At the start of last week, major US equity indices were trading at record levels; the S&P 500 was attempting to push above the 4550 mark for the first time, the Nasdaq 100 was challenging 15.7K and the Dow was pushing the 35.5K level. But over the last week and a half, sentiment has taken a turn for the worse; the S&P 500 has slipped to fresh three-week lows in the mid-4400s and is about 2.0% down from recent peaks, the Nasdaq 100 is at two-week lows under the 15.4K level, also down about 2.0% from recent highs, while the Dow hit fresh seven-week lows in the and has lost its grip on the 35K handle, meaning it is down about closer to 3.0% from recent peaks. These losses are far from catastrophic, but certainly are notable given the market’s tendency this year to spend most of its timing scaling new highs week in, week out. The reason why equity markets have been on the back foot in the last few sessions has not been abundantly clear, but various theories have been put forward by analysts.
First, September is typically not a good month for US equities; over the last six years, despite the S&P 500 advancing nearly 130%, the S&P 500 index has averaged a return of -0.4%. Therefore, with stocks heading into a typically choppy/potentially negative month based on seasonality, taking a bit of risk of the table likely made sense to some and this profit taking may well have contributed to stocks being pushed lower throughout the last few sessions. Traders have also been citing the usual concerns about the impact of rising delta Covid-19 infection rates and whether there might be growth inhibiting winter lockdowns, as well as concerns about US tax policy uncertainty as chatter picks up on Capitol Hill regarding new corporation taxes to fund the Biden administrations ambitious spending proposals.
Another concern being cited is the fact that despite global growth indicators (such as PMI surveys) taking a turn for the worse since July, particularly in China (which often leads the global growth cycle), it looks as though the Fed is going to go ahead with starting to remove some of its extraordinary accommodation policies by the end of the year. Namely, markets now expect the Fed to start reducing the number of bonds and mortgage-backed securities it is buying on the secondary market by the end of the year. For some equity investors, the optics of removing stimulus as growth slows isn’t great and has likely encouraged some profit-taking given that stocks. Speaking of the Fed, we have an important FOMC meeting coming up next week where the world’s most important central bank could hint towards what its QE taper timeline might look like. Ahead of this event next Wednesday, investors may refrain from making big bets. But beyond the coming FOMC meeting, what is next for US equity markets?
Sentiment likely to remain supported
A more hawkish than expected FOMC next week would likely not go down well with market participants and could trigger an intra-day sell-off of a percent or two in the major US equity bourses. But beyond that, most equity strategists would agree that stocks are likely to remain reasonably well supported into the year-end. Does it make that much of a difference to the economy if the Fed starts tapering its QE programme in October or November or next January? Probably not. Beyond that, is it going to make that much difference to the economy if the Fed starts hiking interest rates before the end of 2022 or in 2023 to tame inflation given a strong economic recovery? Probably not.
When it comes down to it in the long run, it seems very likely that 1) interest rates will remain at historically low levels for the foreseeable future (is the Fed going to be able to get rates back to 2.0% this cycle?) and 2) the Fed’s balance sheet is going to remain historically large, even if the bank does allow it to shrink in the coming years by refusing to reinvest the capital from maturing bonds. In sum, the cheap money that equities love so much (because low borrowing rates boost equity valuations) might not be quite as cheap in the years to come, but it is still going to be cheap.
In terms of the outlook for other key factors for equities; despite a recent hit to confidence as Covid-19 infections pick up despite widespread vaccine rollouts, the US economy appears to still be on a strong footing and things should continue to improve as more people return to the labour market over the next 12 months. A good outlook for growth roughly equates to an equally positive outlook for equity earnings. Meanwhile, while we may see some tax hikes pass Congress in the coming months, the hikes are likely to be modest and keep tax levels on US corporations within historically normal levels – the more left-leaning Democrats who would push to raise taxes above historically normal levels are kept in check in the Senate by the presence of a razor-thin Democrat majority that empowers the more moderate Democrats, such as Senator Manchin.
That’s not to say that things can’t and won’t get bumpy over the coming months. After all, things have been bumpy throughout the year as markets have dealt with various setbacks, mostly related to the pandemic. But it seems likely that the “buy-the-dip” mentality that has prevailed so strongly since the announcement of effective vaccines against Covid some 10 months ago will continue to prevail for the foreseeable future. A winning tactic has been to buy when the S&P 500 slips back to its 50DMA. With the index having slipped to within a few points of its 50DMA just yesterday and already bounced about 0.8% for these levels, it would not be too much of a shocker to see the index post further gains ahead of next week’s FOMC meeting, even in a largely wait-and-see market and amid a lack of fresh catalysts.