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Markets, Economy, & Portfolio Management

Markets, Economy, & Portfolio Management

U.S. major equity indexes pulled backed five percent in September; a month known for corrections. The pullback in stocks brought major indexes back to levels where indexes stood three months ago. Year to date stocks are outperforming bonds by a wide margin. Most bond sectors are on track for a negative year. The stock market enters a seasonally strong investment period by the end of October. I expect major equity indexes to move modestly higher in a choppy fashion into year-end.

Market Update

Worries about the impact of the coronavirus' delta variant on the economy, supply chain slowdowns leading to shortages across a few industries, and a regulatory crackdown in China, inflation and tapering fears conspired to slow U.S economic growth for third quarter. In turn, slowing economic growth and inflationary forces caused stocks to swoon by quarter end.

History shows that stock returns remain robust in the months leading up to and following the first-rate hike. More specifically, over the past four rate hike cycles the S&P 500 gained 9.5% in the twelve months prior to the first hike, and 26.0% over the subsequent 3 years according to Credit Suisse. The real damage from higher rates tends to occur later in the cycle when tighter policy inverts the curve.
The U.S. consumer is in its best shape in over a decade with healthy savings, delivered Balance sheets, higher 401-k balances, and home values. Moreover, wages are rising, and anyone who wants a job can to get one. Businesses are in even better financial shape. Corporate America Balance sheets and Income statements are as healthy as they ever have been. However, consumption is not rebounding as fast as forecasted. Supply constraints and Delta variant weighing on spending. Demand for products and services should recover as supply constraints resolve themselves and Delta-variant peaks.

For the stock market to enter a down market US economy must moving towards a recession soon. Cyclical fundamentals do not support a down market. Credit spreads remain below normal including High Yield. Net rating upgrades continues to move upward to the highest level since 2009 according to Bloomberg. Credit markets lead equity markets, credit spreads did not widen last quarter in a material way. Stocks move in opposite direction of spreads and same direction of yields. Yields are rising signaling that third quarter economic growth is just a soft patch.

Lastly, the cumulative A/D line, breadth and price are not diverging a sign that October’s pullback is not evolving into a correction and cyclicals should outperform going forward. The bottom-line, the stock market pullback should end in October on a solid earnings season and move modestly higher into year-end.

Economic Update

US economic growth rate hit a soft patch in the third quarter due to supply chain constraints, labor shortages, and Delta Variance related slowdown effects. Growth rates will remain higher than normal but have peaked as fiscal and monetary stimulus is waning in 2022. Overall, pent-up consumer demand due to supply shortages, supportive fiscal and monetary policy, and favorable credit conditions provide a near-term backdrop for sustained cyclical improvement. There is no sight of a recession ahead.

All major economies are in expansion. Developed markets tend to have more favorable near-term backdrops, with reopening progress in Europe coinciding with improving consumer sentiment. China's deceleration continues, though growth may stabilize toward year-end as COVID-19 fades. The general trend of lasting re-opening as COVID threat wanes implies a continued broadening of the global economic expansion. The International Monetary Fund expects global gross domestic product to grow by 5.9% this year and 4.9% next year.

The US economy in mid cycle. The Delta variant has peaked but supply constraints and labor shortages remain a risk to U.S. economy. Progress on vaccinations should result in a pickup in economic activity as worker return to workforce. U.S GDP projected to grow 6.3% in 2021 – more than double than normal rate even despite COVID! 2022 GDP projected to exceed 3.5%.

Covid case counts, hospitalizations, and deaths are continuing to roll over in the US which is a welcome development. In terms of vaccination rates, we are getting remarkably close to three-quarters of the US population over the age of twelve receiving at least one shot while two-thirds are fully vaccinated.
Portfolio Management Update

Tactical Model Portfolios are overweight equities going into year-end. I see positive earnings outlook until 1Q 2022. Intermediate economic growth will remain above long-term average rate and historically low interest rates are still supportive of economic growth. Mid-cycle fundamentals suggest favoring cyclical value stocks and quality dividend appreciation stocks. I am staying underweight in long term bonds for now and increasing fixed income investments credit quality.

Stock leadership is shifting from growth stocks that outperform in times of slow economic growth to economically sensitive areas of Small-caps and cyclical sectors. Historically, when yields rise, and economy grows at three percent Value stocks beat Growth stocks and cyclical stocks beat defensive stocks.

Favoring Financials, Energy, Industrials, Consumer Discretionary, and Technology stocks in model portfolio’s equity asset allocation. Also, own Healthcare stocks for their cyclical and defensive characteristics. In bond component of model portfolio overweight Floating Rate Bonds, Senior Bank Loans, and Treasury Inflation Protected Bonds.
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