The Navigator | October 2021
The stock market posted its first decline since January, with the S&P 500 losing 4.8% in September. The tech-heavy Nasdaq underperformed the market and fell 5.3%, while the Dow was down by 4.3%. Energy was the only sector that enjoyed a positive return this month, boosted by soaring crude oil prices. September has witnessed a rapid rotation away from growth and technology stocks to cyclical stocks as the benchmark 10-year Treasury yields spiked to 1.5%. Financial stocks outperformed with rising yields serving as a tailwind to bank profitability, while technology stocks got hit with increased implied discount rates weighing on future earnings.
The weakness and increased volatility of the market can be attributed to several factors, including concerns around monetary policy, inflation pressure, and regulatory clampdown in China as well as stretched valuations. The September FOMC meeting sent a strong signal that the Fed will begin to taper around the end of the year. The updated dot plot was taken as a moderately hawkish signal as half of the participants expected at least one rate hike by the end of 2022. While the environment of gradually rising interest rates coupled with negative real rates is generally supportive for risk assets, we anticipate volatility along the way as markets remain sensitive to policy changes and tend to over-react after an extended bull run.
The Chinese real estate sector is also in the spotlight with fears that a possible default by Evergrande, China’s second-largest property developer, might cause a global financial crisis similar to what was triggered by the collapse of Lehman Brothers 13 years ago. The Lehman parallel, in our view, is not valid. Rather than a sub-prime bubble that caused Lehman’s collapse, the Evergrande crisis boils down to a liquidity crunch after the change of government policy widely known as the “Three Red Lines” – three debt metrics that real estate developers have to meet before they can borrow more. Under these new rules, Evergrande no longer has access to debt and is not able to continue its strategy of over-hoarding land and financing interest expense with new debt. Looking forward, instead of a chaotic bankruptcy, we expect Evergrande’s liabilities will be restructured in a relatively well-managed way to limit broader financial disruption. A typical contagion effect to the financial system should be limited as Chinese banks are essentially owned by the government, and Evergrande’s outstanding debt adds up to a negligible amount of the country’s total banking assets.
Although we still stay generally constructive towards risk assets, we are slightly less optimistic and have taken a little equity risk off the table as we see some softness in data and stretched equity valuation. U.S. consumer sentiment has fallen noticeably in the last two months while Eurozone economic sentiment indicators also eased. The August U.S. payroll data disappointed the market with only 235,000 job gains. On the positive side, the PMI index was only a touch below the level of 60, supported by improvement from new orders, production, and inventory. Inflation showed some signs of deceleration as CPI rose 0.3% in August, down from the 0.5% gain in July. A more encouraging development is that the spike in coronavirus infections from the Delta variant seems to be slowing in the last two weeks. The daily average of new cases declined about 25% compared with two weeks ago, and we hope the trend continues in the coming weeks.
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↓ Valuation | With the S&P 500 ending a seven-month winning streak and losing 4.5% in September, valuations for equity improved but are still under pressure. P/E ratios decreased to 25.8 at the end of September from 27 at the end of August. The Forward P/E ratio also declined slightly to 21.3 from 22.4. Inflation-adjusted valuation metrics continued to be negative with inflation rising.
↔ Sentiment | August’s PMI index reading came in stronger than anticipated, hovering around the level of 60, and marking the 15th consecutive month of expansion. The ongoing pandemic and inflation concerns continue to weigh on consumer sentiment. The University of Michigan’s sentiment index remained near its lowest level since 2011. Homebuilder confidence inched up 1 point, helped by a combination of low housing supply and rising demand together with the easing pressure from building-material cost. However, the housing market still faces the challenges of affordability, supply-chain issues as well as rising rates.
↑ Technical | Technical indicators remained positive but looked stretched. At the end of September, the S&P 500 was 4% above its 200-day moving average, 1% below the 100-day average, and 3% below the 50-day average. Volatility spiked later in the month as inflation fears, peaking growth and rising yields kept investors on edge. The VIX level settled at 23.1 at the end of the month, compared with 16.5 at the end of last month. The short-term reversal signal, however, turned positive with the recent market pullback.
↑ Macroeconomic | Payroll employment gains dropped significantly in August to 235,000, less than half of the consensus estimate. The initial jobless claims rose for three consecutive weeks, though claims remained near their lowest level since the beginning of the pandemic. However, we expect the labor market will continue to recover as more workers are able to re-enter the market with the ebbing Delta variant wave. The CPI rose 0.3% in August with both the travel sector (airfare, hotels, and rental cars) and new-and used-car sales seeing price declines in August.
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As of 9/30/2021. Data provided by Bloomberg, WSJ, NorthCoast Asset Management.
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