Market volatility picked up as investors’ focus shifted to headline risks.
U.S. equity markets pulled back during September, with the S&P 1500® posting its largest decline since March 2020. Investors are increasingly concerned about uncertainty surrounding potential infrastructure stimulus, the “peak growth” narrative, lingering supply chain bottlenecks, an intensifying global energy crisis and heightened Chinese regulatory risks, to name a few. 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® declined during the month, falling 4.7% in September. Rising interest rates pressured higher-growth, higher-valuation companies as expectations for additional fiscal stimulus lifted longer-term interest rates. More economically sensitive sectors as well as smaller market cap and value-oriented companies outperformed, although all areas of the U.S. equity market posted losses for the month except for the Energy sector, which advanced 9.4%.
The mounting global energy crisis pushed crude oil prices to their highest levels in almost three years, while natural gas and coal prices exceeded their all-time highs of 2008, just ahead of the upcoming winter months when seasonal heating demand is highest. The demand shock caused by the pandemic and economic lockdowns led to global supply curtailments. Therefore, the economic recovery has been met with depleted stockpiles, which in turn has boosted commodity prices —along with the share prices of Energy stocks.
The S&P 500 Energy sector fell below its 200-day moving average in early September and then rebounded to deliver its second-best monthly return of the year.
The U.S. Consumer Price Index (CPI) has remained above 5% for the past four months, the longest streak since the early 1990s. We continue to believe elevated inflation will be transitory, as headline and core CPI (inflation excluding food and energy prices) readings decelerated month over month in August for the second straight month. While it appears inflation is not worsening, persistent supply and demand imbalances may linger in the near term.
The reopening of the U.S. economy has been moving in a positive direction all year, with economic growth and momentum building.
Economic data continues to indicate we are in an accelerating expansion phase of the business cycle, although recent data has shown signs of moderation.
August U.S. job growth of 235,000 jobs missed expectations by a wide margin; however, forecasts project a pickup of an additional 470,000 jobs in September. Last month’s sizeable payroll miss added to the number of economic datapoints that have come in below consensus estimates, including retail sales, industrial production, and the Conference Board Consumer Confidence index.
As the fourth wave of COVID-19 peaked in early September, economic data, including industrial production, the NFIB Small Business Optimism Index, and housing starts strengthened, which led the Conference Board Leading Economic Indicators Index to exceed expectations. As such, by the latter half of the month, the Citigroup U.S. Economic Surprise Index, which tracks economic data relative to consensus estimates, improved to its highest level of the month. Although the index remains in negative territory (indicating economic data is consistently coming in below expectations), we view the improvement as supportive of continued economic growth.
Source: Bloomberg, L.P.
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Investors are keeping tabs on the Federal Reserve for indications of the timing and pace of its decision to taper quantitative easing. The Federal Open Market Committee (FOMC) has suggested it could begin scaling back asset purchases as soon as November and complete the process by mid-2022. The FOMC also updated its forecast for interest rate increases, with probabilities pointing to rate normalization beginning in late 2022.
The debt ceiling debate has reentered the headlines after the debt limit was reinstated on July 31 following a two-year suspension. Congress was able to avert a government shutdown by passing a nine-week spending bill on September 30, but the U.S. debt ceiling limit remains unresolved.
At the center of the current impasse are two stimulus bills that are being deliberated in Congress — the Senate’s $1.2 trillion bipartisan infrastructure bill and the House’s estimated $3.5 trillion stimulus bill to increase investments in strengthening the social safety net and to address climate change.
Congressional leaders appear to have reached an agreement that would extend the debt ceiling question into December 2021, averting immediate concerns related to this question.
After bottoming out at 1.17% on August 2, the 10-year U.S. Treasury (UST) broke above major technical support levels to end the month at 1.5%. However, at such low levels, we believe the 10-year UST indicates a higher probability of a new round of fiscal stimulus, but at a far lower level than initially proposed in March (Figure 1). Furthermore, breakeven yields at both the 5- and 10-year level have not reacted much to debt ceiling headlines and both remain in a narrow 10 basis point (bp) range since June, reflecting a lack of expectations for a meaningful surge in fiscal stimulus-induced inflation.
As we enter third quarter earnings season, S&P 500 earnings are forecasted to expand 26% year over year, a deceleration from last quarter’s peak growth of more than 90%. While growth is still strong on an absolute basis, nearly 50% of earnings growth is expected to come from just two sectors: Energy and Information Technology. In addition, during the last week of September, we saw the highest number of negative revisions for the third quarter since February. To be clear, we remain positive on the earnings outlook, but investors need to be aware that “peak growth” is impacting earnings estimates as well.
Equity valuations remain high relative to history, as the S&P 500 forward price-to-earnings ratio (P/E) ended the month at 20.3 times (x) compared to the 10-year average of 16.4x. The Russell 2000® is trading at 25.9x compared to its 10-year average of 22.8x. The exception is the S&P 400 MidCap®, where its forward P/E of 16.2x is below its 10-year average 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.
The Bloomberg High Yield Index was flat in September, while the Bloomberg U.S. Aggregate Index declined -0.9%. With credit spreads remaining near their lowest level since 2007 across both investment grade and high yield corporate debt and interest rates stabilizing, we saw below-investment grade credit advance as both yields and spreads declined. The Markit CDX High Yield Index experienced the largest weekly decline in spreads since early February, ending the month with spreads at the lowest level in nearly two months. This is another reminder that the slowdown in seasonal trading influenced Bloomberg High Yield Index spreads, which moved higher in recent weeks.
Developed International Markets
Hope springs eternal during election season in Japan and Germany.
Several macro issues plagued month as the MSCI World ex USA Index delivered its worst monthly performance for the year. Several macro issues plagued equities during the month, including the highly anticipated German federal elections, national gas shortages in Europe and lingering COVID-19 concerns.
Japanese equities led performance, delivering their strongest monthly outperformance versus the index since 2016. Stocks rallied on the news that Prime Minister Shinzo Abe would be stepping down, in the hopes that the next prime minister would be far more supportive of expansive stimulus measures. Since Abe took office in December 2012, the MSCI Japan Index has outperformed the developed market index by nearly 300 bps; however, it has lagged the S&P 500 by more than 550 bps (both annualized). In our view, Japan plays a critical role in reversing the long-term trend of developed market underperformance relative to U.S. equities.
Heading into third quarter earnings season, the blended earnings growth rate (combined consensus estimates and actual results) is expected to decelerate sharply from the second quarter growth rate of 178%, down to 46%. While strong, like the U.S., growth remains concentrated in just two sectors —Energy and Industrials — which are expected to contribute nearly half of earnings growth for the quarter. The Consumer Staples sector, which did not decline as much as Energy and Industrials during the economic slowdown last year, is expected to deliver negative earnings growth for the quarter.
In our view, the contrasting growth rates between different sectors of the developed international economy highlight the outsized base effects from the pandemic-related economic slowdown. We believe this phenomenon should be short-lived as the global economy continues to reopen.
While Eurozone officials have celebrated the region’s 70% vaccination rate, a variety of higher-frequency data, such as OpenTable seated diners, have slowed notably over the past month. In addition, some of the more traditional economic data have also come in lower than consensus estimates lately. As such, the Citigroup Eurozone Economic Surprise Index turned negative in August and fell to its lowest level since July 2020. With lingering COVID-19 concerns and winter months approaching, we believe the Eurozone continues to face a variety of challenges for both economic and earnings growth.
Source: Bloomberg L.P.
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On a year-over-year basis, Eurozone inflation has increased to a nearly 13-year high of 3.4%, raising questions about just how long higher prices may persist and whether the European Central Bank will need to step in (Figure 2). Not unlike U.S. inflation, Eurozone prices are facing a variety of fading base effects from last year, expiring fiscal stimulus and short-term supply chain disruptions in energy markets. One such disruption has been Europe’s natural gas shortage. According to Bloomberg data, natural gas prices in Norway have increased five-fold from a year ago, and the price of natural gas in Germany has doubled in the past month due to stronger demand and falling supply from Russia. Though significant, we believe the supply-demand mismatch is a short-term issue and will settle down as trade and consumption patterns normalize.
Germany’s federal elections led to an apparent victory for Olaf Scholz as the new chancellor; however, the race is still far from complete. The opposition leader Armin Laschet could still become chancellor under a coalition government, although that is a low probability in our view. While we typically do not consider politics to be a long-term market catalyst, we believe German elections are important for investors because of Germany’s longstanding leadership in Europe from both a geopolitical and economic growth perspective. As such, due to the lack of a majority party winning the election outright, it could take a month before a chancellor and coalition government are determined, and their economic policies and agenda along with it.
Chinese real estate concerns overshadow a strong month in a challenging quarter.
Despite a tumultuous month of headline risks, including proclamations of China’s “Lehman Moment” in the real estate market due to solvency issues with China Evergrande Group, the MSCI Emerging Markets (EM) Index outpaced the S&P 500 by more than 50 bps. However, it was a challenging quarter for EM, which had its widest underperformance relative to U.S. large-cap equities in three years.
Third quarter earnings for EM are expected to grow nearly 40% on a year-over-year basis, as calendar year 2021 growth estimates were revised higher to nearly 50% during the third quarter. While 2022 estimates have been revised lower in recent weeks, the growth rate of nearly 7% is on par with developed international consensus estimates. Yet the forward P/E for EM is nearly three turns lower at 12.6x, suggesting the asset class remains attractively valued for long-term investors.
Part of the reason EM equities trade at such a discount, in our view, is due to investor concerns about regulatory risks in China.
Regulatory risks in China remain the primary risk for EM investors in an otherwise fundamentally strong asset class.
The latest bout of concern arose over China Evergrande Group and whether the company’s liquidity crisis (partly induced by stringent capital regulations) would have contagion effects on the broader economy or even globally. The company represents less than 0.1% of the EM index. We believe this is a company-specific issue and it does not affect our view on EM asset allocations.
Economic data across EM was mixed in terms of beating consensus estimates. Export countries such as Brazil and India saw PMI data improve from the prior month, confirming an accelerating expansion in those countries; however, China delivered several data points that fell short of expectations, including retail sales, industrial production and PMI survey data, which in our view is a reflection of the Delta variant’s lingering impact on global trade. For perspective, while the recent peak number of new COVID-19 cases was lower than the previous wave, the duration of the Delta variant wave lasted several weeks longer (Figure 3).
Source: Bloomberg L. P.
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As a natural gas shortage hits Europe, China is facing energy constraints of its own, primarily in the production of coal. Due in part to decreased emphasis on fossil fuels combined with the rebound in energy demand after lockdowns were lifted, there is a shortage of coal in China, which fuels more than 70% of the country’s electricity according to Bloomberg data. We remain confident China has several options to avoid an energy crisis, including an immediate increase in imports from neighboring coal-rich countries such as Mongolia and Australia. We also believe this shortage is influencing the government’s recent policy decision to restrict bitcoin mining, which is an energy-intensive industry.
TEXT VERSION OF CHARTS
Figure 1: 10-Year U.S. Treasury Yield (view image)
Figure 2: Headline Inflation (MUICP All Items) YoY Changee (view image)
Figure 3: New Global COVID-19 Cases, 7-Day Moving Average (view image)
|Date||Number of New Global COVID-19 Cases,
7-Day Moving Average