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A September slump put a pause on the global equity bull market. The S&P 500 Index dropped 4.7% for the month, developed international equities (MSCI EAFE Index) fell 2.9%, and emerging-market (EM) stocks (MSCI EM Index) dropped 4.0%. For the third quarter, the S&P 500 was up just 0.6%, MSCI EAFE was down 0.4%, and EM stocks declined 8.1%. For the year to date, the S&P 500 is up an impressive 15.9%, MSCI EAFE is up 8.3%, and the MSCI EM Index is down 1.2%.

The culprit behind emerging-market stocks’ poor recent showing is China. The MSCI China Index was easily the worst-performing stock market down 18.2% in the quarter. Chinese stocks comprise roughly 35% of the EM equity index.

Meanwhile, within the broad U.S. market, smaller-company stocks and growth stocks beat value stocks for the second straight quarter, with sector performances reflecting a somewhat more risk-averse investor mindset, consistent with the COVID-19-related economic growth slowdown during the quarter.

september 2021 benchmark returns chart

In the bond markets, core bond returns were essentially flat and yields were little changed for the quarter. The 10-year Treasury yield was volatile as the yield plunged below 1.2% in early August, then shot back up in the last two weeks of September. Credit-sensitive bond segments outperformed core bonds, and for the year to date, core bonds are now down 1.6%, while high-yield bonds and floating-rate loans are up 4.6% and 4.4%, respectively.

Investment Outlook

Last quarter we summarized our view that higher inflation was likely a transitory effect of COVID-19 and supply-chain disruptions. We do expect modestly higher inflation in the years ahead, however, we are not discounting the possibility of inflation exceeding the consensus and have prepared our portfolios for this possibility.

Our portfolio positioning includes allocations away from core bonds in favor of inflation-protected bonds, flexible credit strategies, and liquid alternatives. We will continue to monitor inflation closely and adjust our views and positioning as needed.

In the 2nd quarter of last year, we decided to reduce exposure to emerging market equities.  We believed the U.S. economy was in a better position to quickly recover from the COVID-19 pandemic. The decision to trim emerging market equities in 2020 paid dividends in Q3 of 2021. A new concern that emerged in the third quarter is around the excessive borrowing in China’s property sector and within Evergrande Group, one of the country’s largest property developers. Moreover, this has come amidst other regulatory crackdowns in China (such as in the for-profit education industry).

key measures of wage inflation

We have followed these events closely as part of our ongoing research on China and emerging markets. Thus far we are of the view that these risks will be contained. The reality in investing is that information like the problems facing Evergrande is quickly priced in, and such events often create opportunity on a forward-looking basis.

A catalyst for the Evergrande-related turmoil is the Chinese government’s steps to rein in speculation that they believe is leading housing to become increasingly unaffordable, which is contrary to their long-term sustainability goals, such as reducing inequality. This in turn is surfacing issues related to excessive leverage in the property sector that has been built over many years. An orderly restructuring appears to be the most likely scenario.

Closing Thoughts

Our base case for the next several years remains relatively positive, as we expect the economic and earnings growth cycle, interest rates, and government policy to remain broadly supportive of equities and other risk-asset markets.  A further expansion of U.S. equity valuations (price-to-earnings multiples) does appear unlikely, potentially limiting the upside for U.S. stocks amid the current accommodating environment.

As always, we thank you for your trust, and we welcome questions you may have about the investment landscape or your portfolio.

Be sure to read the other articles featured in our October 2021 newsletter: