After seven months of gains, equity markets have been choppier mid-way through September. This is actually quite normal from a historical seasonal standpoint, though the ongoing carousel of concerns continues.
In this note, we provide perspective on three of the top concerns on investors’ minds, and why despite these issues and a bumpier near-term path, we remain overweight equities.
Concern #1 - Peak economic growth
After the economy sharply rebounded during the past year, growth slowed over the summer. This downtick was primarily caused by ongoing supply constraints and the resurgence of COVID-19 trends due to the Delta variant. Yet, our view is that economic growth has more likely been deferred rather than lost.
The good news is we are seeing signs that the Delta strain is peaking, though we acknowledge this remains tenuous. And, while supply constraints linger, the rebuilding of depleted inventories should add to growth next year, buffering the economy.
Indeed, our macro team recently pushed off a quarter point of economic growth from 2021 into 2022 as activities—such as large gatherings and returning to offices—are delayed. We now expect roughly 6.2% U.S. economic growth for this year and a healthy 4.5% pace next year, which would still be about double the pre-pandemic trend.
As we move later into the year, our work suggests the economy will prove more resilient than currently feared. Indeed, the Citi U.S. Economic Surprise Index, which measures how economic reports come in relative to expectations, has declined sharply but now is depressed and at an area that has tended to be followed by positive economic surprises.
Our research also shows that the economically-sensitive areas of the equity market already reflect the summer slowdown.
- This is evident by the substantial underperformance of many of the cyclical sectors of the market over recent months.
- Likewise, over the past three months, cyclical sectors have seen among the most dramatic fund outflows of the past 10 years.
- These trends indicate investor expectations have been reset sharply lower. We view this as a positive sign for these sectors given markets are all about how data comes in relative to expectations as opposed to whether data is good or bad on an absolute basis.
Concern #2 – The Federal Reserve taper
On the margin, the Federal Reserve (Fed) is set to be less accommodative, but this has been well telegraphed.
Importantly, we expect the central bank will begin reducing its monthly asset purchases late this year through mid-next year. That said, the Fed will still be increasing its balance sheet (just at a slower pace), likely to the tune of $300 to $400 billion, well into the middle of next year.
Concern #3 – The potential for higher taxes
While the tax picture is far from clear, the consensus is centered on the corporate tax rate rising closer to 25% from the current 21% today and an increase in capital gains for those earning over $400k to 25% from 20%. (With the current 3.8% net investment income tax, the capital gains tax rate would be 28.8%).
When we analyze the historical impact of tax policy on market returns and economic growth, we fail to find a consistent relationship.
For example, despite extremely high taxes, the 1950s had the best stock market returns of the past 70 years as well as a robust economic environment, aided by the post-WWII boom.
Conversely, despite very low taxes, the 2000s were beset by the aftermath of the bursting of the technology bubble, record high valuation levels, and the 2008 global financial crisis.
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