Filtering Out the Noise

If you write about financial markets every week, as we do, it can be challenging to come up with dramatic insights on schedule. This is a good thing, for often what is needed is not a clarion call to action, but rather a step back to put in context what is really going on.

September reminded investors, again, that it is the cruelest month for equities. Since 1945, September has produced an average negative monthly return for the S&P500, the only month of the year with that distinction. This September, the S&P500 lost nearly 4%, with most other major indices ending in the red as well. (The exception was the Japanese market, which rose for the month.)

The decline in major equity markets last month was not, however, accompanied by falling bond yields. Quite the contrary — during the final two weeks of the month, yields rose smartly, and the curve steepened, typically signs of improving growth. Echoing that theme, small capitalization, value and more cyclically sensitive sectors outperformed in September. Commodity prices, including energy (oil, coal), foodstuffs and steel also made strong gains. Those outcomes are not consistent with widespread growth fears.

And yet conventional economic releases were mixed last month. The Atlanta Federal Reserve’s ‘GDPNow’ estimate plunged. In August, it was predicting over 6% annualized growth for the third quarter. That number has recently dropped to just 2.3%. Yet the manufacturing ISM manufacturing index, which alongside the yield curve has proven to be a reliable indicator of the cycle, remains firmly in expansionary territory.

Like other investors and market observers, we find recent market gyrations challenging to discern. Is market angst driven by global growth fears? Inflation and tapering? Political and geopolitical uncertainty? Or is it mostly noise?

Here is our take.

To begin, a variety of newsworthy events are weighing on investor sentiment. Difficult negotiations and partisan point-scoring around the need to lift the US debt ceiling are more than a distraction. Investors recall how government shutdowns and even default risk, however remote, have roiled markets in the past.

At the same time, the failure of the Democratic Party to unite on the twin infrastructure bills in Congress has fueled concerns about future US fiscal stimulus spending and prompted some discussion of dire 2022 mid-term election consequences, which could make Washington even more ungovernable. It is not an over-statement to note that the future of Biden’s presidency likely depends on successfully driving through his economic plans.

In China, Xi’s crackdowns on corruption, corporate excesses and property speculation have raised doubts about China’s commitment to growth. Moreover, China flew 36 military jets over Taiwan’s defense zone last week in a show of force to mark the founding of the People’s Republic of China — a worrisome development at a time of rising US-China tension following the AUKUS submarine deal. Finally, elevated inflation and long-lasting supply bottlenecks are raising uncertainty about how the Fed and other central banks may respond. Will they keep their nerve and allow inflation to overshoot, as they have previously pledged, or will they speed up tapering and eventual rate hikes?

Still, it is easy to exaggerate the importance of these negative factors and omit some positive developments. For instance, the latest evidence suggests that Delta-variant infections in the US and elsewhere have peaked and are now declining. Threats to economic reopening appear to be receding.

In the past, we have noted that the coincidence of high equity valuations, peak earnings, and moderating global growth are sufficient to introduce more volatility into capital markets. For the same reasons, equity returns are likely to be more subdued.

But that is not the same as concluding that the bull market is over, or that a major correction is now likely. Given unattractive bond returns and negative real (inflation-adjusted) returns on cash, investors will not be easily dislodged from the only game in town, namely equities.

Indeed, based on decades of experience, central bankers are wary of using monetary policy to address price increases that arise mainly from supply-side rigidities, so long as inflation expectations remain stable, and demand is not surging. That’s precisely the case today, which is why investors ought not to become overly concerned about monetary policy tightening.

The days of easy returns in markets are over. High valuations create higher hurdles for growth and earnings. Economic and policy fundamentals are not as unambiguously positive. Risk-adjusted returns will be lower. But that fact, alone, is no reason to panic. Instead, get used to it and adjust expectations accordingly.

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