The Stock Market and the Business Cycle

September 9, 2021

A “golden rule” for asset allocation is to remain bullish on equities unless there is a good reason to think that a recession is around the corner. This rule has strong empirical support as equity bear markets rarely occur outside of major business cycle downturns. Nevertheless, there are different shades of bullishness. Stocks generally perform best coming out of recessions when the economy is weak but improving, and worst when the economy is falling into recession.

We are currently in an intermediate phase, where global growth is slowing but still very solid. Historically, stocks have posted positive returns during such phases.

This intermediate phase can last for an extended period of time. On a 12-24 month horizon, economic growth in developed economies, as well as the trend in financial markets, is not likely to be impacted by new waves of COVID-19. Easy monetary policy, a high level of household savings, and robust corporate revenue growth will support economic growth and the trend in stock prices. This means our outlook remains positive on risk assets.

As we expect bond yields to eventually rise, we still expect to see very low returns on fixed income. We also expect commodities to resume their uptrend, and as a result it is likely that the U.S. dollar resumes its downtrend over the coming year.

Monitoring the Risks

September and October have historically always been volatile months and given the fact that most equity markets have posted solid gains this year, it is important to monitor the risks for signs that it could be time to turn less positive on equity markets. We see several potential risks for markets, which we discuss below.

The Emergence of Vaccine Resistant Covid Variants

The Delta variant continues to spread globally. While the new strain does not seem to be any more deadly than other variants, it is a lot more contagious. The currently available vaccines do seem to offer substantial protection. While a vaccine-resistant strain could emerge, it is likely that vaccine producers will be able to adjust their formula to keep the virus at bay. As such, we see Covid as only a modest risk to global stocks.

In the U.S., the Center for Disease Control estimates that from February 2020 to May 2021 only 1 in 4.2 COVID-19 infections were reported, suggesting that there were approximately 120 million total infections during that period. That would be quite positive for the economic outlook if accurate, as it would imply that the true immunity rate in the US is probably higher than the vaccination rate would imply.

A possible “Goods Recession”

Even if Covid fades from view, the dislocations caused by the pandemic will persist for a while longer. The pandemic and stay-at-home policies made us spend a lot more on goods and much less on services. Overall consumer spending in the U.S. is broadly back to its pre-pandemic trend, however, service spending remains below trend while goods spending is above trend. Retail sales, which are dominated by goods, are also firmly above trend. It is possible that consumers will shift their spending pattern from buying goods to buying services in the next few months. Which could mean, for example, that we stop spending money on home improvements and instead go on holidays again. On a macroeconomic level, it does not really matter but it could hit manufacturers and retailers, which would have a negative impact on macroeconomic data, causing financial markets to interpret it as an economic slowdown.

Higher Bond Yields

Stocks represent a claim on future corporate cash flows. Higher bond yields reduce the present value of those claims, potentially leading to lower stock prices. Our view is that we are currently in a sort of goldilocks scenario: an economy that is strong enough to keep deflationary forces at bay, but not so hot that the Fed must intervene to raise rates. This was confirmed by Fed chairman Powell’s speech at the Jackson Hole conference last week. He focused on separating the notions of tapering asset purchases and increasing interest rates. A useful analogy is that by slowing down asset purchases, the Fed is merely taking its foot off the accelerator. Increasing interest rates will be when the foot goes on the brake.

We don’t think the economy will see adverse effects from the Fed’s announcement of lower monthly bond purchases (i.e. taper), which is likely to happen at one of the upcoming Fed meetings, as the economy has enough upward momentum. Financial markets seem to agree as August was another positive month for risk assets.

Higher Tax Rates

The Biden Administration is aiming to raise the corporate tax rate from 21% to 28%, bringing it halfway back to the 35% level that prevailed prior to the Trump tax cuts. Similar discussions around raising corporate or personal taxes are happening in Europe and China.

Analyst estimates do not appear to reflect the prospect of higher taxes. However, we think that the impact of higher tax on earnings-per-share for S&P 500 companies could be quite, likely less than 5% in 2022. Given that earnings are expected to rise by 9% next year, this would still leave earnings growth in positive territory.

Weaker Chinese Economy and Regulatory Crackdown

With credit growth back to its 2018 lows, the authorities are likely to ease monetary policy over the coming months. While the crackdown on internet companies could continue, it is unlikely to spill over to other sectors. Unlike Chinese companies in the telecom or semiconductor sectors, Beijing does not see most online platforms as contributing much to the economy. What they do see are companies with the potential to undermine the authority of the Communist Party (and in the case of online education providers, reduce the birth rate by burdening parents with high educational expenses).

Meanwhile, Chinese stocks listed in offshore markets have suffered a massive blow from Beijing’s recent regulatory overhaul, which appears overdone. All of this justifies a position in Chinese equities today.

President Xi Jinping’s new economic doctrine of “common prosperity” does not mean taking down the private sector. It means addressing the income inequality problem. In some ways, “common prosperity” is not very different from President Joe Biden’s $3.5 trillion budget blueprint, which also aims to deal with social inequality issues.

Many large Chinese tech companies, such as Tencent, Alibaba or JD.com are trading at 15-20 times forward earnings, while similar companies in the U.S. command a forward P/E of 30-50. In other words, Chinese stocks are trading at half of the market valuation of their American peers but have comparable or faster earnings growth.

Geopolitical Risk

The chaotic U.S. withdrawal from Afghanistan and the Taliban’s reconquest of Afghanistan has little significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected yet both equity markets have been outperforming over the course of the Taliban’s military gains. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. The U.S. is conducting a strategic pivot from the Middle East to Asia Pacific.

Judging by defense spending or trade balances, this does not mean the U.S. is retreating from its global role. While the desire to phase out wars could open the way to defense cuts, the reality is that the confrontation with China and Russia will demand continued large defense spending. The U.S. also continues to run large trade deficits, which gives it influence as a consumer and provider of dollar liquidity across the world.

In the context of the U.S. withdrawal from the Middle East, the U.S. – Iran negotiations are important. If they fail, the risk of war will increase in the Middle East and the U.S. could remain entangled in the region. That is why from a geopolitical perspective it is in both sides’ interest to reach a deal. Iran needs a reprieve from economic sanctions to rebuild its economy and the U.S. wants to decrease its involvement in the Middle East. However, if there is no deal, we could see higher oil prices because of the geopolitical risk premium, which can be disruptive to global financial markets.

Investment Conclusions

The bottom line is that timing a correction is always difficult and often not successful. What investors should do is to make a judgment call on the future path of the cyclical process for the economy and position their portfolios accordingly.

Growth is slowing but will remain solid for the remainder of the year. The forward earnings yield on the MSCI All-Country World Index stands at 5.2%. While this is not particularly high in absolute terms, it is still very high in relation to bond yields.

Stocks outside the U.S. currently have a higher earnings yield of 6.4% and lower valuations. Lower valuations may be justify given lower growth, but we expect the gap in economic growth in the U.S. vs Europe and Asia to get smaller as the U.S slows down, while Europe and China could surprise on the upside going forward. This could mean that international markets catch up to U.S. market performance. Another consequence of this is that it is likely we see a weaker U.S. dollar going forward. Lastly, a weaker dollar combined with continued economic growth should also be positive for commodity prices.

One way to deal with market risks, both upside and downside, is to maintain a balanced exposure to different asset classes, regions and sectors. As portfolio managers we always aim to adjust portfolio weights based on shifting policy expectations, equity valuations, and risks.

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

The MSCI ACWI Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes.