by Liz Ann Sonders, Jeffey Kleintop, Michelle Gibley, Michael Townsend, and Kevin Gordon, Charles Schwab & Company Ltd.
Although the S&P 500 index has climbed steadily year to date—up more than 20% as of September 22nd—overall index performance is masking a lot of choppiness beneath the surface. Global stocks face waves of worry about near-term issues, despite favorable longer-term economic forecasts. And while it’s clear the Federal Reserve is moving toward tighter policy, the pace of the change is uncertain. Meanwhile, Congress is wrestling with multiple issues that could affect markets.
Global stocks and economy: Waves of worry
September and October come with a history of market volatility, and we saw a reminder of that on September 20th, when concerns about a potential default of Chinese property giant Evergrande Group helped drive stocks to their lowest drop since May. Despite a favorable economic environment forecast for 2022, markets may again opt to focus on near-term growth worries, including:
- Evergrande, the world’s most indebted property developer and among the most highly leveraged companies in China, has recently been struggling to meet its debt obligations amidst regulatory changes, leaving investors worried about the potential fallout of default.
- While new global COVID-19 case counts have begun to recede after the delta variant surge this summer, ambiguity surrounding approval for booster vaccine doses could trigger investor concern over the potential for another rise in cases.
- The European Central Bank says it will marginally reduce the pace of its asset purchases. Although tapering is likely to make little difference to financing conditions, stock market volatility could arise from investors conditioned to react in response to changes in stimulus from central banks.
- Late-September elections in Germany and Japan (the world’s third- and fourth-largest economies), may not lead to dramatic changes in policy. However, it may take months for Germany to form a new government, raising uncertainty around future policy direction.
- Shipping logjams are back and at the worst levels of the pandemic, raising risks to corporate sales, manufacturing production and inflation. As we near the third quarter earnings reporting season, the potential for sales or earnings disappointments may be rising.
Looking beyond the next few months, we believe that the 2022 global economic environment may be favorable for investors. Central banks are preparing to rein in the pace of stimulus, with particular focus on the expected pace of growth in the economy and inflation. The Organization for Economic Cooperation and Development (OECD) forecasts that every one of the 45 major economies in the world will be growing next year, with about half experiencing slower growth than in 2021.
Growth is expected to rise in all major countries in 2022
Source: Charles Schwab, Macrobond and OECD data as of 9/17/2021.
Global economic growth is expected to be 6% for 2021 and 4.9% for 2022, according to the International Monetary Fund (IMF). If realized, this would be the fastest growth in at least a generation, or probably closer to two or three. Not since 1973 has growth been 6% or higher. Although not a hard-and-fast rule, when world economic growth drops below 2% it is considered a global recession. Likewise, growth above 4% is understood to be an economic boom. It’s exceedingly rare for global growth to exceed 4% for two years in row.
Stocks have tended to perform well with robust global growth. In particular, the MSCI EAFE Index has historically produced above-average returns when global growth was above 4%. A rising tide of rapid growth tends to lift stocks, despite waves of worry over near-term concerns.
U.S. stocks and economy: Parsing through “the market”
While the crisis within China’s property sector stemming from Evergrande’s debt problems has contributed to recent volatility within the U.S. equity market, it isn’t the sole reason for the weakness. The S&P 500 has maintained a steady climb this year, largely uninterrupted by the NASDAQ’s correction in February/March, the collapse in several speculative market segments (e.g., meme stocks, special purpose acquisition companies, newer IPOs, etc.) since March, and sideways move in small-cap stocks since February.
Overall S&P 500 index performance suggests a relatively tame market, but there has been considerable churning underneath the surface. Not only have sector rotations remained swift and sizable, but many stocks within the S&P 500 have already reached correction territory this year. While the S&P 500 has yet to see even a 5% correction in 2021, nearly 90% of its members have already had at least a 10% correction at some point.
Tranquility for the headline S&P 500 masked by messy internals
Source: Charles Schwab, Bloomberg, as of 9/22/2021. Past performance is no guarantee of future results.
The underlying weakness also suggests some fundamental challenges the economy is facing in the near term—not least being disagreements in Washington over the debt ceiling and the likelihood of slower economic growth in the latter half of the year.
Pressures from supply chain-related constraints and subsequent inflation concerns are still acting as headwinds for the economy. Depressed inventories—which caused second-quarter real gross domestic product (GDP) growth to be slower than expected—are taking longer to be rebuilt. Meanwhile, consumption (particularly within the services sector) is cooling, evidenced by the flat growth in restaurant retail sales in August. That has in turn caused economists to revise down their growth estimates for the latter half of the year. The consensus estimate for third-quarter growth has fallen from a peak of 7.2% in July to 5%, and fourth-quarter estimates have started to soften as well.
Growth expectations dim
Source: Charles Schwab, Bloomberg, as of 9/21/2021. Growth rates expressed in annualized quarter/quarter terms, adjusted for inflation.
Many economic uncertainties remain, and given the ongoing sharp swings in sector leadership within the stock market, we continue to emphasize a factor-based approach—for example, focusing on fundamental factors such as high free-cash-flow yield, which suggests the company is generating enough cash to support itself and reinvest for growth. Maintaining a focus on high-quality segments of the market–e.g., companies with strong balance sheets, meaning strong sales and earnings relative to total assets—historically tends to work well in an environment that is still choppy, especially as the trajectory of the virus continues to influence market and economic results.
Fixed income: Fed signals policy change
The Federal Reserve has indicated it is poised to end its bond-buying program soon and is on track to raise short-term interest rates in the next year or so. Yet bond yields have held in a steady range over the past few months, even in the face of rising inflation. While it seems counterintuitive, we believe it makes sense. The economy has shown some signs of slowing down from its rapid pace of expansion in the first half of the year as the COVID-19 delta variant has spread, and employment growth has slowed in the service sector. But just as importantly, the signal from the Fed that it is moving toward shifting its policy stance may be contributing to holding down yields.
With the Fed signaling that its easy policy stance is changing, the markets are starting to reflect the prospects that growth and inflation will likely cool off longer term. Recently, financial conditions—a measure of how easy or difficult it is to finance economic growth—have reached the easiest level in many years. Loose or easy financial conditions historically have been correlated with strong economic growth, higher inflation, and elevated asset prices—and that’s what we’ve witnessed this year.
Financial conditions remain accommodative
Note: The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
Source: Bloomberg. Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 9/13/2021. The Y axis is truncated at -2.0 for scale purposes. For reference purposes, 2020 low was -6.335.
Meanwhile, the Fed and other central banks were indicating a tolerance for higher inflation. The tolerance stems from the long stretch of below-target inflation of the past decade and concerns that the COVID-19 crisis could drag on growth longer term. Nonetheless, it is a significant shift from previous cycles, when the Fed tried to act pre-emptively against rising inflation.
Now the picture appears to be changing again. At its most recent Federal Open Market Committee (FOMC) meeting, which ended September 22nd, the Fed indicated it will likely begin reducing the pace of its bond purchases later this year and may begin to raise short-term interest rates by the end of 2022. We believe the official announcement of tapering will take place at the November FOMC meeting, with actual tapering starting soon thereafter. Fed Chair Jerome Powell indicated that he expected bond purchases to end by the middle of next year, implying a brisk rate of decline in purchases. We estimate that the Fed will reduce its Treasury purchases by $10 billion per month and mortgage-backed securities (MBS) purchases by $5 billion per month.
Note: Chart assumptions are based on a November tapering start.
Source: Bloomberg. Federal Reserve Balance Sheet Securities Held Outright: Treasuries & Mortgage-Backed Securities (FARWUST Index, FARWMBS Index). Monthly data as of 7/30/2021.
Once the Fed ends its quantitative easing program, it opens the door to raising the federal funds rate and actual tightening in policy. That’s where the pace of the Fed’s moves will become important to the outlook for bond yields. The median estimate shown in the Fed’s “dot plot” suggests an initial rate hike could occur next year, with three more rate hikes by 2024, bringing the federal funds rate to 1%. While a federal funds rate at 1% is still low, it represents a significant shift up from where rates have been since March 2020. All of this implies that financial conditions are likely to get tighter.
Median estimate in Fed dot plot suggests initial rate hike in 2022
Source: Bloomberg. FOMC dot plot as of 9/22/2021.
It’s worth noting, however, that these projections are not policy plans. They can change, and some of the people currently making these projections may be gone from the Fed in the next few years. The upshot is that investors will need to pay attention to how fast or slow the Fed is to shift from “very easy” to “less easy” to “tight” monetary policy. The market appears to be pricing in a relatively quick move, which would cap out inflation and bond yields at low levels. However, consumers are starting to anticipate inflation staying elevated longer term. If the Fed moves slowly, it could allow those expectations to become embedded, leading to higher yields.
Our view is that yields have room to move higher across the yield curve over the next six to 12 months, but we don’t anticipate a surge in intermediate to long-term yields. We look for 10-year Treasury yields to move up to the 1.65% to 1.75% level.
Washington: Markets eye debt ceiling standoff
With the end of September just around the corner, Congress is wrestling with an extraordinary pile-up of legislative issues that have potentially significant market implications. The most immediate deadline looms on September 30, when the federal government’s fiscal year ends. Congress has failed to pass appropriations for fiscal year 2022, so without a temporary fix, a government shutdown could begin on October 1. A tentative deal to provide temporary funding through early December is in the works but will need final approval from both the House and Senate by the end of September to prevent a repeat of the 35-day shutdown in January 2019.
Meanwhile, markets are warily eyeing the congressional standoff over raising the debt ceiling. With its ability to borrow curtailed, the Treasury Department has indicated that its ability to meet the nation’s obligations will run out by late October. Republicans on Capitol Hill are refusing to support a debt ceiling increase or suspension, while Democrats are insisting that they will do so only with bipartisan support. The stalemate risks rattling the markets, as previous debt ceiling battles have sparked market volatility whenever there has been uncertainty about when and how Congress will act. While anxiety is increasing as the two political parties dig in, it is also true that Congress has never failed to raise the debt ceiling before the country went into default. Lawmakers are expected to find a way forward in October, but investors should be prepared for a spike in volatility.
At the same time, Congress is considering two massive bills that form the heart of President Joe Biden’s economic agenda. A bipartisan infrastructure package that includes more than $1 trillion in spending on roads, bridges, rail, public transit, the electrical grid, broadband expansion and more has been approved by the Senate and is poised for approval in the House as soon as the end of this month. More complicated is a proposed $3.5 trillion bill that focuses on expanding Medicare, addressing climate change and boosting social programs. That bill, which includes both corporate and individual tax increases, is bogged down in a tussle among Democrats over its size and scope. The bill will likely have to be significantly downsized to win the support of moderates in the Senate. Expect negotiations to continue through much of October.
The House version of the $3.5 trillion package includes a number of proposed tax increases. The bill would take the top individual income tax rate back to 39.6%, impose a new surtax on income over $5 million, increase the capital gains rate for wealthier taxpayers and reduce the amount of inherited assets that are exempt from the estate tax, among other provisions. But the details are likely to change as the bill continues to inch its way through the legislative process in the weeks ahead. While it’s appropriate to consult your financial advisor and a tax expert about the potential implications for your situation, we would caution against making any dramatic portfolio changes until there is more clarity about what the final legislation might look like.