Economic concerns and earnings are starting to weigh on stocks
Wall Street’s imperviousness to bad news, which allowed stocks to double in value from their pandemic panic lows, may start to crack.
When the Federal Reserve signaled in September that it would tighten monetary policy soon by cutting asset purchases, the stock market took it right, but not for long. The S&P 500 edged higher for a few days before turning the tide, pushing the index more than 5% below the peak it reached earlier in the month, which was its biggest drop of the year. .
Despite this setback, the market managed to achieve a gain of 0.2% in the third quarter.
A greedier Fed isn’t the market’s only concern. Inflation, until recently dismissed by the Fed as a transitional artifact of the pandemic, is becoming increasingly persistent as the prices of goods, services and labor rise. What is recognized as transient, however, is the shock to economic growth and corporate profits provided by several trillions of dollars in additional spending by Congress.
With a number of threats to prosperity increasingly difficult to ignore, many investment advisers have become less enthusiastic about stocks. They lower return expectations and recommend exposure only to narrow niches.
“We are not at all optimistic today,” said David Giroux, head of investment strategy at T. Rowe Price. âWhat really drives the market is profit growth,â he said. âWe can’t repeat some of the things we’ve done this year. Profit growth could slow in 22, perhaps dramatically. “
After being a colossal boon to the economy, fiscal stimulus – in the form of huge federal spending – can now turn out to be three problems for the stock market in one. Public spending focused on the pandemic that has boosted growth is on the decline. There is a broad consensus that taxes will rise soon to help pay for these expenses. And, because many people took direct stimulus payments and invested them in the stock market, stocks rose faster than they otherwise would.
The positive effects of so many stimulus may have run their course, with domestic equity funds tracked by Morningstar losing 0.6% in the third quarter, with financials-focused portfolios among the clear few winners.
The SPDR The S&P 500 ETF Trust, which tracks the index and is the largest exchange-traded fund, returned 0.6% in the quarter, beating the average for actively managed mutual funds.
The very fact that many investors until recently seemed indifferent to the dangers facing the economy is what some find troubling.
“There is complacency in a lot of things,” said Luca Paolini, chief strategist at Pictet Asset Management. He listed some of his concerns: â’Inflation is temporary.’ May be. Maybe not. Six months ago, consumption was booming. People had money and time. Now they have less money and less time. Profit momentum has clearly peaked from six months ago. I am concerned that the market is ignoring the deteriorating economic outlook.
By some measures, stocks are as expensive as at almost any time in history. The S&P 500 is trading at around 34 times the past 12 months of earnings. Sarah Ketterer, managing director of Causeway Capital Management, is concerned that corporate earnings face many headwinds and that their impact on equities could be particularly high at such rich valuations.
âInflation is up, economic growth is down,â she said. âThe phenomenon of supply chain disruption is global, creating cost increases and pressure on margins. Companies in many industries have reported difficulties in sourcing commodities and important components of manufactured goods, such as semiconductors, hampering production and making what they produce more expensive.
Rising prices pushed up interest rates in the bond market, lowering bond prices and limiting bond funds in the third quarter. The average rate rose 0.2%, dragged down by a 2.9% drop in emerging market portfolios.
âI’m struggling to find an area where costs haven’t increased, and this could continue for a while,â Ms. Ketterer said. “No one knows how long it will take to unravel the tangled situation in the supply chain.”
The situation seems particularly complicated in Asia, where many raw materials and intermediates come from. China has been at the root of several disturbing recent events, including power cuts that have hampered manufacturing and financial instability at the China Evergrande Group, a giant and heavily indebted developer.
Some Asian market specialists see little chance that Evergrande’s woes spill over into the entire Chinese financial system, let alone beyond. Matthews Asia, a mutual fund manager, said in a note to investors that mortgage lending standards in China are quite strict, with large down payments required and the packaging of securities loans sold to investors minimal.
“Evergrande’s problems are unlikely to cause systemic problems and the likelihood of it turning into a global financial problem is remote,” Matthews analysts said. But they added that restrictions could be imposed on the real estate sector in the coming quarters.
It will be OK Malik, head of equities at Nuveen, an asset manager, also doesn’t expect Evergrande to become a global problem, but she warns it’s not China’s only problem.
âThe government is focusing on social issues, and some of them lead to a moderation in the growth rateâ of the Chinese economy, she said. While broader central bank policies would help, she added, “we think China might get worse before it gets better.”
Chinese equity-focused funds deteriorated in the third quarter, collapsing 13.8%. International equity funds in general lost 2.9 percent.
As prices and risks in the domestic and foreign stock markets increase, the opportunities for strong and relatively secure gains diminish.
Mr. Giroux said he “buys what is on the minds of the market in the short term,” such as stocks of managed care providers, which are trading at a discount to the market because earnings growth has been subdued.
He said he would avoid small businesses, as well as companies that have benefited from fiscal stimulus packages, including automakers, heavy industry companies and semiconductor manufacturers.
Ms Malik, who said she was âmoderately bullishâ overall, prefers small businesses and European stock markets. She also likes office software makers like Salesforce and HubSpot, and high-quality cyclical companies like Nike.
Mr. Paolini also favors European equities.
“Europe’s record is pretty strong,” he said. âThe vaccination rates are high; the story of Covid is over â, but government stimulus continues across the region, soâ they don’t have the same fiscal cliff as in the US and UK â
His other recommendations include financial stocks, which tend to benefit from higher interest rates, and drug companies.
Ms Ketterer believes there is more potential for recovery stocks in the event of a pandemic to appreciate. In particular, it expects Rolls-Royce, which manufactures jet engines, to benefit from operational restructuring, and Air Canada, which has cut costs during the pandemic and has a strong balance sheet and little competition, is doing well as travel resumes.
Ms Ketterer remains determined to try and pick winners when there may not be many winners to choose from.
“What are we doing?” she said. âWe are not going to hide. We don’t want to be in cash, and we don’t want to be in bonds if rates go up.
Mr. Giroux said he doesn’t care much about bonds or cash – money market funds – right now either. It favors bank loans, variable rate securities created by grouping together loans that banks have granted to corporate clients. They are earning almost 4%, and that could increase if market interest rates rise. The risk of default is mitigated because bank loans occupy an important place in the capital structures of companies.
The turmoil in the stock market of late is hardly an oversight when viewed on a phenomenal last 18-month chart, so a single-digit percentage return may seem meager. But it can start to sound generous if the time is right for investors to learn to live on less.
âThe risk profile of stocks over the next three to five years is not as good as it was a year ago as valuations are high, sentiment is good and earnings growth is expected to slow Said Mr. Giroux. âWe pull out risky assets when things are going pretty good, and right now things are going pretty good. “