Third Quarter Recap

Economy Heats Up Then Levels Off

The third-quarter rebound in the U.S. economy, which will be reported at the end of October, was likely over 30%, a sharp turnaround from the 5% and 31% falloffs in the first two quarters. Even so, the economy may not fully return to pre-pandemic levels until the middle of next year. However, housing and capital spending have essentially made up all their lost ground. The rebound in capital spending, which is centered on technology investment, bodes well for productivity growth. Higher productivity could keep inflation low and help corporate margins advance.

As the quarter ended, there were signs the recovery may be leveling off. The COVID-19 economy has become increasingly more bifurcated between tech-sensitive industries that benefit from the work-from-home trends and those dependent on direct consumer engagement. The global resurgence of the virus has hindered reopenings and full consumer re-engagement in the travel, leisure and retail industries.

While nationwide lockdowns are not likely, any targeted or regional closures would further delay the reopening of certain sectors and prolong current capacity restrictions. In addition to infection and mortality rates, government officials are keeping a close eye on hospital utilization rates to get a better sense of the strain on the health care system.

Key Market Drivers

Equity Markets Lose Some Momentum

In August, U.S. equity markets moved to new record highs, more than recovering from the previous quarters’ sharp losses. This rebound was followed by a 10% correction in September, which many investment professionals view as a healthy occurrence. That said, the correction could also be a harbinger of coming stagnation in economic growth, and likely reflects the impact of a second virus wave and the deepening partisan political divides.

Growth stocks outperformed value stocks again during the quarter. The price premium has increased for companies that can consistently grow revenues in this uneven recovery. Better breadth of market participation would signal greater market health. But even with the September correction, there was no discernable rotation to the more value-oriented, cheaper sectors of the market.

Our Perspective

Equity Markets


  • The U.S. equity market is trading at approximately 23x 12-month earnings estimates, which may seem expensive. However, with low interest rates across the yield curve and growing confidence that earnings will continue to advance into 2021, the current valuations appear reasonable.
  • European equities decoupled from the other developed markets with notable relative underperformance and, in some cases, negative total returns. This poor performance was likely due to the strong euro and the more virulent second wave of COVID-19 in this region.
  • Chinese markets have performed well thanks to the strength of the country’s economic recovery. The advances in the Chinese market and a rebound in commodity prices have helped emerging markets match the rise in U.S. equities.
  • Japanese equities also benefited from the performance in Chinese markets, producing positive but more muted returns.
Bond Markets

  • Yields across the Treasury curve barely budged during the quarter. The Fed’s forward guidance may have taken some of the mystery and uncertainty out of forecasting where bond yields are headed.
  • While the high-yield market has benefited from the economic recovery, investors should remain cautious as weakness in energy markets and the travel, leisure, and retail sectors may lead to more credit downgrades and outright defaults.
  • Emerging market debt had virtually the same return as the U.S. high-yield market but for different reasons. The declining dollar helped boost the currency return in these debt markets. Other drivers were the relative strength of the Chinese economy and some stabilization in oil prices.
  • The dollar was weak against a trade-weighted basket of currencies for much of the quarter. This weakness could merely be a function of strong global equity markets, which have attracted dollar-based investors to foreign markets. It could also be due to the Fed’s new average-inflation targeting policy. The lower dollar could have a slightly positive impact on the earnings of U.S. multinational corporations.

Monetary Policies/Currencies

  • After providing massive liquidity injections to essentially guarantee liquidity in the bond markets, the Fed announced it’s implementing an average-inflation targeting policy. This approach will let inflation run above the 2% target to compensate for the many years it has fallen short of this level.
  • While the Fed would prefer not to move to negative interest rates, it has signaled a willingness to stay at a virtual zero rate for at least the next few years.
  • Other central banks worldwide will likely match this policy with some, such as the Bank of England, seriously contemplating negative rates to match those on the continent.
  • With monetary policy mainly impacting liquidity and apparently unable to stoke demand, another dose of fiscal policy is likely necessary to replace lost incomes and support struggling businesses in what has been dubbed a “K-shaped” recovery. Unfortunately, the outlook is not promising, given the intense partisan battles over the scope of the fiscal package.

What This Means for Investors

With an apparent plateau in economic growth, equity markets seem to be keying in on other potential risks. The intensity of the presidential election season may provoke some near-term volatility. However, we again remind investors that political issues pale in comparison to the analysis of the economy in attempting to discern longer-term market direction. Trade risks do not appear to be as market moving as they were last year. But growing tensions with China could revive talk of tariffs and other trade barriers. The progression of the virus going into flu season is likely the most significant risk to the markets. Optimism over the development of an effective vaccine by year-end may be misplaced, with the economy still having to adapt to virus surges and continued restrictions. It’s more realistic to expect full consumer re-engagement and complete economic recovery sometime in 2021.

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