After months of gains, September marked the first time since January that the U.S. stock market failed to end a month at a higher point than it began. Uncertainty surrounding a large Chinese property developer caused market jitters and sent U.S. stocks down nearly 3% intraday. The US market mounted a recovery in just three trading days, but then higher interest rates in the final few days of the month triggered another stock selloff. For the entire month of September, US large cap stocks fell 4.6%, US small caps declined 2.9% and international stocks decreased by 2.8%.
Bonds were not immune to rising interest rates, nor the related losses; the Bloomberg U.S. Aggregate Bond Index fell 0.9% last month. For some time, we have been concerned about the interest rate risk embedded in long-term bonds. Accordingly, we positioned our fixed-income portfolios to mitigate the risk from rising interest rates. This strategy has shown merit for both September and 2021 as a whole. The overall bond market has fallen while our clients’ bond exposure shows positive returns. Owning inflation-hedged bonds has been important for performance, too.
The subject of inflation is a long and complicated one, and it has been a quiet driver of this recent volatility. Year-over-year inflation numbers, as measured by the urban consumer price index (CPI-U), sit above five percent now, as they have for the past four months. Central banking officials, both in the U.S. and abroad, have repeatedly stated that high inflation is due to supply disruptions caused by the pandemic. In our opinion, supply chain disruptions will be resolved eventually, and pricing pressures will ease as the economic recovery progresses and abnormally high GDP growth rates subside. That is the good news. More troublesome is the persistent labor shortage and how governments around the world have swelled demand with fiscal deficits. In the U.S. specifically, surging rental costs are a striking example that is not yet being fully acknowledged. According to our calculations, had rental prices been fully reflected in the latest CPI data, the August yearover- year inflation number would have been about 7.5%, not 5.3%.
This elevated inflation has made our allocation to Treasury Inflation-Protected Securities (TIPS) in our fixed income portfolios fortuitous. Year-to-date, TIPS have outperformed the overall bond market by nearly 6% as inflation numbers have been higher than market expectations. Historically, it has been easier to hedge against inflation with stock exposure. Even so, we have been mindful of our exposure to technology stocks. When interest rates rose in January, the technology-heavy Nasdaq underperformed the U.S. market by over 7 percentage points through May. Then when interest rates fell again, the Nasdaq made up all its lost ground to match the U.S. market’s return. With this end-of-September increase in interest rates, the Nasdaq once again underperformed the U.S. market by about 2% and it would not surprise us to see this dynamic persist.