United States

Concerns about elevated inflation took center stage as the focus shifted away from Federal Reserve tapering and key legislation.

U.S. equity markets continued to show resilience, recovering from the shallow 5% pullback in September and pushing toward new all-time highs. The S&P 1500® posted its largest monthly gain since Nov. 2020, increasing 6.8% as markets moved steadily higher throughout the month. Investors focused on third-quarter earnings season, lingering supply chain bottlenecks and an intensifying global energy crisis, while uncertainty surrounding monetary stimulus tapering, debt ceiling maneuvers and key legislation remained in the background. We maintain our view that markets will remain in a high-volatility regime as COVID-19 persists, economic data moderates and we approach a shift in fiscal and monetary policy.

The S&P 500® rebounded in October, gaining 7.0% during the month, adding to its 24.0% year-to-date gain. 

At seemingly opposite ends of the spectrum, both mega-cap tech and interest-rate sensitive stocks led large-cap stocks higher as interest rates moderated during the month, helping the growth style edge out value by almost 4.5% as more defensive stocks lagged during the equity rally. Small-cap stocks also gained, rising 4.3% and recovering their losses from the third quarter. However, a resurgence in COVID-19 cases has weighed on supply chain-related small-cap companies since June.

Investors are growing skeptical of the “transitory” characterization of rising inflation as continued increases test this view. We believe increasing inflation is due primarily to labor shortages and supply chain constraints that emerged because of the pandemic. Therefore, the duration of elevated inflation is likely dependent on one driver: COVID-19. The Delta variant not only delayed the global reopening process, but several Asian countries also had “zero-COVID” policies until recently, resulting in periodic lockdowns and compounding already strained global supply chains. As economic reopening resumes, we expect labor shortages to ease and supply chain bottlenecks to resolve with price levels likely to respond in kind (please see our recent publication Inflation Vibrations for more details). 

In addition to inflation, other economic datapoints continue to be impacted by the path of the pandemic including last month’s sizeable payroll miss and a weaker third quarter GDP estimate. September U.S. job growth was revised from 194,000 to 312,000 and the October report came in above expectations, adding 531,000 jobs. The Consumer Price Index came in above 5% for the fifth consecutive month as prices for fuel, durables and used vehicles increased, and oil prices reached their highest level since 2014.

Long-term interest rates began to moderate mid-month as legislators reached an agreement to avoid a government shutdown and extend the debt ceiling. As the prospects for significant fiscal stimulus were pushed out until later in the fourth quarter, investors pivoted their attention to third-quarter earnings season to gain insights into future growth trends, supply chains and labor markets, all of which could impact consumer sentiment and future economic strength.

Third-quarter earnings season passed the halfway point with 65% of S&P 500 constituents having reported. The blended earnings growth rate (actual growth rate combined with consensus estimates) is 37.8%, an improvement from the 27.5% growth rate estimated at quarter end. Fourth-quarter earnings revisions have increased to 21.5% from 18.6% at the end of the third quarter. The 2021 consensus earnings growth estimate has increased to 44.8%, while 2022 estimated growth has declined to 8.2%. Notably, investors appeared to look past disappointing results and guidance from Amazon.com, Inc. and Apple Inc., which we believe speaks to the underlying strength and breath of the market. 

Economic data continues to indicate we are in an accelerating expansion phase of the business cycle, although recent data has shown signs of moderation. Equity valuations remain high relative to history, as the S&P 500 forward price-to-earnings ratio (P/E) moved modestly higher, ending the month at 21.2 times (x) compared to the 10-year average of 16.4x. The Russell 2000 P/E traded lower to 25.3x but remains above its 10-year average of 22.8x. The exception is the S&P 400 MidCap®, where its forward P/E of 16.4x is below its 10-year average of 16.7x. As a result, large-cap equities are at their most expensive level relative to mid-caps over the past 10 years. We continue to believe upward revisions in 2022 earnings estimates are necessary across the board to justify valuations at their current levels. 

After moving 53 basis points (bps) to top out at 1.70% on Oct. 21, the 10-year U.S. Treasury (UST) moved lower to end the month at 1.55% (Figure 1). Yields remain above major technical support levels. We believe recent increases in the 10-year UST yield indicates a higher probability of a new round of fiscal stimulus, but at a far lower level than initially proposed by President Biden in March. The breakeven yields at both the 5- and 10-year level moved higher in October and remained above their 50-day and 200-day moving averages, indicating expectations for additional fiscal stimulus-induced inflation.

Figure 1: 10-Year U.S. Treasury Yield, % 
Yields dipped on prospects of fiscal stimulus


Source: Bloomberg, L.P.

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The UST yield curve flattened further during October, with the spread between 2- and 10-year yields falling to its lowest level since mid-August. The 2-year UST rose to its highest level since March 2020 as investors await the Federal Reserve’s (Fed’s) widely anticipated announcement about the tapering of its quantitative easing program that began in March 2020.

The Bloomberg U.S. Aggregate Index was largely unchanged, while credit spreads remained near their lowest level since 2007 across both investment grade and high yield corporate debt. We believe the ongoing quest for yield in fixed income is causing investors to increase their risk exposure in exchange for incremental income, thus driving down yields and spreads in corporate credit. While credit spreads should in fact be declining in the accelerating expansion phase of a business cycle, we believe fixed income valuations are more stretched than equities. We continue to question if investors are being fully compensated for the additional level of risk.

Volatility remains high in cryptocurrency markets, with Bitcoin pushing above its all-time high of nearly $66,000 as the first bitcoin exchange-traded fund launched on Oct. 19. 

Bitcoin finished the month at $61,000, a gain of more than 100% since falling below $30,000 in July, rising above its 50-day and 200-day moving averages. It has now surpassed the peak levels last seen in April, which was prior to moves by China and the United States to tighten regulations and increase tax compliance on cryptocurrencies.

Developed International Markets

Equities delivered strong performance despite geopolitical concerns.

The MSCI World ex USA Index delivered its best monthly performance since May, but a look under the hood shows a tale of two backdrops. On one hand, like domestic markets, European stocks focused on an encouraging earnings season, and all developed Eurozone countries posted positive returns on the month. On the other hand, Japan, the largest index component by market capitalization, was down 3.4%, its lowest monthly return since March 2020.

With third quarter earnings season underway, the blended earnings growth rate is currently 48.9%. While this level is strong on an absolute basis, for perspective, more than half of that growth is from just two sectors, Industrials and Energy. 

Guidance from companies reporting earnings suggests global supply chain issues have hit developed international markets particularly hard, although the ongoing demand recovery appears promising.

Japanese equities declined on concerns that the newly elected Prime Minister Fumio Kishida’s party won with the smallest majority in nearly 10 years. In our view, this narrow margin will make it more difficult for the National Diet to pass new measures to support Japan’s economy, which has been struggling during the pandemic.

In Germany, while still unofficial, Social Democrat (SPD) Olaf Scholz is on his way to succeeding Angela Merkel as chancellor. The more important near-term focus is on forming a coalition government, as the Social Democrats did not receive enough votes in the latest election for an outright majority. As it stands, a potentially fragile three-party coalition is forming between the SPD, the Free Democrat Party and the Greens. We continue to monitor political developments as a splintered federal government in Germany could affect the policy leadership Europe has been accustomed to for nearly 20 years. 

The MSCI World ex USA Index delivered its best monthly performance since May, but a look under the hood shows a tale of two backdrops. On one hand, like domestic markets, European stocks focused on an encouraging earnings season, and all developed Eurozone countries posted positive returns on the month. On the other hand, Japan, the largest index component by market capitalization, was down 3.4%, its lowest monthly return since March 2020.

With third quarter earnings season underway, the blended earnings growth rate is currently 48.9%. While this level is strong on an absolute basis, for perspective, more than half of that growth is from just two sectors, Industrials and Energy.

Japanese equities declined on concerns that the newly elected Prime Minister Fumio Kishida’s party won with the smallest majority in nearly 10 years. In our view, this narrow margin will make it more difficult for the National Diet to pass new measures to support Japan’s economy, which has been struggling during the pandemic.

In Germany, while still unofficial, Social Democrat (SPD) Olaf Scholz is on his way to succeeding Angela Merkel as chancellor. The more important near-term focus is on forming a coalition government, as the Social Democrats did not receive enough votes in the latest election for an outright majority. As it stands, a potentially fragile three-party coalition is forming between the SPD, the Free Democrat Party and the Greens.

Eurozone vaccination rates now exceed those of the United States, potentially supporting a rebound in travel and hospitality. However, a variety of higher-frequency data, such as OpenTable seated diners, have yet to show a meaningful improvement. In fact, some more traditional economic data show the fastest part of the economic recovery may be behind us. For example, the Eurozone Markit Composite PMI of Manufacturing and Services fell to 54.3 in October, a notable downtrend from the peak in July (Figure 2). In addition, the Citigroup Eurozone Economic Surprise Index, which measures data surprises relative to market expectations, fell to the lowest level since June 2020. In our view, this indicates earnings revisions for the fourth quarter may have limited upside in the region.

Figure 2: Markit Eurozone Composite PMI
Eurozone PMI has been flagging since its peak in July


Source: Bloomberg L.P.

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On a year-over-year basis, Eurozone inflation has increased to 4.1%, matching the strongest level on record, reached in the summer of 2008. In our view, the situation is similar to the United States in that the base effects from last year and short-term supply chain disruptions in a variety of industries have boosted prices as COVID-19 continues to linger. Industrial powerhouse Germany is leading inflation higher, with its latest reading of 4.5%, the highest since the early 1990s. 

While the inflation spike will be relatively short term, elevated prices have many investors looking to the European Central Bank (ECB) for potential action. Thus far, ECB President Christine Lagarde has struck a similar tone to that of Fed officials, insisting rapidly rising inflation will be transitory.

As part of its plans to pursue a two-year research stint into the viability of a central bank digital currency, the ECB announced in late October the members of a new digital euro advisory group. The group is set to advise the ECB on the potential creation of a central bank digital currency. We believe this initiative reflects a broader move toward exploring ways to leverage blockchain technology to implement monetary policy more efficiently.

Emerging Markets

Investors shrugged off real estate headline unease as earnings season ramps up.

The MSCI Emerging Markets Index delivered positive returns as Chinese equities had their best monthly return since January. Just three out of 11 sectors had positive returns for the month, with the majority coming from Consumer Discretionary as Chinese equities rebounded from September’s 5% decline.

A few notable emerging market (EM) economic reports came in below consensus estimates during the month. In China, the October manufacturing PMI was 49.2, the lowest reading since Feb. 2020. While a reading below 50 suggests markets are contracting, we believe it is a short-term function of supply chain shortages that continue to be impacted by the pandemic.

Brazil, the largest economy in South America and more than 4% of the EM Index, not only surprised to the downside, but also had negative year-over-year growth rates. It is important to note the data from Brazil is on a one-month lag compared to U.S. reports, meaning it reflects data from August when COVID-19 cases were having a significant impact on economic activity in South America. We expect this trend to subside in coming months.

Earnings season is underway in EM, and with the blended growth rate of 37%, reports are surprising to the upside by an impressive 5,700 bps. 

With these strong beat rates, the earnings growth rate for EM continues to be not only the strongest compared to the S&P 500 and MSCI World ex USA but is now above 60% for calendar year 2021. While the strong growth rate for 2021 is lowering that of calendar year 2022, looking even further to 2023, growth is resumes its upward trend, confirming a strong earnings outlook for EM. 

The Chinese real estate market remains under investor scrutiny, as headline risks caused the sector to decline nearly 6% during the month, with embattled developer China Evergrande Group declining more than 20% in October. While Evergrande managed to meet all its October interest payments, investors remain concerned about a $2 billion bond that matures in March. From an earnings perspective, the Real Estate sector delivering positive growth in the third quarter and revisions for both the fourth quarter and calendar year 2022 are moving higher. 

Energy prices have climbed higher over the past two months in part due to supply-demand imbalances, but also due to the surprise oil production agreements from OPEC+ (Figure 3). The Bloomberg Commodity Index was up a second month in a row, as the price of Brent crude reached its highest level since 2014. Many investors have expected members would increase energy production in recent months; however, the group has kept its daily 400,000 barrel increase unchanged despite growing shortages in Europe. Potential changes to the OPEC+ production agreement remain a key factor holding oil prices at these elevated levels.

Figure 3: Brent Crude Oil Spot Price, $/Barrel
Brent prices at the highest level since 2014


Source: Bloomberg L. P.

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TEXT VERSION OF CHARTS

Figure 1: 10-Year U.S. Treasury Yield, % Yields dipped on prospects of fiscal stimulus (view image)

Date Treasury Yield
10/29/2021 1.55
9/29/2021 1.52
8/30/2021 1.28
7/29/2021 1.27
6/29/2021 1.47
5/28/2021 1.59
4/29/2021 1.63
3/29/2021 1.71
2/26/2021 1.40
1/29/2021 1.07


Figure 2: Markit Eurozone Composite PMI Eurozone PMI has been flagging since its peak in July (view image)

Date Eurozone PMI
10/30/2021 54.3
8/31/2021 59.0
6/30/2021 59.5
4/30/2021 53.8
2/28/2021 48.8
12/31/2020 49.1
10/31/2020 50.0
8/31/2020 51.9
6/30/2020 48.5
4/30/2020 13.6
2/29/2020 51.6
12/31/2019 50.9
10/31/2019 50.6
8/31/2019 51.9
6/30/2019 52.2
4/30/2019 51.5
2/28/2019 51.9
12/31/2018 51.1
10/31/2021 53.1


Figure 3: Brent Crude Oil Spot Price, $/Barrel Brent prices at the highest level since 2014 (view image)

Date $/Barrel Brent Price
10/29/2021 84.38
10/29/2020 37.65
10/30/2017 60.90
10/28/2016 49.71
10/29/2015 48.80
10/29/2014 87.12