Beacon 'Pointe of View'

Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research

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The Quick Facts

Stocks post worst month since March 2020
10-year Treasury yields increased 18bps to close at 1.49%
Fed likely to start tapering its QE (“quantitative easing”) program at November meeting
Fed’s “dot plot” now split on 2022 interest rate hikes
Dollar hits one-year high as market anticipates U.S. interest rate hikes
China Evergrande worries contained by China central bank

After seven consecutive months of gains, the S&P 500 equity benchmark posted the biggest monthly slide since March 2020 with a negative return of 4.7%. Volatility made a comeback in September and roiled risk assets.

Many market observers worry about China, specifically the recent news about Evergrande, a major Chinese real estate company that is heading to default on its loans. Banks in the U.S. have very little exposure to Chinese real estate and only about 2% of the S&P 500 revenues are coming from China. While China Evergrande is not the largest of our worries, a more generalized crackdown on free markets in China is a worry. The relatively new policy of “common prosperity” is not a positive development for emerging market stocks. Coupled with the other issues to worry about, starting with a tightening Fed, inflation, the debt ceiling, trillions in new fiscal spending, big tax hikes, a vaccine-resistant Covid-variant, ongoing supply chain issues, etc., this new policy is cause for concern.

Despite a 4.7% stumble in September, the S&P 500 notched a small gain over the July-to-September period (+0.6%), while the tech-heavy Nasdaq suffered modest 3Q losses (-0.2%). The tug-of-war between growth and value persisted throughout the month and quarter. Nearly all of value’s outperformance in September occurred in the final week following the September 22^nd Federal Open Market Committee (FOMC) meeting, which coincided with long rates spiking higher. Since the beginning of the year, value has modestly outperformed growth. The Russell 1000 Growth is now up 14.3% year-to-date (YTD), 1.8% behind the Russell 1000 Value, which is up 16.1% YTD. International markets continue to underperform with the MSCI EAFE up 8.8% YTD and the China-heavy MSCI Emerging Markets now down 1.4% YTD.

September Asset Class Performance

Ten out of eleven sectors finished lower in September, including seven sectors with declines of more than 5%. Energy (+9.0%, +42.0% YTD) was the only positive sector in September, helped by the WTI Crude Oil $/bbl. 10% move higher on the month. Materials was the worst performing sector in September (-7.2%, +10.7% YTD). Since the beginning of the year, the reopening trade is very apparent with energy topping YTD returns at 42.0%, followed by financials at 28.9% and real estate at 24.3%.

Following the September FOMC meeting, Chair Jerome Powell indicated the central bank could begin tapering as soon as the next meeting in November. Chair Powell noted that rate hikes would not commence until after the taper process is completed by the middle of 2022. What longer-term interest rates look like after the Fed is no longer buying bonds will determine whether the “dots” showing several rate hikes by 2023 are realistic or not. Despite consumer price inflation running hot at 5.3% in August, Chair Powell said he expects some relief over the first half of 2022 and that inflation expectations remain at levels consistent with the Fed’s 2% average inflation target.

U.S. politics have moved to the forefront for investors. Last week the U.S. Congress passed a spending bill permitting the government to stay open until December 3. The extension will allow politicians to focus on raising the debt ceiling and passing President Biden’s stimulus package. Outside of the U.S., China’s government has been reinforcing state power through broad regulatory reforms, raising concerns it may lead to wider economic damage. China (and to some extent Europe) are also facing a power crunch which is crimping economic growth forecasts and roiling global commodity markets.

The benchmark 10-year Treasury yield broke higher from a six-week ~1.30% level and closed in September with a net rise of 18bps to 1.49%. The breakout came following the September 22^nd FOMC meeting and coincided with two consecutive rises in jobless claims. The 10-year/2-year Treasury spread widened 11bps to 1.21%. 10-year Treasury yields remain historically very low when looking at 230 years of interest rate data.

The U.S. Dollar Index (indicates the general international value of the USD) hit a one-year high in September with a monthly gain of 1.7%. WTI saw a monthly gain of 9.9%. Gold finished down 3.1% for the month at $1,757/oz. Bitcoin gave back some of the earlier gains in the quarter with a negative return of 7.6% in September. Bitcoin is still up almost 50% YTD at $43,436. The CBOE Volatility Index (or VIX), also known as the fear-gauge, spiked mid-September to 25.7 and remained elevated at 23.1 at the end of the month. September lived up to its reputation of being a volatile month and dented stock portfolio returns.

Investment Summary – “Inflation, Rates, and Rotation” in an Era of Financial Repression

We will hold our quarterly Investment Committee meetings mid-October and provide you with an update on our asset class preferences in the November edition of the ‘Pointe of View.’ In the meantime, we remain “risk-on” given the expansion mode in global activity and pandemic developments. We have somewhat less conviction when considering the risks/rewards available in asset classes. We are also reaching peak policy stimulus and the Fed is about to start tightening. We prefer Equity and Alternatives to “safe” Core Fixed Income given the current and expected negative real yield environment. Equity risk premia remain within historical range, neither rich nor cheap at 3.2%, marginally lower than the 20-year average. We maintain our positioning that reflects a rotation from U.S. Large Cap Growth to U.S. Large Cap Value, U.S. Small Cap, EAFE (growth) and EM equities given economic reflation. We retain the inflation protection position in TIPs. We are now neutral U.S. High Yield (corporate and muni) and overweight U.S. Short Term, as we expect interest rates to continue rising from exceedingly low levels. We added to the shift in our overall allocation to Alternatives, specifically maintaining the focus on Private Credit, Private Real Estate and Real Assets while adding an allocation to Hedge Funds.

Equities, Fixed Income and Alternative Investments — *As of September 30, 2021. Pending quarterly review mid-October. Source: Beacon Pointe Investment Committee’s Preferences.*

Chart of the Month – Equity Risk Premium

The equity risk premium (ERP) is the price of risk in equity markets. The ERP is the excess return earned by an investor when invested in the stock market over a risk-free rate, typically the 10-year U.S. treasury rate. The traditional approach of looking at price-to-earnings (P/E) is an absolute value approach which fails to compare the relative options available to an investor at any point in time. For instance, while the S&P 500 may look expensive on an absolute basis at ~21x forward earnings vs. historical averages, on a relative basis, the current 3.2% equity risk premium is in line with the 20-year average. With the risk-free rate (10-year U.S. Treasury yield) at 1.5% nominal yield (and negative real yield), U.S. equities appear relatively attractively valued. The relative valuation argument holds only as long as the 10-year yield remains low. Yields are affected directly by inflation expectations and monetary policy as dictated by the Fed, and so are all risk assets on a relative basis to the 10-year Treasury yield, the benchmark for the risk-free rate.

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October 2021

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