Q3 2021 Market Commentary: Correction Concerns

Executive Summary

As the market continues to bounce back post-pandemic, we’ve seen some interesting themes emerge. This quarter, we’ve reported weekly on many of these topics, such as rising inflation, signs of economic recovery, the strength of the dollar, and the seasonality of market behavior — all while keeping a sharp eye out for signs of an impending correction.


Let’s dive into the key themes that emerged in Q3 and talk about whether or not there should be a concern for a correction.

Theme 1: Cautionary Components in our Dashboards

First, we’ll start with the yield curve. As a refresher, the yield curve graph shows yields, or interest rates, of bonds with equal credit quality but different maturity dates. So, for example, a normal curve reflects higher interest rates for 30-year bonds compared to 10-year bonds, which you might expect (a higher return for holding the bond longer).

Think about it this way: banks can create money by loaning out their depositors’ cash, using a short-term payment and a long-term receipt. If the outcome is positive, it doesn’t matter where the interest rate is; banks can profit from lending long and borrowing short, which allows them to create credit (or money) in the system, bullishly affecting asset prices.


If the yield curve flips, banks begin to stop borrowing. Instead, they may call loans to pay depositors, which in turn shrinks the money supply.

This quarter, the yield curve showed a significant amount of movement. We ended the quarter close to where we started, but there was quite a bit of change over the last few weeks as rates came off their lower bound and moved back up 20 basis points (remember, a basis point is a hundredth of a percent). At the moment, we do not see a pullback. Demand for cash is greater than the demand for loans, so we likely don’t have to worry about a correction — yet.


Where is our concern coming from? We see from the following spider graphs that the money supply has dipped. Our spider graphs give a high-level look at how well the market is doing. Remember, the market is a forward-looking economic indicator, so it’s the first to dip.


In June’s graph, you can see an essentially robust economy, save for transportation and consumer sentiment. Those dips are primarily due to the chip shortage’s impact on vehicle purchases and resulting consumer sentiment.

Graph showing relative health of the economy, represented by connecting lines around a circle moving through consumer, housing, manufacturing, transportation, employment, recession, money supply, yield curve, and bullish index categories. Transportation and consumer insights are low.
Source: Internally created document from Factset data​

Then, in July, we started seeing a deterioration in that bullish percent index. With the money supply dipping like this, we’re keeping a close eye on our dashboards for other signs of an impending correction. Now, moving into August, the money supply has slowed, and the bullish percent index is further down, which is concerning. But remember, it is customary to see a pullback in money supply as we get closer to September and October.

Graph showing relative health of the economy, represented by connecting lines around a circle moving through consumer, housing, manufacturing, transportation, employment, recession, money supply, yield curve, and bullish index categories. Vehicle, consumer insights, and bullish percent index are low.
Source: Internally created document from Factset data​

Theme 2: The Dollar as the “Fastest Turtle”

When it comes to the money supply, we see countries worldwide trying to solve the same problem: printing. Some are printing more money; others, less.


Compared to other major world currencies (e.g., the yen, euro, Canadian dollar, pound, krona, and franc), the dollar is quite strong. The continued strength is mainly because the U.S. dollar is a global currency, holding its demand. This gives the U.S. Federal Reserve an advantage over many other countries, as the global market makes the dollar more attractive.

Next, let’s look at credit spreads on BBB (“triple B”) bonds, the lowest quality while still being investment grade.

Graph showing credit spreads on BBB bonds.
Source: FRED Economic Data

The spread, or extra yield someone gets for taking credit risk, has remained constant throughout the quarter. Bondholders did get paid to hold a little extra credit, which is what the Morningstar graph shows at the bottom: higher-yield bonds performed well.


The data tells us so far; markets are not pricing in credit risk. Interest rates are moving up, but they’re doing so across the board. If we were to be moving into a recession, the bond market hasn’t predicted it yet.


Theme 3: Global Energy Problems Emerging

Basic materials and industrials were among the lowest-performing sectors in the U.S., reflecting a broader global energy issue. We haven’t seen oil prices as high as they are now in the U.S. since 2014. Furthermore, China is suffering an energy crisis due to a general global coal shortage and an unfavorable trade policy with Australia (which has since been revised).


Still, those aren’t even the biggest energy headlines this quarter. Instead, the main story here is Europe’s sky-high natural gas prices. In April, the price was under $20, but it’s already spiked to $117. These spikes ignite shock waves through the system, impacting fertilizer prices, ammonia plants, and greenhouses. In many ways, Europe’s food sector is simply not economically viable at these prices. We guess there will be a sharp market correction as gas prices get resolved, but we don’t know what that looks like yet.


Fortunately for the U.S., natural gas issues are somewhat regional, so we see a domestic impact, but it is not proportional.


Other Q3 Observations

While not standalone themes, there were other observations worth mentioning this quarter. The observations are:

  • The third wave of coronavirus did happen, but new medical options lessened its severity.

  • We see exports — not imports — grow as cargo ships struggle even to make it into port in the U.S., let alone get unloaded.

  • The U.S. grew more quickly than the global economy. Global GDP was only 5%, primarily due to issues with emerging markets (such as the Chinese real estate debacle).

  • Municipal bonds performed well, while taxable bonds stayed reasonably flat.

  • Secretary Yellen has called for a debt ceiling, saying we will default on bonds if we pass one by Oct. 18. We don’t think this will happen, as not enough people are pushing for it. If it does go through, we don’t believe the “Build Back Better Bill” will go through at its total proposed $5 trillion thresholds.

  • The Federal Reserve met in September to discuss their balance sheet. While their strategy isn’t finalized, they signal they will likely reduce those assets at the end of the year and continue mid-2022. About $600-700 billion in asset purchases will be added, growing the balance sheet to a bit of shy of $9 trillion. That’s still a lot of accommodative policy, but it’s a bit of a tightening relative to where we were.

Please contact your lead advisor about how these themes impacted the market and portfolio performance this quarter.


Conclusion

While we see early signs of an impending correction in our dashboards, we don’t believe there is cause for concern just yet. Still, if the yield curve starts dropping, you’ll find us becoming more conservative. We continue to keep a finger on the pulse of the market and will be sure to update you with important updates to our dashboards.


To learn more about correction concerns in Q3 2021, be sure to listen to our recap video below.

To ensure you don’t miss an update, join our live Weekly Market Insight webinars on our YouTube, LinkedIn, and Facebook accounts. We’re here to help make sure you’re doing the right things to preserve your wealth — a crucial part of our mission to help you become and remain financially self-reliant.


As always, feel free to reach out to your lead advisor with any questions or discussion points!

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Disclosures


Securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

The opinions expressed are those of John Gatewood as of the date stated on this material and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended to endorse any specific investment or security.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested directly. Returns represent past performance, are not a guarantee of future performance, and do not indicate any specific investment. Diversification and strategic asset allocation do not assure a profit or protect against loss. When interest rates rise with fixed income securities and bonds, bond prices usually fall because an investor may earn a higher yield with another bond.

Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. The bond’s issuer is obligated to return the investor’s principal (original investment). As a result, high-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase, and reverse repurchase transaction risk.



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