Heads I win, tails I win
Uncertainties and vacations may feed volatility but bull trend carries on.
As we head into the Dog Days of August, it’s worth remembering volatility is normal as trading thins and everyone heads to the beach. We wouldn’t be surprised if there’s even a modest correction as investors grapple with five big unknowns: 1) How much will the delta variant’s surge impact the economy’s reopening?; 2) What is inflation’s trajectory—i.e., how transitory will its run-up prove to be?; 3) Have GDP and earnings growth already peaked?; 4) Will China’s toughened policies toward its stock market and tech giants impact growth and investments in the all-important Asian markets?; and 5) When, and to what degree, might the Fed start to tighten?
The good news: each of these questions has at least two possible outcomes, either of which should be bullish for stocks. So, even though volatility in this upwardly biased market may pick up as investors parse incoming data and events, in the end, we think we are entering a "Heads I win, tails I win" moment in this secular bull. Here’s why:
- Delta variant. This Covid-19 variant is causing a much-publicized resurgence of the virus globally, though it already has peaked in countries such as India and the U.K. where it hit first. In the U.S., delta variant cases continue to climb, particularly among lower-vaccinated populations. But there are several reasons for optimism, including the peaking pattern in the U.K., which would imply the U.S. peak may be reached by mid-August. Also, the rise in hospitalizations and deaths generally has been muted, especially among the vaccinated, while Covid’s resurgence has spurred a reacceleration of vaccinations, bringing the U.S. on the edge of herd immunity. In our view, the risk is the potential reaction of consumers and businesses may push the recovery's trajectory modestly lower. But even if the resurgence takes longer to peak, the good news is it will pass, either very soon (our base case) or just soon.
- Inflation. We and our Federated Hermes colleagues have written much on this topic already, so we won’t rehash that here. Suffice to say, we think we could be entering a period of higher-than-normal inflation as supply and demand shortages in commodities and logistics challenges take longer to sort out than expected, and labor shortages against this backdrop lead potentially to higher-than-expected wage hikes. The alternative case is the Fed’s—that all this will prove transitory. Both cases actually would be good for the two drivers of equity prices: higher inflation would drive higher nominal earnings growth, and transitory inflation would drive lower discount rates/higher valuations.
- Peak growth. We think the concerns on peak growth are overblown. Unlike any previous economic recovery, this one is likely to be viewed through the lens of history as more a resumption of an existing long up-cycle rather than a sharp and short-lived economic recovery. Normally, economists worry about “peak growth” in the latter, since the peak normally presages an upcoming slowdown. But this time, “peak growth” is simply the arithmetic reality of year-over-year comparisons against negative numbers that going forward are becoming less negative. In our view and even consensus, a long robust expansion lies ahead of us, as we are only just now re-achieving the GDP levels of late 2019. Earnings, too, likely continue on a strong upward pace. Consensus estimates throughout this “peak” earnings season have been rising (not falling!) on a daily basis since the season began in mid-July; at $235 on the S&P 500 for 2023, they are now above our previously “overly bullish” forecast.
- China policy. Our colleague Calvin Zang just published a good read on this, so in sum: we think concerns over China policy toward the public equity markets are significantly overblown, presenting an interesting entry buy opportunity for Asian stocks. But if we are wrong and the forward stance remains discouraging, doesn’t this just become another TINA, i.e., There Is No Alternative, driver for U.S. equities?
- The Fed. All eyes are presently on our central bank and the timing of the start of taper. We think late September, finally giving a lift to bond rates and the financial sector, a key component of the value indexes. But if we’re wrong and the Fed continues to take the other side of the questions above, lower rates for longer would likely give new life to the big growth stocks as their valuations, and more broadly those of the entire market, expand even higher.
So, brace yourselves for the weeks ahead. August could portend some dog days as data and news arrives addressing all five questions above. But we recommend holding tight to an overweight in equities, and continue to lean into the cyclical stocks, which would be the primary beneficiary of our base-case scenario for most of these questions. But even if some of the alternative scenarios play out, the good news, again, is either way, by year-end, long stock positions are likely to be rewarded. After all, from our perspective, it’s a “Heads I win, tails I win” market.