Near-term Weakness Long-term Strength

The S&P 500 is off to a slow start in the month of September.  The market sits less than 2% below an all-time high, but a string of down days has put some participants on guard.  This comes as concerns about stagflation and fiscal problems grow.  No doubt, the wall of worry is getting taller, but the equity market still has several powerful catalysts in its corner.  

Inflation pressure continues to build even as economic growth expectations moderate.  Price increases continue to be fueled by supply chain bottlenecks and a widespread labor shortage.  Despite job openings at a record high, total payroll employment sits well below its pre-covid level and the monthly gain in August came in significantly below estimates.  These bottlenecks have begun to weigh on the output of both goods and services.  In addition, services have the added pressure of a delta variant slowing the reopening process.  Because of this, GDP estimates for the next several quarters have been reined in.  There is real potential for stagflation to set in as we move past the easy comparisons to 2020.  Understandably, this is a concern for corporate sales and earnings.  

Developments out of Washington are another looming threat.  September is shaping up to be a challenging month on the Hill.  Congress must tackle funding to avoid a government shutdown, a debt ceiling increase, and the advancement of two substantial infrastructure packages.  The first two items come and go every few years without causing much of a stir, but the infrastructure packages are a bigger deal because of the potential for significant tax increases.  

As part of the $3.5 Trillion fiscal package put forth for reconciliation by the Democrats, we may see a rise in the corporate tax rate, changes in the treatment of foreign income for US corporations, increases to dividend and capital gains taxes for high income filers, and a host of other tweaks to the tax code.  Should the legislation pass as proposed, earnings growth in 2022 could be wiped out and then some.  Ultimately, we expect the size of the deal and thus the size of the tax impact to shrink over the course of negotiations, but they will be significant, nonetheless.  We have noticed that the growth in earnings expectations for 2022 has slowed, but the full impact of such dramatic changes to the tax code is not yet fully reflected in the estimates.  This is a figure we will watch closely as the negotiations play out.  We will also be looking for the winners and losers as the details become clearer.  

Though the road ahead is potentially rockier than what we have seen so far this year, we continue to have confidence in the strength of the equity market over the long-term.  For one, equities continue to receive a great deal of support from accommodative Fed policy.  We see few signs of the Fed backing off its low interest rate stance any time soon.  With rates so low across the yield curve, stocks continue to offer an attractive risk premium relative to fixed income.  We do not believe there is an alternative to stocks for investors seeking real returns.  

Companies are also sitting on abnormally wide profit margins.  This comes as a result efficiency gains and a lack of investment opportunities with so many bottlenecks during the pandemic. When the logjam eventually clears, companies are going to be well positioned to invest heavily in capital expenditures.  These expenditures have the potential to fuel a long-awaited productivity boom.  Productivity gains are essential for economic growth to materialize in the decade ahead.  We believe that companies have a long runway for opportunity on this front.  When combined with the TINA effect, we see little reason to be bearish on equities over the long run.  We believe near-term weakness should be viewed optimistically.  

Preston May, CBE®
Research Analyst