Stocks finished higher after a volatile week, as investors weighed the risks around the Chinese property market, U.S. government funding, and monetary policy.

At its closing trough, the S&P 500 Index had dipped by 4% from its early September peak, but it has rallied and trades just 2% below its all-time high. It has been 224 trading days since the last 5% correction, the 8th longest streak since 1930. This steady performance is a reflection of the impressive economic improvement since the reopening that has led to better-than-expected profit growth.

The S&P 500’s 20% year-to-date return has been entirely driven by earnings growth, as the forward Price-to- Earnings multiple (a valuation measure) has contracted from 24x to 22x. Consensus earnings-per-share forecasts for 2021 have risen by 20% since the start of the year and 5% during the last 3 months. Importantly, we remain optimistic in our economic outlook that should support further earnings gains and consequently higher stock prices—despite the above-mentioned risks (discussed below).

Evergrande Not Viewed As Contagion Risk: Our Chief Investment Strategist wrote a note last week discussing China Evergrande Group’s (one of China’s largest property developers) financial problems. The bottom line is that we do not view the problems in China’s property market as a contagion risk that derails the U.S. bull market. Chinese policymakers may want to make an example of Evergrande, but not to the point that they will stand by in the face of a broad contagion. In a worst-case scenario, a credit event could ripple across China and into some neighboring markets, tempering investors’ enthusiasm for risk for a short while. However, we believe it is unlikely to impart a severe or lasting impulse in the U.S.

No Consistent Reaction to Shutdowns and Debt Ceiling Showdowns: With a potential government shutdown and debt limit showdown looming, concerns are growing about potential market spillovers. Treasury Secretary Yellen warned that the Treasury will likely exhaust its cash and extraordinary measures in October. While the ultimate outcome is uncertain, equity market performance around 14 government shutdowns since 1980 and debt limit showdowns in 2011 and 2013 shows no major consistent reaction of the S&P 500 to these fiscal catalysts. Rather, the underlying macroeconomic environment has been more important for equity performance.

Muted Reaction to More Hawkish Fed: Equity investors took in stride hints by the Federal Reserve of an imminent start to tapering bond purchases and a potentially earlier-than-expected liftoff to higher interest rates. At its September meeting, the Federal Open Market Committee (Fed’s rate setting committee) delivered a slightly hawkish message, recognizing slower economic progress due to the Delta variant, but also robust improvement in the labor market and somewhat stickier inflation than it previously assumed. However, the Fed remains optimistic and expects growth and employment to re-accelerate in 2022.

Along with its positive view on the economy, the committee has shifted to a more hawkish stance on monetary policy. Their data now suggests the potential for liftoff by the end of 2022 and three interest rate hikes in both 2023 and 2024. Perhaps most notably, the Fed also gave the first official signal that tapering its bond purchases could “soon be warranted,” suggesting a tapering announcement in November is now likely. Fed Chairman Powell suggested at his press conference that tapering is likely to end by mid-2022 and we shouldn't expect any rate hikes until tapering is done. Stocks rallied on this news, which is viewed as still accommodative monetary policy.

Leading Economic Index Remains Encouraging: The Conference Board’s Leading Economic Index (LEI) increased 0.9% in August, the most in three months, and above the consensus of 0.7%. Eight of its 10 components made positive contributions, led by fewer initial jobless claims. On a year/year trend basis, the LEI eased to 10.0%, off the record peak of 16.7% in April, but still several times higher than the 2.2% gain per annum historically. These indicators suggest that even though growth momentum has slowed in the third quarter, as captured by business surveys and other indicators, the outlook for growth in the next six months remains decidedly positive. We view positive economic indicators as the most important support for profits and ultimately stock prices.


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