September 2021 | Thoughts from our Equity Team

September 2021 | Thoughts from our Equity Team

Published on September 28th, 2021

We believe the risk of a market correction may be elevated in the near term. The economy appears to be slowing due to rise of the Delta variant and various disruptions to global supply chains.  The Federal Reserve is likely to begin tapering its asset purchases in the coming months, and since that event disrupted the capital markets in 2013, it is possible it could do so again. The U.S. government may shut down on October 1, but this is not a significant concern to us, because we believe any shutdown would be brief, and historically investors have looked through brief shutdowns. More concerning to us is the approach of the debt limit, which is possible as soon as mid-October, and for which markets sold off significantly in 2011, even though the ceiling was ultimately raised before an actual event of default. Finally, the risk of a correction is elevated because of negative seasonality, as September and October are the weakest months for stocks, on average.
 
The U.S. market declines last Friday and Monday, September 20th, we believe were sparked at least in part by concerns about China, which has a trifecta of issues: a slowing economy, heavy-handed government intervention across a variety of sectors, and the looming default of Evergrande, the nation’s largest high yield issuer, with over $90 billion in bonds outstanding. We do not expect the U.S. capital markets to suffer significant contagion from China for two reasons. First, we expect Beijing to act in order to prevent an Evergrande default from cascading into a financial crisis, because it has the means and the will to do so. We believe that China can hardly afford a financial crisis on top of its slowing economy and Covid risk. Just a few weeks ago, Beijing bailed out Huarong, a bank with significant holdings of troubled loans, which indicates it may act if called upon. President Xi Jinping wants to reduce risk and sail as smoothly as possible into his appointment to a third term next October. Second, we are not seeing signs of the contagion in the usual channels: commodity prices remain high, and spreads remain tight in the U.S. high yield market, where the issuance window is wide open. In 2016, when turbulence in China impacted U.S. markets, commodity prices declined, and U.S. high yield spreads materially widened, and these are both stable.
 
Having said all of that, we have not assumed an overly defensive posture, because we believe if there is a correction it is likely to be fairly short and shallow, and we think risky stocks may perform well coming out of it and through year end. The U.S. Delta wave appears to have peaked as the 7-day average of cases peaked on August 31 and has since declined by 11% as reported by the CDC. We expect this decline to continue based on Delta waves observed in other nations, before plateauing at a higher level due to winter seasonality. In the coming months, additional vaccinations, boosters for seniors, and authorization in children under 12, the largest pool of unvaccinated Americans, could set us up for normalization in 2022. We believe that Economic growth remains strong even if it has slowed somewhat, with the Wall Street consensus expecting 5% for the third quarter, down from 7% previously. 

We think Monetary policy remains accommodative, and it works with long and variable lags, such that the extremely easy policy of the last 18 months should continue to support economic activity and asset prices through next year. We expect the yield curve to steepen as quantitative easing is reduced. We believe the combination of declining Covid cases and a steepening yield curve should support those stocks that benefit most from reopening the economy. This cohort of stocks is riskier, which makes us reluctant to reduce our overall risk exposure, despite harboring some near-term concerns. In the last 50 years, there were 15 instances where stocks advanced by 15% or more in the first 8 months of the year. Stocks had positive returns in the final 4 months of the year in 13 of these 15 instances, with an average gain of 5%. A strong beginning and middle like we have experienced this year historically has portended a strong finish, which we believe the strategy is positioned to benefit from, should it come to pass.

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