What a difference a month makes. Markets ended September with the first 5% pullback of the year, but October saw the S&P 500 snap back to a record high, rising around 7%. As we discussed in our letter last month, our work suggested that the September setback provided a welcome reset and an opportunity for investors to position for renewed market strength heading into year end. And with equities oversold entering October, many of the same concerns that had weighed on markets became catalysts as those fears subsided. The government shutdown was kicked down the road, the government spending bill and corresponding tax increases appear set to be slimmed down, COVID-19 trends improved, and, importantly, corporate earnings proved fiercely resilient. Indeed, companies are holding up relatively well despite many obstacles – including supply disruptions, labor challenges, commodity inflation, and the ongoing pandemic.
Companies are beating profit expectations by a double-digit margin for the sixth consecutive quarter, and S&P 500 forward earnings estimates just reached another record high, aided by pricing power and efficiency on the cost side. This serves to reinforce one key theme of the past year – corporate earnings power and adaptability has been underappreciated. Our work also suggests the third quarter growth scare is in the review mirror, and the economy is set up for positive surprises, aided by improving COVID-19 trends, further job gains, and the rebuilding of depleted inventories. Our macro team is expecting above-trend U.S economic growth into 2023. Outside of the U.S., the international developed and emerging markets (EM) rose last month but made fresh cycle price lows relative to the U.S., reinforcing our long-standing domestic overweight position. Valuations for international markets remain cheap, and we are finding some opportunities, but we await a reversal in comparative earnings and price trends before upgrading our view.
We retain a negative view of EM given the continued China regulatory crackdown alongside a property slowdown and underwhelming profit trends. Notably, outside of China, EM central banks are moving to a tightening bias at a faster rate relative to developed markets. Higher energy prices are also likely to weigh on EM Asia, which accounts for nearly 75% of the EM index and is a large importer of commodities. Turning to the bond market, yields moved up slightly over the past month. In a well-telegraphed move, the Federal Reserve (Fed) is set to start reducing its asset purchase program as crisis-level support is no longer needed. Global markets, however, have quickly moved to price in a quicker pace to a monetary tightening cycle given some of the stickier inflation trends. That said, our fixed income team concludes the U.S. bond market is now starting to price in a more aggressive move higher in shortterm rates than is warranted and anticipates the yield curve steepening from the recent flattening.
Moving forward, following the sharp equity gains already seen recently and with sentiment no longer depressed, it would be normal to see a short-term digestion period. Moreover, inflation remains sticky, COVID-19 concerns could resurface in the winter, and we are moving past peak policy accommodation. This should inject some volatility and lead to a moderation of market gains in 2022. Still, the primary market trend appears higher, and in the eight periods since 1950 where stocks were up more than 20% through October, as they are this year, the S&P 500 tacked on additional gains by year end 100% of the time with an average gain of 6.2%. Of course, that sample size is small, and this is only one factor for investors to consider, but markets should remain well supported by firming economic trends, and this should also aid cyclical areas, including small caps. Accordingly, we maintain an overall equity tilt relative to fixed income and cash.
Keith Lerner, CFA, CMT
Co-Chief Investment Officer
Chief Market Strategist
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