Seasonal trends may shift to become a tailwind
Stagflation scares overblown as economy remains resilient
Comparison to 2011 debt ceiling crisis misplaced
The fall season began a few weeks ago, and while the leaves and temperatures may be shifting in parts of the country, market volatility has still been bringing the heat. The growing list of concerns—Delta-induced slowing economic momentum, China’s Evergrande default possibilities, surging energy prices, and DC brinkmanship—stoked the first S&P 500 5%+ pullback since October of last year. This pullback was not a surprise as volatility tends to seasonally increase during the September to early October time frame. We cautioned investors not to cool on the equity market as we expected the pullback to be short-lived. This week, we saw a few of these lingering near-term risks turn over a new leaf, and with the big banks set to kick off the unofficial start of the third quarter earnings season next week, the equity market may experience its own change of season as we go into the end of the year.
Bottom Line — The Equity Market Will Continue To Weather Near-Term Risks | The realization of a 5%+ pullback in the equity market was expected from both a duration (second longest period of time without a 5%+ pullback) and seasonal standpoint (September/early October historically weak). However, based on history, those same seasonal trends should shift in favor of equities heading into the end of the year. In fact, since 1990, from October 10 through the end of the year, the S&P 500 has been up 5%, on average. Even more notable, it has notched positive performance during this closing part of the year in 27 of the last 31 years. While we do not base our decision on seasonal factors alone, other fundamental factors (above-trend economic growth, healthy earnings, attractive valuations versus bonds, and increasing dividends/buybacks) corroborate our optimistic view on equities. In particular, pro-cyclical sectors are best positioned to benefit from strong pent-up demand, rising consumer confidence, and a continued decline in COVID cases leading to a further reopening of both the US and global economy. Below are two risks that we believe have recently been ‘misplaced’ and ‘misunderstood’ by the market.
Stagflation Talks Are Not Worth Shaking Like A Leaf | Once Chairman Powell cautioned that the transitory surge in inflation would last longer than previously anticipated, the possibility of stagflation (slowing economic growth, high inflation, high unemployment) began to circulate in the headlines and unnerve investors. However, the attempt to draw parallels between the current economy and prior periods of stagflation, primarily the late 1970s/early 1980s, is ‘overblown’ and unlikely. First, while GDP is likely to slow, it will maintain an above-trend growth rate. Rather than stagnating as it did decades ago, expectations for 2022 growth are nearly double the average of the last 15 years (Raymond James 2022 estimate: ~3.3%). Demand is not the issue of this economy as supply constraints continue to impair growth. However, much of that demand will likely be deferred into 2022. Second, employment conditions, both job creation and wages, continue to improve. The current unemployment rate (+4.8%) is just over half of the 9% level of the 1970s, and is expected to trend lower. Third, inflation, albeit higher than the Fed’s desired target, is less than half the double-digit levels seen during the 1970s. And not to mention, US companies have become much more creative and resilient in tackling these temporary supply chain issues (chartering ocean vessels, moving production facilities, employing more technology, altering hiring plans, etc.) While not our base case, we would be more concerned about stagflation in Europe, where economic data is struggling (manufacturing and service PMIs trending lower), the region is inherently more susceptible to the surge in energy prices (as they import most of their needs), and any inflationary pressures could force the single-mandate ECB (focus on inflation) to prematurely raise interest rates.
Fear Of Debt Default: Not Comparing Apples To Apples | Policymakers reached a temporary deal on the debt ceiling, avoiding the potential for an unprecedented debt default until at least early December. With the October 18 ‘ deadline’ quickly approaching, investors, in our opinion, were erroneously comparing the potential decline in the equity market to the ~20% decline seen during the 2011 debt ceiling crisis. However, there were significant differences between the two time periods. In 2011, negative equity performance was exacerbated by the European Debt Crisis, the surprise downgrade of the US credit rating by S&P, a weaker economy (two quarters of negative growth in 2011), and much weaker consumer confidence. The economy and earnings environment are much healthier today than it was back in 2011. Regardless, our base case is that the Democratic Party will eventually employ budget reconciliation to pass their ‘physical’ and ‘human’ infrastructure (with the debt ceiling) by year end and avoid further potential for a debt default. But, brinkmanship is not gone.