Weekly market wrap

Climbing the Wall of Worry

With no shortage of headlines to worry about, volatility made a comeback last week after being dormant for most of the past six months. The financial troubles of a large Chinese property developer added another brick to the proverbial wall of worry, which includes growth slowdown concerns, inflation pressures, a dial down of central-bank stimulus, and the debt ceiling. This growing number of uncertainties resulted in the biggest daily S&P 500 loss since May, before stocks rebounded as the week progressed¹. We view last week's brief stock-market rout as a temporary and not completely unexpected setback within the confines of an ongoing bull market. We'd offer the following perspectives.

Evergrande's debt woes unsettled global markets, but contagion risk likely limited

• The potential default of the indebted Chinese property developer Evergrande was the catalyst for the S&P 500's first 5% pullback (based on intraday prices) in almost a year¹. With a $300 billion debt load, an amount equivalent to around 2% of China's GDP, and $100 billion of real estate sales last year, Evergrande's size triggered fears of financial contagion at a time when growth in the world's second-largest economy is decelerating².
• An announcement that the company settled its domestic bond payment later in the week sparked a relief rally, but questions remain about interest payments on dollar-denominated bonds and the way a potential debt restructuring will look. Nevertheless, the direct exposure to Evergrande's debt owned by non-Chinese creditors and investors does not appear large enough to threaten the financial stability of the global banking system. To this point, a slew of banks, including Credit Suisse, which underwrote the most Evergrande bonds among international banks in the last 10 years, have issued statements emphasizing their limited direct exposure to the property developer.

As China worries intensify, will a policy pivot follow?

• A possible softening of the housing market adds another headwind to Chinese economic growth, which has been weakened by restrictions to curb renewed outbreaks of COVID-19 cases, a slowdown in credit growth, and a regulatory crackdown across a wide variety of sectors. We think that, as has happened over the past decade (namely in 2011/2012, 2015, and 2018), the crisis of confidence will trigger additional steps by policymakers to relax policy and ease liquidity to help growth.
• The fact that Chinese equities did not reach a new 52-week low last week, and that the emerging-market benchmark kept pace with the S&P 500 despite the gloomy headlines, is a sign that a lot of bad news is possibly priced in, and that a policy stimulus is expected.

^{Source: FactSet, MSCI EM, S&P 500, the MSCI EM and S&P 500 are unmanaged indexes and cannot be invested in directly. Past performance is not a guarantee of future results.}

The chart shows the performance of Emerging market equities which bottomed relative to U.S. equities in August and remained resilient last week despite the Evergrande headlines.

Warning signals are not flashing red

• Over the past month we have argued that some complacency was setting in and a choppier road likely lies ahead for stocks as the pace of global economic growth temporarily moderates. Last week's short-lived spike in volatility was an example of the periodic setbacks that we expect to see as the expansion advances. Pullbacks are likely to become more frequent, and the pace of gains will slow.
• Yet we think stocks will continue their upward climb over the next few years, supported by positive economic and corporate fundamentals. Last week's market indicators are also consistent with the view that the bull market remains intact.
  • High-yield corporate credit spreads (the extra premium of below-investment-grade corporate bonds over safer government bonds) widened only marginally and remain near historical lows, indicating increased confidence in the economy along with expectations for subdued credit risk and defaults.
  • Companies and sectors that are more sensitive to the economic cycle rallied, with financials and energy leading the S&P 500. Consistent with the theme of cyclicality, small-caps and value-style investments outperformed.
  • The benchmark 10-year Treasury yield rose to the highest rate since early July, as the Fed signaled that tapering of the bank's bond purchases is around the corner (likely to be announced at the November meeting and concluded by mid-2022)¹. We believe that the positive reaction in stocks and the steepening of the yield curve following the announcement reflect confidence that economic growth will be strong enough next year to handle the gradual removal of the Fed's stimulus.

Some pessimism is likely baked into the prices

• While the S&P 500 is less than 2% off its record high and was down 5% at its worst on Monday, the average stock in the index had declined 14% by the same day¹. This difference between performance of major indexes and the average stock is even more pronounced in small-cap stocks, which have been correcting for months now as growth rates peaked, suggesting that investors have not been ignoring the growing headwinds. For investors and professional money managers, this dynamic could present opportunities to further diversify portfolios, adding quality stocks at potentially discounted valuations.

^{Source: FactSet, The S&P 500, Russell 2000, MSCI EAFE & MSCI EM are unmanaged indexes and cannot be invested in directly. Past performance is not a guarantee of future results.}

The graph shows the maximum decline from recent highs of major indexes and the decline in the average stock in those indexes, which has been more severe.

Looming uncertainties may keep the market on its toes

Even with nerves calming as stocks rebounded strongly and finished higher for the week, volatility is likely to stay elevated in the near term. The two uncertainties that could be in the spotlight in the coming weeks are a potential government shutdown and debt-ceiling showdown, and profitability headwinds that could be on display when companies start reporting third-quarter earnings in mid-October.

• Government shutdown and debt ceiling: A familiar standoff
  • By September 30 Congress needs to fund the government to avoid a government shutdown. And by next month it needs to raise the debt ceiling so that the U.S. doesn't default on its obligations. Over the past decade there have been three government shutdowns, with the longest lasting 36 days between December 2018 and January 2019. The impact to the economy has been limited in the past, with the underlying fundamentals exerting more influence on stock-market performance. For example, stocks rose during the 2013 and 2018 shutdowns, but the halting of many government-agency activities might have added to the pressures that resulted in brief market pullbacks prior to the events (the more impactful market force in 2013 was the Fed's bond tapering, and in 2018 the global growth slowdown, together with a corporate profit squeeze and rising rates).
  • A failure to raise or suspend the debt ceiling would have severe consequences for financial markets. But fortunately, there has been no precedent of the U.S. government defaulting on its payments. Still, an 11th-hour resolution back in 2011 led to a U.S. credit-rating downgrade for the first time in its history, increasing borrowing costs, shaking investor confidence, and triggering a market pullback. We expect that a government shutdown will be avoided and a deal to raise or suspend the debt ceiling will be reached, but headline risk will likely be high as both parties engage in political posturing. We would recommend that investors avoid changing investment course purely based on the dramatic headlines that will likely be prevalent as the negotiating process unfolds.

^{Source: FactSet, The S&P 500 is an unmanaged index and cannot be invested in directly. Past performance is not a guarantee of future results}

The graph shows the performance of stocks during the two longest government shutdowns over the last decade.

• Corporate earnings could be less of a tailwind: Temporary profit-margin challenges ahead
  • S&P 500 profit margins hit a record in the second quarter as revenue rose at a much faster pace than costs on the back of strong economic growth. The third-quarter earnings season is fast approaching and could bring some profitability challenges due to a combination of slower revenue growth and input-cost pressures from supply and labor shortages. As it becomes more difficult for companies to pass the increased costs to consumers, earnings growth could slow, also suggested by the recent peak in the ISM manufacturing Purchasing Managers' Index. These pressures will likely prove temporary as supply-chain disruptions ease in the coming quarters, but they could still trigger some volatility along the way.

^{Source: FactSet, The S&P 500 is an unmanaged index and cannot be invested in directly. Past performance is not a guarantee of future results.}

The graph shows that the pace of earnings growth will likely slow as economic activity moderated in the third quarter.

Putting it all together, we doubt that the laundry list of risks will subside immediately and that markets will return to the tranquil conditions experienced earlier this year. Yet we remain confident that the economy remains on solid footing, and we believe that stocks continue to look attractive relative to other alternatives. As long as fundamentals are positive and there is healthy skepticism, stocks will likely continue to climb the proverbial wall of worry.

Angelo Kourkafas, CFA
Investment Strategist

^{Sources: 1. FactSet, 2. Bloomberg}

Weekly market stats

^{Source: Factset, 09/24/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * 4-day performance ending on Thursday}

The Week Ahead

Important economic data being released this week include personal income, personal consumption, and consumer confidence.

Review last week's weekly market update.