Global markets fell in Q3 as the post-COVID recovery showed signs of losing momentum in many parts of the world. Declining central bank support, inflationary pressures, geopolitical issues, and a repricing of global market risks pushed interest rates higher which weighed on both bond and stock returns. Domestically, politics and policy headlines dominated market sentiment as investors searched for a catalyst to help push equity prices higher but instead found the government adding to market volatility rather than quelling it. Overseas, China sparked a rapid risk-off shift in foreign markets. The government crackdown on the crypto and corporate sectors dragged Chinese equities into a bear market correction. Additionally, the default of real estate giant Evergrande stoked fears of a contagion fallout in Chinese property and global bond markets. With uncertainties mounting and the outlook for many recovery tailwinds showing signs of fading many markets slipped through September. Overall, the MSCI All Country World Index fell -1.5% and the Bloomberg Global Aggregate Bond Index fell -0.9%.
Q3 2021 Market Commentary
Domestic Equities
Domestic equities finished the quarter flat to down at the index level. Nearly all the drawdown for the quarter occurred in September. After hitting all-time highs, the markets were roiled by the Evergrande crisis in China, declining consumer confidence in the US, and the Federal reserve announcing plans to taper asset purchases and consider key interest rate hikes in 2022. Additionally, the potential gridlock on Capitol Hill led to concerns that the US would default on a debt payment before a budget could be approved, which according to Treasury Secretary Janet Yellen would, “trigger a historic financial crisis”. The combination of pressures on risk assets led to the first significant decline in domestic equity markets in nearly 18 months. Digging into factor performance, growth outperformed value for the quarter, but the outperformance was mostly due to higher relative returns in July and August. Value underperformed significantly for the quarter, but also held up better than growth during the September sell-off which was a sign that a market rotation was underway. At the sector level, financials led the way (2.7%) followed by utilities (1.8%) and healthcare (1.4%). Industrials were the worst performing sector (-4.3%) along with materials (-3.5%) and energy (-2.0%). Financials were the beneficiaries of rising interest rates, while utilities and healthcare gained from a shift-towards defensive positioning. Overall, the rapid rotation between factors and sectors intensified the shift towards risk-off sentiment and led to the S&P 500 returning 0.2%, the Dow Industrials losing -1.9%, and the growth and biotech heavy NASDAQ losing -0.4%.
Foreign Equities
Foreign equities generally underperformed versus the US with the MSCI ACWI Ex US Index declining -2.9% for the quarter. Performance was highly variable among developed and emerging markets as well as regions. Eurozone equities fell more than -2.0% for the quarter. Somewhat surprisingly, the index was dragged down by its largest economy, Germany, which declined -4.4% for the quarter. Like the US, Germany has been dealing with political issues after incumbent chancellor, Angela Merkel chose to not seek re-election. Germany was also susceptible to declining global growth projections given its position as a powerhouse manufacturer and exporter. Excluding Germany, the European Monetary Union (EMU) fell -1.2%. The region overall experienced sharp inflationary pressures through the end of the quarter because of massive supply shocks in natural gas which is a major input in European electricity production. UK markets outperformed the rest of Europe with returns of -0.2%. The Bank of England hinted at the need to adjust policy measures given inflationary pressures but held steady on rates. Ultimately, rates rose due to market pressures which helped value stocks and weighed on growth sectors. Rising rates were a benefit to the UK index given the overweight to both energy and financials which outperformed late in the quarter.
Japan was one of the best developed market performers during Q3. Japanese equities bucked the general trend lower during September and rose over 5% leading to total returns of 4.7% for the MSCI Japan Index. The rise was supported by a weaker Yen versus the US dollar. Japanese markets have a high negative correlation to their currency and as the global shift to risk-off assets triggered demand for the US dollar Japanese markets benefitted from the weak Yen tailwind. The markets were also supported by a growing backlog of corporate orders and capital spending plans which had been delayed during the pandemic but are now supporting improved corporate earnings expectations.
Emerging Market performance was dominated by the fallout in China but did include some bright spots for the quarter. Legislative and credit risks weighed on Chinese and periphery emerging markets. The government crackdown on the online education and gaming sectors led to severe selloffs in Chinese tech stocks. Shortly after, the news that Evergrande, one of the nation’s largest property developers, would default sent ripples of fear through the global bond and equity markets. Although the fallout from the government policies and Evergrande proved to be mostly contained to China the headlines intensified the shift towards risk-off assets through the end of the quarter. China’s large weighting in many emerging market indexes led to a decline for most EM benchmarks. The MSCI China Index fell -18.8% and the MSCI EM Index fell -8.8%. Brazil was another EM detractor, falling more than -22% for the quarter. Despite the heightened risk landscape and poor outlook for China, all was not lost in EM markets during Q3. Both India and Russia outperformed significantly with returns of 12.3% and 9.5% respectively. India benefitted from a rebound in consumer demand and easy money polices while Russia rose along with two of its main commodity exports, crude oil and natural gas, through the second half of the quarter.
Fixed Income
Fixed income markets were nearly as volatile as equity markets in Q3. Rates initially declined ahead of central bank meetings and pressure from diminishing global growth expectations. We then saw rates reversed course in many regions through the end of the quarter as pressures from inflation, the potential fallout from the Evergrande default, and the US debt ceiling issues were digested. On a global basis, more central banks have now been raising rates and pulling back on stimulus measures than cutting rates. This shift is important for bond markets because of inverse relationship between bond prices and interest rates, and for equity markets because of the positive correlation we have seen in central bank balance sheet growth and the equity markets in recent years. The result was a relatively flat return outcome for bond markets. Domestically, US rates jumped following higher than expected inflation readings and the Federal Reserve’s comments on reducing bond purchases and raising key interest rates. Additionally, the potential for a US default pushed rates higher through September but the Barclays US Agg Bond Index held on for a return of 0.1%. The global bond market fared worse than the US as the potential fallout in China was felt closer to home. Many foreign banks have significant exposure to the Chinese markets and fear of a systematic credit market decline led to spreads widening. The Bloomberg Global Agg Index fell -0.9% and the Bloomberg Global Agg Ex US Index fell -1.6%. Emerging market bonds were the worse performing subsector in the fixed income market which is unsurprising given the exposure to the Chinese bond market. The Chinese bond market sold off quickly after the Evergrande default as investors were rushing to get out of risky debt in case the issue proved to be more systematic of issues plaguing the entire Chinese real estate sector. Overall, the Bloomberg EM Local Bond Index fell -2.8% for the quarter. As rates rose on inflation expectations Treasury Inflation Protected Securities (TIPS) were one of the bright spots in the fixed income markets. TIPS are a long-duration asset, which means they are negatively impacted by rising rates, but they have the benefit of interest payments which are indexed to inflation. Signs that inflation may be stickier than policy makers originally forecast led to higher demand for this unique fixed income asset.
Alternatives
Keeping with the theme of other asset classes the Q3 return range for alternative assets was extremely wide. Losses ranged from -31.8% for the once high-flying precious metal palladium and positive 4.5% for the global crude oil benchmark, Brent. The dispersion was largely due to demand outstripping supply in the energy markets while the slowdown in China and a stronger US dollar weighed on both industrial and precious metals. Global energy markets were squeezed as demand exceeded supply for oil and natural gas. The pain was felt most acutely in Europe where natural gas prices rose exponentially for many countries. The spike resulted in rapid responses from governments to try and limit the inflationary pressures and potential hit to consumer spending if energy prices were to remain elevated throughout the winter. Russia stepped in to ease supply constraint fears, but the expectation of an ongoing supply and demand imbalance added significant momentum to energy prices heading into Q4. In the metals markets, industrial metals were hit by declining demand in China and fears that the real estate market fallout would lead to a contraction in future development projects. Copper was one of the hardest hit metals, falling -15.0%.
Precious metals, which have historically held up well during periods of inflation, also declined. The pullbacks were driven by a stronger US dollar and higher interest rates. Commodities are inversely correlated with the US dollar because a weaker dollar typically leads to more affordability and demand for commodities. Higher interest rates are a headwind for precious metals because many investors will begin shifting assets to yield generating fixed income positions rather than hold non-yield producing precious metals despite their propensity as an inflation hedge and risk mitigator. Gold fell -0.8% and silver fell -15.8%.
Real estate outperformed during the quarter. The sector was an equity market leader through August which helped lead to better quarterly returns despite significant declines in September. Overall, the FTSE NAREIT All Equity REIT index rose 0.2%. Domestically, the Dow Jones US Real Estate Index rose 0.8%. Digging into real estate, residential real estate was the strongest performer as demand for housing remained elevated and supply has not been able to keep up.
Hedge funds returns were positive overall but mixed at the strategy level. September was the best relative performance month for hedge funds. Four of the five major strategies generated positive returns compared with losses of -2.0% to -5.0% in equity markets. Overall, the HFRI Composite Index was up 1.4% for the quarter. Performance was driven by relative value and credit strategies which were up 1.2% and 0.8% respectively. Both relative value and credit strategies stand to benefit during periods of heightened volatility in equity and interest rate markets. The worst performing strategy was Event-Driven which declined -0.5%