Key takeaways

• Pent up demand and a strong backdrop for jobs should provide momentum.
• Persistent inflation may challenge the Federal Reserve’s (Fed) policy outlook.
• High valuations reduce the margin of error. 

Markets rallied through July and August, but concerns bubbled just below the surface

The private sector looks well-positioned to take the baton from policy makers. But we believe the easiest wins are behind us, and the combination of slowing, but above trend growth and inflation is tricky. 

Despite a spurt of late-breaking volatility, most asset classes ended with a positive return for the quarter. Markets rallied through July and August, but concerns bubbled just below the surface. With many asset classes priced to perfection coming into September, news about the collapse of a shaky real estate developer in China prompted a spike in volatility that brought other fears to the fore. Markets ended the quarter on somewhat of a sour note as investors focused on negatives like high inflation, slowing growth and public policy dysfunction. While the S&P500^® eked out a gain, tech stocks lagged on fluctuations in rates, and small caps fell on a weaker outlook. Credit held in well as investor demand continued despite heavy issuance and higher volatility. Once again, high quality assets underperformed as carry lifted returns on lower rated bonds. Commodities logged a strong performance as supply and demand imbalances persisted.   

Easy wins seemed to fade during the quarter, but the outlook remains solid even as supply chain bottlenecks and a resurgence of COVID added headwinds. Over the quarter, consensus growth declined from 7% to 5%¹, as data fell short of lofty expectations for rapid normalization. Consumers were discouraged by a dramatic uptick in housing prices as demand outstripped the supply of homes and rental units. Bottlenecks were everywhere as pent-up demand strained the supply chain, and pricing of everything from inputs to end products rose. Labor shortages, caused by a lack of childcare, enhanced unemployment, and the emergence of the Delta variant, added sand to the gears of the economy. While companies are signaling further price increases, earnings may come under pressure in some sectors. Despite these challenges, the economy surpassed its pre-pandemic size, even after factoring in inflation.

With fiscal support waning, we believe the private sector needs to pick up the slack. Fortunately, available vaccines have been effective, schools reopened as planned, and plenty of jobs are available for returning workers. Signs point to a successful transition. While the unemployment rate remains elevated at 5.2%,² reported job openings exceed unemployed workers. Growth is likely to remain well above trend next year, and the economic outlook remains strong by historical standards.

Policymakers are under pressure to square easy monetary policy with higher-than-expected inflation

Atlanta Federal Reserve Bank data indicates that job switchers are notching solid raises compared to those who don’t change employers. Gains by hourly workers are surpassing those of college-educated professionals.   

Policymakers are under pressure to square easy monetary policy with higher-than-expected inflation, raising uncertainty around the pace of tightening. So far, Fed officials are sticking to their playbook, and monetary policy was unchanged in the quarter. In a speech at the Jackson Hole Symposium in August, Jerome Powell all but announced that the Fed is ready to taper its bond buying later this year as long as payroll growth remains steady. However, he took pains to separate the decision to taper from the decision to hike rates which he won’t support until the labor market recovers fully. While acknowledging higher than expected inflation, Fed staff still believe that price increases are largely transitory, though cracks are emerging within the Federal Open Market Committee.   

As solid growth and higher than expected inflation challenge investors’ fortitude, market participants are looking for a steady hand. Instead, Washington seems to be doing everything in its power to introduce volatility. The lack of action on a measure to increase the debt ceiling to accommodate previous appropriations reflects poorly on our political process, though no one seriously suspects the US will default. Democratic infighting is slowing the introduction of a much-needed infrastructure bill and the president’s human capital initiative. Republicans are digging in their heels and looking for opportunities to make the opposing party go it alone. Jerome Powell is up for reappointment in the early spring, and the administration hasn’t yet signaled its intentions. Adding to self-inflicted wounds, two Fed governors stepped down in the wake of questions around personal trading, adding even more turnover at the central bank.  

We expect solid but decelerating growth at the same time inflation may be stickier than expected. With fundamentals likely to hold up, this is not a bad backdrop for risk assets, but a steady hand from policymakers is needed to wind down unconventional supports. While we don’t expect a massive overshoot, inflation risks are to the upside compared to expectations for a quick return to normal. Rates do not reflect a premium for this uncertainty, and some assets are still priced to perfection. Volatility at the end of the quarter was a sign that investors are less certain about how this transition will play out, and continued surprises may roil markets.