Inflation concerns continue to weigh on equity and bond markets

Thoughts

• The tone of equity markets as shifted from optimistic to skeptical, with the S&P 500® Index breaking a seven-month winning streak and has now dropped in three of the past four weeks. The driver of investor concern is the peak in economic and earnings growth, a shift in monetary and fiscal policy from a tailwind to a headwind, and persistent supply chain and input cost pressures. Commodity prices continue to surge, while interest rates and the dollar have stabilized following recent moves.
• September was the worst month in a year, with the S&P 500 in a 5% correction for the first time in nearly a year. The Index managed a modest gain for the quarter, stretching the winning streak to six. The year remains strong, with the S&P 500 returning 16% for the first three quarters. Participation is strong, with 412 S&P 500 company stocks in positive territory, the third most of any year since 2001. With the calendar switching to October, the seasonality begins to improve, with the fourth quarter historically strong.
• With equity allocations at record levels for individuals, hedge funds modest sellers and buyback activity limited because of an earnings-related quiet period, it is unclear where incremental dollars will come from for equities.

News

• Inflation continues to run at elevated levels, with August’s core PCE deflator (the inflation metric preferred by the Fed) at 3.6% versus a year ago, above the 3.5% estimate and in line with July. This is the highest reading since 1991. The term “stagflation” is surfacing frequently in the press, with the potential that surging prices for energy, food, autos, and home goods could stifle consumer confidence and spending at a time when economic growth is slowing and fiscal and monetary support waning. Fed Chair Powell this week testified to Congress that inflation pressures are more persistent than initially thought, but the Fed’s belief is that it remains transitory. The global economy is beginning to reflect the stress from cost pressures, with manufacturing data in Asia falling and inflation in the eurozone at a 13-year high.
• President Biden concedes that the price tag for the domestic spending bill will need to come down from the $3.5 trillion target, likely to roughly $2 trillion. He also supports delaying any vote on the $1.2 trillion bipartisan infrastructure deal until an agreement is made on the second piece of legislation. Bringing the price tag down would require taking programs out, beginning them later, or funding them for only five years instead of 10. This is seen by critics as a tactic to disguise the total cost, forcing Congress to renew in five years.
• Third-quarter earnings season unofficially launches next week, with the current consensus estimate for 28% growth. Estimates have moved higher through the quarter for a record fifth straight quarter, though recent revisions have turned 1% lower in September as a wide range of companies have warned due to supply chain issues and inflation. For that reason, management commentary will likely be a more significant driver of market reaction than the headline number. For the past two quarters, strong earnings beats were met with a tepid share price reaction, indicating that earnings beats were embedded in share prices.
• Relations between the U.S. and China remained strained, with U.S. trade representative Lai expected to call Beijing out for not complying with phase one of the trade deal to buy $200 billion of U.S. goods over two years. This could trigger a variety of responses, including levying additional tariffs or launching additional investigations into Chinese subsidies. China continues to struggle with the potential failure of property developer Evergrande, working to limit the internal contagion at the expense of global bondholders.

What to Watch

• A broad set of economic data awaits next week, with durable goods on Monday, PMI composite and ISM non-manufacturing on Tuesday, consumer credit on Thursday, and the monthly payroll report on Friday.