US Strategy Weekly: Weakening Underpinnings

In a recent US Strategy Weekly (“Earnings Estimates and Inflation” August 25, 2021) we wrote that we thought the trend of the 2021 equity market could be simplified into two main positive components: 1.) a strong earnings rebound and 2.) historically easy monetary policy. Therefore, we are not surprised by this week’s sell-off since both of these underpinnings are currently coming under pressure.

Earnings

As we noted last week, consensus earnings forecasts may have made an important shift in late August. Very simply, after more than a year of steadily rising earnings estimates, forecasts are beginning to edge lower. And while estimates still reflect a positive growth rate for 2021 and 2022, these growth rates are falling, and this is noteworthy. Steadily rising earnings estimates have provided a continuous incentive to buy stocks while also providing good fundamental support in the event of any negative news shock. But now, with estimates drifting lower, downside support is less definable and reliable. This change could result in less demand for stocks and could make speculators more cautious in the final quarter of the year.

As an example of the current earnings shift, the S&P Dow Jones and IBES Refinitiv estimates for 2021 decreased $0.30 and $0.40, to $198.32 and $200.63, respectively, this week. Similarly, estimates for 2022 fell $0.35 and $0.42, bringing full year forecasts to $217.69 and $219.93, respectively. According to IBES estimates, with the SPX at 4360, the market is trading at 23.4 times trailing 12-month and 19.8 times next calendar year’s earnings forecasts. Neither multiple is cheap when compared to its respective long-term PE average of 15.8 times trailing or 17.7 times forward earnings. And unfortunately, estimates are being shaved just ahead of third quarter earnings season, which will make third quarter results and CEO comments on future earnings growth more important than ever. Also, analysts have theorized that the proposed Biden corporate tax rate changes could shave an additional 5% off earnings in 2022 which would make current 2022 estimates too high. In sum, investors may no longer be able to rely on rising earnings growth to boost stock prices in the months ahead.

Monetary Policy

In another turnaround, Federal Reserve Chairman Jerome Powell, in remarks delivered to the Senate Banking Committee on Tuesday, cautioned legislators that inflation is higher and lasting longer than he anticipated. In fact, Powell noted that as the economy continues to recover from the pandemic the increase in demand is putting more upward pressure on prices and supply bottlenecks in a number of sectors have not abated as expected. In our opinion, Powell’s comments should not have surprised investors since we saw few signs that inflation was indeed temporary. Yet it did seem to catch investors off guard, and the 10-year Treasury note yield jumped from 1.48% to 1.53%. Technology stocks swooned in response to the rise in interest rates which is a normal reaction for growth stocks. In most valuation models, the 3-month or 10-year Treasury yield is used as the risk-free rate to measure the relative attractiveness of equities to bonds. As interest rates rise, stocks with higher PE multiples and little or no dividend yield will look less attractive in these models. Along with Chairman Powell’s comments this week are comments from other Fed governors that monetary policy is about to change. At separate speaking engagements this week, Fed Governor Lael Brainard and regional presidents John Williams of New York and Charles Evans of Chicago all indicated that they are comfortable with a first phase of tapering and that a gradual pullback of monthly bond buying is appropriate. Quantitative easing has helped to support markets and the economy since March 2020. But comments from Chairman Powell and other Fed officials this week suggest investors may no longer be able to rely on monetary policy to support stock prices in the months ahead.

Geopolitical Backdrop

Neither a slowdown in earnings growth nor a shift in monetary policy are insurmountable hurdles for equities; however, both changes suggest the “easy” part of the bull market may be over. Meanwhile, a number of issues in the geopolitical/economic environment could become major problems. Perhaps the most worrisome is China’s power crunch which has been triggered by a shortage of coal supplies. At least 20 Chinese provinces and regions which make up more than 66% of the country’s gross domestic product, have announced some form of power cuts, mostly targeted at heavy industrial users. These power cuts have halted production at numerous factories including those that supply Apple (AAPL – $141.91), Tesla (TSLA – $777.56), and Toyota (TM -$184.85) and is expected to impact the production of steel, aluminum, and cement. It will reverberate through many global sectors including chemical producers, carmakers, building supplies and shipping companies. Overall, this could easily become a much bigger problem than the Evergrande crisis which continues to overhang the Chinese property market.

Plus, China’s energy shortage it is putting pressure on oil prices and lifted WTI (CLc1 – $74.26) over $75 a barrel this week which will put more pressure on global inflation. In short, China’s energy/property crises could easily slow global growth and increase inflation around the world. In the US, potential monetary policy changes are pushing interest rates higher at a time when Congress is threatening individuals and corporations with higher tax rates. Both will slow growth. Bull markets are known to “climb a wall of worry,” and it appears there will be many worries in the fourth quarter.

And there are more international concerns. In the UK, a combination of the pandemic and the county’s departure from the European Union are resulting in a shortage of tanker drivers to transport fuel across the country. Media reports of a handful of gas stations closing due to dwindling supplies triggered panic buying in Britain and created massive lines at gas stations. In Germany, a lack of clarity about the composition of the next government following Merkel’s departure, is creating a crisis for the European Union. Without a clear government in Germany a range of decisions from economic policy to defense are being delayed in the EU. In the background, many countries in East Asia and the Pacific continue to face major setbacks in their recovery from the coronavirus. There is no shortage of worries in the globe.

The debt ceiling will become a major financial topic in coming days. But keep in mind that the US government has been shut down several times due to a debt ceiling crisis, most notably in 1995 (one 5 day and one 21 day stretch), 2011 (when Treasury Secretary Timothy Geithner utilized “extraordinary measures” such as the sale of assets from the Civil Service Retirement and Disability Fund and the G Fund of the Thrift Savings Plan to acquire funds) and 2013 (which stretched on for months and also included “extraordinary measures” to pay obligations). Typically, a government shutdown includes the closure of national parks and any other nonessential personnel to save cash flow for social security payments and payments on debt. In general, the debt ceiling debate has been a political game of hot potato.

Technical Wrap Up There was little change in the technical condition of the equity market this week. However, the popular indices and their moving averages may be the most interesting of all technical indicators. The SPX and Nasdaq Composite are currently testing their 100-day moving averages which is normal in a bull market. The DJIA has broken its 50 and 100-day moving averages but still trades above its 200-day MA. The Russell 2000 is the most important index in our view having broken below its long-term 200-day moving average last week yet is holding slightly above this level (now 2213) currently. The RUT is the best representation of the broad-based market; therefore, holding above this 200-day moving average may be critical for the overall market. In general, the underpinnings of the equity market appear to be deteriorating and a defensive position including holding energy or financial and those stocks with good dividend yields and lower-than-average PE multiples may be the best strategy for the fourth quarter.     

Gail Dudack

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