Filtering Out the Noise

by | October 4, 2021

If you write about financial markets every week, as we do, it can be challenging to come up with dramatic insights on schedule. This is a good thing, for often what is needed is not a clarion call to action, but rather a step back to put in context what is really going on.

September reminded investors, again, that it is the cruelest month for equities. Since 1945, September has produced an average negative monthly return for the S&P500, the only month of the year with that distinction. This September, the S&P500 lost nearly 4%, with most other major indices ending in the red as well. (The exception was the Japanese market, which rose for the month.) 

The decline in major equity markets last month was not, however, accompanied by falling bond yields. Quite the contrary – during the final two weeks of the month, yields rose smartly, and the curve steepened, typically signs of improving growth. Echoing that theme, small capitalization, value and more cyclically sensitive sectors outperformed in September. Commodity prices, including energy (oil, coal), foodstuffs and steel also made strong gains. Those outcomes are not consistent with widespread growth fears.

And yet conventional economic releases were mixed last month. The Atlanta Federal Reserve’s ‘GDPNow’ estimate plunged. In August, it was predicting over 6% annualized growth for the third quarter. That number has recently dropped to just 2.3%. Yet the manufacturing ISM manufacturing index, which alongside the yield curve has proven to be a reliable indicator of the cycle, remains firmly in expansionary territory. 

Like other investors and market observers, we find recent market gyrations challenging to discern. Is market angst driven by global growth fears? Inflation and tapering? Political and geopolitical uncertainty? Or is it mostly noise?

Here is our take.

To begin, a variety of newsworthy events are weighing on investor sentiment. Difficult negotiations and partisan point-scoring around the need to lift the US debt ceiling are more than a distraction. Investors recall how government shutdowns and even default risk, however remote, have roiled markets in the past. 

At the same time, the failure of the Democratic Party to unite on the twin infrastructure bills in Congress has fueled concerns about future US fiscal stimulus spending and prompted some discussion of dire 2022 mid-term election consequences, which could make Washington even more ungovernable. It is not an over-statement to note that the future of Biden’s presidency likely depends on successfully driving through his economic plans. 

In China, Xi’s crackdowns on corruption, corporate excesses and property speculation have raised doubts about China’s commitment to growth. Moreover, China flew 36 military jets over Taiwan’s defense zone last week in a show of force to mark the founding of the People’s Republic of China – a worrisome development at a time of rising US-China tension following the AUKUS submarine deal. Finally, elevated inflation and long-lasting supply bottlenecks are raising uncertainty about how the Fed and other central banks may respond. Will they keep their nerve and allow inflation to overshoot, as they have previously pledged, or will they speed up tapering and eventual rate hikes?

Still, it is easy to exaggerate the importance of these negative factors and omit some positive developments. For instance, the latest evidence suggests that Delta-variant infections in the US and elsewhere have peaked and are now declining. Threats to economic reopening appear to be receding. 

In the world of politics, the Democrats are still more likely to unite around compromise infrastructure spending legislation than hand Republicans an easy victory. Already, progressives are moderating some of their spending plans (around a five-year time horizon), opening new negotiations with recalcitrant moderates and center-right senators. In China, fears about Xi’s crackdown are easily overdone. China’s leadership is unwilling to inflict much harm on its economy. And as we have argued in these pages, military tensions between the US and China may simmer, but need not erupt. 

In the past, we have noted that the coincidence of high equity valuations, peak earnings, and moderating global growth are sufficient to introduce more volatility into capital markets. For the same reasons, equity returns are likely to be more subdued. 

But that is not the same as concluding that the bull market is over, or that a major correction is now likely. Given unattractive bond returns and negative real (inflation-adjusted) returns on cash, investors will not be easily dislodged from the only game in town, namely equities. 

Markets are often noisy and fundamental investors are well-advised to ignore periodic excesses. To be sure, investors have plenty to think about and complacency is never warranted. Yet there is less to fear today than many pundits suggest. Growth was always going to slow as emergency fiscal stimulus faded, but recession risk remains very low. As we’ve long argued, inflation was never going to be as ‘transitory’ as the Fed and other central banks had argued, but that is not the same thing as saying that inflation is becoming unhinged. 

Indeed, based on decades of experience, central bankers are wary of using monetary policy to address price increases that arise mainly from supply-side rigidities, so long as inflation expectations remain stable, and demand is not surging. That’s precisely the case today, which is why investors ought not to become overly concerned about monetary policy tightening.

The days of easy returns in markets are over. High valuations create higher hurdles for growth and earnings. Economic and policy fundamentals are not as unambiguously positive. Risk-adjusted returns will be lower. But that fact, alone, is no reason to panic. Instead, get used to it and adjust expectations accordingly.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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