September ended a run of steady gains for stocks. In a turbulent month, global stocks dipped 5% after reaching another record high early in the month. Investors were lulled by seven months of steady gains. While well within the historical norm, September’s pullback feels jarring after a period of calm.
Although stocks get the headlines, the rise in interest rates is more notable. Over three trading days in September, the 10-year treasury yield rose over 25 basis points to 1.5%.
Higher interest rates reverberated across financial markets. Interest-rate sensitive segments of the stock market lagged the broad market. Growth-oriented tech stocks and real estate lagged while banks and shares of financial companies outperformed.
While the showdown in Washington over the debt ceiling and the inflation narrative are drawing a lot of attention, the rally in the US Dollar and higher real yields suggests neither of these narratives matter as much as the Fed’s plan to reduce asset purchases.
It’s evident the ongoing pandemic impacted supply more than demand. Bottlenecks and supply chain disruptions are proving frustratingly difficult to resolve. The last twenty years have championed just-in-time delivery and globalization of the supply chain, allowing businesses to run with a lean inventory. COVID has exposed weaknesses in this system as cross-border restrictions and labor shortages remain persistent.
Monetary policy, particularly extraordinary bond-buying, has its limits when it comes to production problems. Recent signals from the Fed suggest this view may be gaining traction within the institution. The $120 billion per month asset purchasing will soon be winding down.
We have seen this movie before. The last time the Fed began reducing asset purchases in 2013, the market struggled to digest the move. Real yields jumped 1% in roughly a month. The S&P 500 initially dropped about 5% but finished the year up over 32%.
Despite hiccups in September, the stock market has performed extremely well this year. Global stocks are up over 11%. Gains have been driven in large part by increased corporate profitability as the economy reopened.
Profitability, innovation, and growth will always be important for stocks, but the virus is the boss. That has been evident recently as economic activity slowed while the delta variant spread across the US. The virus will not be eradicated, but with vaccines and new drug therapies, its impact will be less acute over time. More importantly, the economy has and will continue to adapt to the evolving health backdrop.
Part of the evolution is the transitioning from the acute phase of the economic recovery into a prolonged but slower period of growth. Analysts’ estimates suggest earnings growth could be in the zone of 10% next year. That’s still healthy but lower than this year’s earnings growth which will likely be in the neighborhood of 22%. That means there is a path for continued growth for stocks if all goes as planned.
What It All Means
In 2011, Congress flirted with default on US debt. As a result, Standard & Poor’s, a credit rating agency, downgraded the US to AA+ from AAA. Paradoxically, over that time yields on government debt fell, boosting returns on US Treasury bonds. In the threat of default, investors still regarded US Treasury debt as a safe haven. Financial markets can, and often do, behave in unexpected ways.
The financial markets have digested a pullback in monetary policy accommodation before. It may not all go smoothly this time, but it will not be a carbon copy of 2013 either. What’s important is that the unexpected doesn’t derail your long-term strategy.
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