Economic news: Q4 2021 investment outlook

Market news

At a glance

A positive environment for the economy and markets for the rest of 2021 remains our base case. Investors still have risks to face, including changing monetary policy, inflation and the continuing global coronavirus pandemic.

As we begin the year’s final quarter, we retain a positive outlook for diversified portfolios and economic growth. Despite a solid total return environment for many asset classes, especially traditionally riskier ones, the year’s final stanza will present some challenges to a generally placid investment backdrop. We are in a transitional time period, with the world adjusting to a persistent pandemic, potential changes to central bank policy that has been mostly pro-growth and markets digesting dogged inflationary pressures.

In the segments that follow, our investment leaders share their perspective across asset classes and geographies as we work to synthesize what may impact markets and your portfolio. As always, we appreciate your trust and welcome any questions you may have. Our best wishes for a safe and healthy end of the year to you and yours.

― Eric Freedman, Chief Investment Officer, U.S. Bank

Global economy

Quick take: Accelerating global growth through the third quarter reflected economic reopening after last year’s coronavirus shutdowns. Forward growth prospects are likely above average in the United States, while Europe and Japan return toward long-term averages. Emerging markets continue to combat coronavirus infections, leading to more mixed growth prospects.

Our view: The world entered a multi-speed economic recovery as COVID-19 vaccinations continue to grow and economies reopened. Our base case is for moderation in prices from well above-average levels. Supply shortages and coronavirus infections are key factors that could affect our expectations on both downside and upside.

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    • The United States is confronting policy risks as growth and inflation moderate toward longer-term average levels. We are probably past peak economic growth acceleration following the pandemic-induced shutdown, though the softer patch in 2021’s third quarter will likely lead to reacceleration into early 2022. Growth will likely remain above long-term average levels into 2022, then slow late in the year as fiscal stimulus benefits conclude. Inflation rates are likely to remain above long-term averages for much of the rest of 2021 before slowing toward the Federal Reserve’s (Fed) 2 percent target next year. The economy faces both positive and negative risks in the near term: First, the slow uptake in job openings could lift wages and drive inflation higher for longer as companies raise prices to compensate. Second, should shortages cause companies and consumers to abandon spending plans, prices could slip as activity falls.
    • Vaccination progress is helping developed markets’ recovery. Europe and Japan are in recovery after struggling to exit recession at midyear. An acceleration in vaccination rates allows more economic reopening, normalizing economic activity. Automatic economic stabilizers, such as generous unemployment assistance, mean there is less pent-up consumer demand as the economy reopens.
    • Despite an early recovery, emerging markets are still combating COVID risks. China and major emerging market economies escaped first from pandemic shutdowns and have moved into the more moderate growth expansion phase of the economic cycle, though limited vaccination rates are a headwind. Slower growth led China to loosen credit policies to support the economy, though it’s limited by increased regulation of key industries, including education, finance and technology. China appears likely to maintain its economic expansion, but at a slower pace than the past decade.

U.S. equity markets

Quick take: Factors that have recently helped propel equity prices higher may be on the cusp of changing, potentially fueling increased volatility while weighing on future performance. We retain a favorable outlook for equity performance as we look through year-end to 2022, though we anticipate more subdued returns compared to those experienced so far in 2021.

Our view: We maintain our “glass half-full” orientation for U.S. equities. Rising revenue and earnings, moderate inflation and relatively low interest rates support our outlook for rising U.S. equities into year-end and 2022.

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    • Broad-based sector performance reflects economic recovery and expansion. The S&P 500 ended the third quarter up 14.7 percent for the year, above the historical longer-term annual average of roughly 10.5 percent. All 11 S&P 500 sectors have generated positive returns, with nine rising 9 percent or more. The defensive-oriented Consumer Staples (up 2.6 percent) and Utilities (up 1.7 percent) sectors are lagging behind secular and cyclical growth sectors, which is customary during periods of economic recovery and expansion. Positive broad-based sector performance is typically indicative of a market that is poised to grind higher.
    • Earnings are trending toward record levels. Rising earnings are providing valuation support and the basis for U.S. stocks to trend higher. Analysts have revised consensus earnings estimates for S&P 500 companies in 2021 to more than $200 per share, up from approximately $165 at the start of the year, according to Bloomberg, FactSet Research Systems and S&P Global.
    • Below-extreme valuations support our glass half-full outlook. The S&P 500 ended the third quarter trading at roughly 21 times consensus 2021 earnings of $201, below the dot-com era extremes of nearly 30 times in 2000 and below pre-pandemic 2019 levels of roughly 28 times. According to Bloomberg and the U.S. Bureau of Labor Statistics, based on data extending back to the 1950s, price-earnings multiples typically don’t become compressed, resulting in lower equity prices, until periods of sustained inflation exceeding
      4 percent.
    • Equities remain an alternative for income-oriented investors. The relative attractiveness of dividend-paying equities over select fixed income alternatives remains favorable, helping support equity prices. At present, 42 percent of S&P 500 companies offer dividends yielding above the 10-year Treasury yield of 1.5 percent.
    • We continue to monitor risks for their potential to weigh on equity valuation and prices. Investors’ list of worries includes the impact of COVID variants on the pace of economic and earnings growth, inflationary trends that may prove to be sustained versus transitory, monetary and fiscal policy changes, and geopolitical events. The release of third quarter earnings results, along with companies’ forward guidance, are among immediate catalysts that we expect to impact equity prices into year-end.

International equity markets

Quick take: Foreign developed (largely continental European and Japanese) earnings estimates remain upwardly biased, providing the basis for prices to move higher. Performance has been broad-based ― 10 of 11 sectors have posted positive returns in 2021 and nine of the top 10 countries by index weighting have delivered double-digit gains for investors. Emerging markets’ modest year-to-date price gains belie the volatile path they have taken this year, in sharp contrast with domestic equities’ steady price performance.

Our view: Muted inflation, relatively low interest rates and still-accommodative monetary policies across Europe and Japan provide valuation support for foreign developed equities. Vaccine progress and China policy outcomes remain key catalysts for emerging market equities’ prospects, and we view return opportunities and virus/policy risks as reasonably balanced. A relatively stable dollar and continued global reopening amid vaccination progress support ongoing corporate profit growth recovery and future price appreciation.

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    • Foreign developed equities retain catch-up return potential relative to domestic alternatives. Due to relatively high exposure to economically sensitive sectors (Energy, Financials, Industrials and Materials), foreign developed equity performance is sensitive to investors’ future economic growth and inflation expectations. Foreign equities finally eclipsed the previous all-time high set all the way back in October 2007, suggesting investors have not yet fully priced in the region’s recovery potential if vaccination progress continues and the global economy continues to recover and reopen.
    • Vaccination progress is driving economic reopening and equity performance in foreign developed markets. Authorities have administered at least one vaccine dose to 73 percent of France’s total population and 65 percent of Germany’s, and the recent Delta variant surge appears to have crested in Japan. Cyclical sectors have delivered double-digit year-to-date performance gains, as has the Consumer Discretionary sector, which reflects relaxed activity restrictions and consumers’ increased mobility and confidence.
    • Diversified investors need to consider rule of law when allocating assets across the globe. In the United States, regulatory and other policy changes that impact capital markets are infrequent and often relatively well telegraphed. Over the past year, China’s regulatory authorities have asserted greater control over key industries, highlighting the additional rule of law risks that investors in emerging market equities must navigate and the additional policy uncertainty, or risk premium, they price across emerging markets.
    • China’s policy outcomes remain a key factor for emerging equities’ fortunes as we conclude 2021 and look toward 2022. Despite emerging markets’ heterogenous country makeup, spanning Asia, Latin America, Africa, Europe and the Middle East, Chinese-domiciled companies comprise the largest proportion of emerging markets’ country exposure, and China’s largest publicly traded companies are consumer-oriented e-commerce, mobile gaming and social media enterprises at the center of regulators’ recent scrutiny.

Bond markets

Quick take: Growing consensus for the eventual removal of Fed policy stimulus didn’t disrupt bond returns in the third quarter. Coupon income paired with small increases in bond prices drove positive returns across the fixed income market. Bonds with longer-term maturities outperformed as the market began pricing in additional interest rate hikes in coming years, dampening longer-term growth and inflation expectations.

Our view: We continue to see opportunities in riskier bonds with higher current income, with a focus on niche sectors like non-agency mortgage-backed securities, bank loans and some additional high yield bonds. Traditionally safe bonds like Treasuries and agency mortgage-backed securities are less attractive due to their low absolute yields and risk of rising yields (falling prices), particularly if Fed asset purchase reductions come to fruition by year-end.

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    • Limited income from low Treasury yields and gradual reductions in Federal Reserve asset purchases dampen our Treasury return outlook. The Fed is unlikely to raise interest rates until mid-2022 at the earliest, but it will likely begin trimming asset purchases later this year. We expect longer-term bond yields to rise modestly, but rates are unlikely to return to historical averages in the near term. Treasuries and other high-quality fixed income options like investment-grade corporate and municipal bonds provide important portfolio diversification, but we see opportunities to hold larger-than-normal allocations in riskier (but well-diversified) higher yielding bonds for additional income but not necessarily price gains.
    • The ongoing economic recovery should lead to riskier high yield bonds outperforming, despite fully valued investment-grade corporate bonds. Investment-grade and lower-quality bond yields remain near all-time lows due to strong credit fundamentals and low default expectations. Alternate sources of yield offer better value, such as corporate loans and mortgage bonds not backed by the government (non-agency). Loans are good substitutes for corporate bonds, considering similar borrowers, reasonable valuations and less sensitivity to Treasury yields. Non-agency mortgages offer a compelling source of yield and limited risk exposure to rising interest rates. They also sport strong fundamentals driven by rising home prices, which serve as loan collateral, homeowners with strong balance sheets and high savings and improving payment histories.
    • Municipal bonds provide a valuable source of non-taxable income, though yields are low versus history. Credit fundamentals have strengthened from tax revenues that rapidly improved, already recording a new high of first quarter state and local tax collections. Strong investor demand for tax-advantaged income relative to limited municipal bond issuance supports municipal bond prices. We continue to recommend somewhat higher-than-normal allocations to high yield municipal bonds for highly taxed investors, though the focus remains on capturing income rather than anticipating price gains. We also emphasize credit selection, considering the degree of idiosyncratic risks inherent in the high yield municipal market.

Real assets

Quick take: Real Estate was among the top-performing equity sectors in the third quarter, benefitting from improving fundamentals. The third quarter slip in commodity prices reflected near-term growth concerns, though supplies remain relatively tight across key markets.

Our view: Growth resulting from a return to a somewhat normal economy should be a positive for property prices, though rising interest rates will likely limit investor returns. In contrast, cyclical commodities prices are likely to continue their rise as long as growth remains solid, given relatively tight supplies for energy and metals markets.

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    • The economic backdrop should be supportive for property prices, though excess capacity continues to exist in retail and office properties. Landlords may struggle to raise rents across many commercial property markets. Additionally, the secular growth Real Estate properties ― cell towers, data centers and industrials ― appear priced to perfection. If interest rates rise too far, incomes relative to property prices could become dislodged from their historic low levels and move higher, hurting investor returns.
    • An economic expansion should be a favorable backdrop for commodities and commodity producers. Tight supplies reflect limitations on oil exporting countries’ output and improved cash flow stewardship among U.S. shale oil producers. Ongoing global economic recovery should continue to modestly lift prices despite planned output expansion from oil exporting countries.

Alternative investments

Quick take: Hedge funds are generating some of their strongest returns in years in 2021 due to tactical positioning around economic and capital market trends. These have targeted inflation expectations, reopening beneficiaries and changes in investor capital allocations, such as the willingness to pay a premium in search for yield. Hedge fund managers aim to hold onto the strong returns in 2021 by staying nimble.

Our view: Modest volatility creates an attractive investment environment for hedge fund strategies. We expect greater market divergence and opportunities among interest rates, credit and equities as the global economy emerges from COVID-19. Hedge fund managers may be quicker to cut unprofitable positions in the fourth quarter to hold onto gains made earlier this year.

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    • Hedge funds have favored companies expected to benefit from economic reopening. They also rotated away from those companies at times to strategically pursue quality and value opportunities. Healthcare, Energy and Materials are notable sectors that have been targeted and fallen out of favor this year.
    • Increased regulatory rhetoric and lack of edge in gauging future policy outcomes has made hedge funds especially reluctant to invest in China. Hedge fund strategies have reduced their holdings in a variety of the country’s sectors and neighboring countries, and also selectively added to short positions — investments that stand to gain if asset prices fall.

Private markets

Quick take: Upward-trending equity prices continue to support an active initial public offering (IPO) market. The IPO market has already posted the busiest year since the dot-com era in 2000. Technology sectors’ strong performance is encouraging more private companies to go public, with almost half of IPO proceeds this year allocated to technology companies. Meanwhile, Special Purpose Acquisition companies (SPACs) have faced headwinds from new regulation and federal investigations into recent mergers.

Our view: We expect heightened IPO activity through year-end, assuming equity markets remain strong. Despite some early challenges, new SPAC issuances should continue as regulatory changes enhance investor confidence in overall governance. Both routes remain viable options for companies seeking access to public investors and to generate liquidity for private equity investors.

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    • Our themes around digitization and healthcare innovation remain intact. Secular trends and healthcare and technology advancements continue to support a strong pipeline of private companies creating or reshaping markets ripe for transformation.
    • The Financial sector presents attractive private equity opportunities. Consolidation within the industry, digital transformation and technological innovation is creating efficiencies, expanding markets and introducing new product offerings — all conducive to private equity investing.

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This commentary was prepared September 2021 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.

U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The S&P 500 Total Return Index includes the same stocks but include the reinvestment of dividends. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Reinsurance allocations made to insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies. Special Purpose Acquisition Company (SPAC) managers may be unqualified or incompetent, a risk made more pronounced by lack of any operating history or past performance of the SPAC. There is a risk that an acquisition may not occur, and the investment may decline in value even if the acquisition is completed.

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