in COVID-19 cases had weighed slightly on the economic recovery. Finally, after investors ignored the looming policy battle in August, politics once again became an influence on markets as Democrats unveiled new details on a $3.5 trillion spending and tax plan that included increases to the corporate tax, personal income taxes for high earners, and changes to capital gains and inheritance taxes. Those factors weighed on markets initially in September, but the volatility was compounded by the news that the second-largest property developer in China, Evergrande, was likely going to default on debt payments. Fear of potential financial market contagion hit stocks in late September and the S&P 500 suffered its first 5% pullback in nearly a year.

Markets remained volatile into the end of the quarter as the Federal Reserve confirmed market expectations that it will begin to reduce Quantitative Easing before year-end, while Washington approached the looming deadline of a government shutdown with no extension in sight, although that was avoided in the last few days of the quarter. The S&P 500 finished September with moderate losses although the index still logged a positive return for the third quarter.

In sum, last quarter the market remained resilient, but the last weeks of September served as a reminder to investors that markets will face the resolution of numerous macroeconomic unknowns in the fourth quarter, and while fundamentals remain decidedly positive, market volatility should be expected. Fourth Quarter Market Outlook

Market performance in the third quarter reflected continued improvement in the macroeconomic outlook as a society, the economy, and risk assets showed resilience in the face of another wave of COVID-19, while corporate earnings were better than expected. However, that should not suggest that risks no longer remain. In fact, the next three months will bring important clarity on several unknowns including future Federal Reserve policy, taxes, the pandemic, and inflation.

The Federal Reserve has recently communicated that it will begin to taper Quantitative Easing in Q4, but markets do not yet know when exactly the Fed will start to scale back those asset purchases or the pace at which they will be reduced. If the Fed starts to taper QE sooner than expected, or the pace of reductions is faster than the market has currently priced in, it will cause additional volatility.

Meanwhile, in the third quarter, investors were reminded that politics can be a powerful influence on markets, and over the next several weeks we will learn whether the debt ceiling is extended and if there will be any significant tax increases. If policies from Washington are viewed as negative for corporate earnings or consumer spending, they will cause a rise in market volatility.

Finally, inflation remains elevated and at multi-decade highs, and that combined with continued supply chain disruptions, due to the ongoing pandemic, is starting to impact corporate margins and profitability. If an increasing number of companies warn about future profitability due to these factors during the upcoming third-quarter earnings season, it will negatively impact markets.

Yet while risks always remain, macroeconomic fundamentals are still decidedly positive and it is important to remember that a well-executed and diversified, long-term financial plan can overcome bouts of even intense volatility such as we’ve seen over the last two years.