The S&P 500 continued to reach new all-time highs in the third quarter as investors looked for a return to a pre-pandemic world. It was a similar story for small and mid- cap stocks, although their performance was mostly flat after record runs in the first half of the year. Stocks in general benefited from a positive combination of the economic recovery and accommodative policies from the Federal Reserve. This quarter wasn’t entirely smooth sailing, though, as volatility sharply picked up during the final few weeks of September.
Stocks moved steadily higher to start the quarter as the vaccine rollout lifted the economy to near pre-pandemic levels, which in turn led to another round of solid corporate earnings. The mood changed late in the quarter, however, as three forces descended on the economy. First was a realization that the vaccine effectiveness wasn’t turning out as hoped and whether that meant more lockdowns were in store. To a lesser extent, the second economic trouble spot involved manufacturing. Supply chains still haven’t returned to normal and there have been serious shortages of key parts impacting companies’ ability to ship products. Lastly, the budget fight in Washington is putting into question the government’s finances.
The last few days of the third quarter had a substantial impact on quarterly index returns. For the majority of the third quarter, the Nasdaq had solidly outperformed both the S&P 500 and the Dow Jones Industrial Average as investors continued a trend from the second quarter by moving to less economically sensitive large-cap tech shares. However, during the last week of the quarter, as global bond yields rose, there was heavy selling in tech shares as investors rotated into other market sectors. The Nasdaq still slightly outperformed the S&P 500 while the Dow Jones Industrial Average produced a negative return for the third quarter thanks to the late September sell-off.
By market capitalization, large-cap stocks outperformed small-cap stocks in the third quarter. In fact, small-cap stocks had a negative return for the quarter as rising COVID-19 cases, mixed economic data, and the prospects of eventually higher interest rates caused investors to favor large-cap stocks as the outlook for future economic growth became less certain.
From an investment-style standpoint, growth outperformed value in the third quarter, thanks to tech sector gains, although the amount of that outperformance shrunk considerably during the final week of the quarter as tech shares declined.
Looking forward to the fourth quarter, we believe the stock market will hold on to the current gains, but there are still enough policy concerns that it’s likely going to be a bumpy ride for the next couple of months. It’s a different story for the bond market. The Federal Reserve has indicated that it will begin to taper quantitative easing in the fourth quarter, but no one knows when exactly the Fed will start to scale back those asset purchases. The pace at which they implement those changes could have a significant impact on bond prices and thus yields.
Inflation is another subject the bond market is going to have to deal with. Inflation ran at a fresh 30-year high in August as supply chain disruptions and high demand fueled ongoing price pressures. This is on top of massive deficit spending. The core personal consumption expenditures price index, which excludes food and energy costs and is the Federal Reserve’s preferred measure of inflation, increased 0.3% in August and was up 3.6% from a year ago. That’s the highest increase since the early 1990s. The Fed has stated that these pressures are temporary, but we don’t think so.