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The S&P 500 stock index ended September down by 4.8%, its first monthly drop since January and the largest fall since March 2020. Vincent Nichols, investment specialist for US equities, reviews recent events and the outlook for US stocks.
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The S&P 500 Index ended a seven-month winning streak in September. In seeking an explanation, the first thing that comes to mind – and probably the most common or obvious answer that you hear for various disappointments either at the company or macro level – is of course the rapid spread of the Delta variant of Covid-19. It is only now that we are seeing markets roll over, just as we are also seeing the Covid backdrop improve. There are many variables at play, some perhaps interrelated to the Covid resurgence.
US GDP seems to have peaked and it may now decelerate faster than previously expected. Many economists have drastically slashed their estimates for third quarter US growth. Some of this is surely related to consumers being more reluctant to get out of the house and spend on various leisure activities. Many of the durable goods US consumers would rather spend their money on face a myriad of supply chain disruptions.
The good news is that consumers still have the desire and capacity to spend more, but current circumstances are pushing this spending a little further down the road. If this does prove to be the main culprit for recent weakness in stocks, then logically it would seem that now is yet another great opportunity for investors to buy the dip.
The other variable that may be more concerning is that we are now getting into the late hours of the monetary and fiscal stimulus parties. Revellers are a bit weary and thinking about the sobering-up that lies ahead after the excesses.
Tapering of asset purchases by the US Federal Reserve is likely to begin before the end of the year. Although the Fed will continue to purchases substantial volumes of securities, prudent investors will be discounting future expectations. They will note that the Fed’s playbook is looking increasingly hawkish.
The US emergency pandemic unemployment benefits ended in September. As a result, around seven million Americans have just experienced what amounts to a significant pay cut. This may ultimately prove to be a healthy development from the corporate perspective. It should help to alleviate supply and demand mismatches in the labour market. This in turn would relieve upward pressure on wages, particularly among the lower skilled workers. Overall, however, this seems to be having a negative impact on sentiment at the moment.
Of course, the resurgence of the Delta variant has had a direct impact on employment. We saw disappointing US job growth in August, with particular weakness in Covid-sensitive industries. Initial unemployment claims have also jumped in recent weeks.
A rise in inflationary pressures is certainly another factor playing a role in market behaviour. Inflation at the wholesale level rose by 8.3% in August compared to August 2020. That is the largest annual gain since the US Labor department began calculating the 12-month number in 2010.
Supply chain bottlenecks and a shortage of workers have pushed prices higher. Sharp increases to input costs and wage hikes will ultimately squeeze corporate profits, at least in the short term.
Companies with pricing power and resilient business models and low, or at least stable, variable costs should have an advantage if such an environment is sustained for an extended period.
Price rises for many raw materials should abate as the Covid-related disruptions ease. We saw this earlier in the year with lumber prices and are now seeing it, albeit in a less volatile manner, with iron ore and steel prices.
Rising costs and margin pressure are one thing, but an inability even to supply products or services to meet consumer demand is another related challenge. This is already having an impact on the top line for many companies, whether consumer durables or consumer services, but this is likely more temporary.
The bigger concern is probably on the wage front, where costs could prove to be stickier. The expiration of emergency unemployment benefits should help slow further increases, but we are unlikely to experience a significant reversal, if any. Companies with a larger proportion of low-skilled workers could be the most at risk of margin compression.
The consumer sector had a tremendous year last year, particularly in the market rebound after the first quarter of 2020, so it is not too surprising to see some relatively modest underperformance so far this year, given these circumstances. If most of these issues do prove to be transitory, the financial buzzword of 2021, then there may be a good opportunity to allocate to the consumer sector in near the future.
Meanwhile, even if government handouts do decline sharply, consumer savings are still quite robust. And if the third wave of Covid continues to subside in the US, the job market will also improve. All of this should feed into healthier, more sustainable economic conditions, rather than the economic climate being dependent on government stimulus.
The challenge now is timing. What does transitory really mean? We gain comfort from the fact that buying quality businesses at reasonable prices should more often than not prove profitable. More importantly, companies at the cutting edge of innovation that are disrupting their industries and gaining share, have the opportunity to outperform in any market environment. The pandemic has only accelerated many of these market evolutions, so investment strategies that favour such investments at the expense of those being left behind, should benefit disproportionately.
After strong outperformance following news of the vaccine rollouts last year and early this year, US small caps ran far ahead the rest of the US stock market, but have since given up their lead. US small cap stocks have come a long way. They are more sensitive to economic conditions, so the fact that US growth forecasts have fallen significantly for the third quarter after a likely peak in the second quarter is not supportive of stocks lower down the market cap spectrum.
We should remind ourselves that in the six months between 24 September 2020 and 15 March 2021 the small-capitalisation S&P 600 Index rose by 69%. That was more than triple the gain of the large-cap S&P 500. Subsequently, however, valuations of small caps tailed off while prices of large-company shares maintained a brisk rising pace. The Russell 2000, a standard benchmark for US small caps, has significantly underperformed the S&P 500 this year. Since July, for example, the index has fallen by nearly 4% compared with the S&P 500′s gain of almost 4%.
This underperformance has not coincided with fundamentals, though. US small cap earnings expectations for 2021 have improved nearly every month this year – and more rapidly than those of their large cap peers. This leaves relative valuations looking very attractive, in my view. Small caps are trading at a steep discount to large caps whereas historically they trade at a modest premium.
Small caps have other merits too. The S&P 500 is increasingly driven by the information technology and communication services sectors. Together these account for 39% of the total index. Those high-tech sectors amount to only 16% of the small-cap S&P 600. Over the longer term, the small-cap indices have the advantage of being broadly diversified.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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