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Resilient markets face headwinds to growth

August 17, 2021

Market performance since 2019 has been nothing short of remarkable, given all the headwinds and potential pratfalls investors have had to contend with over this time. If you asked investors at the start of 2021 if they’d take the S&P 500 Index 19% year-to-date gain for the full calendar-year return, I think their reply would be a rousing “Absolutely!” This year’s strong performance for U.S. stocks has come on the heels of the 17% gain from 2020 and the 31% rise in 2019.

This resilient market has overcome a host of challenges, yet the current bull run is likely to be tested in coming months on several fronts. At present, the fundamental backdrop is favorable for the equity rally to continue, but challenges are out there too.

Last week, I had the opportunity to speak on Nasdaq Trade Talks about some of these challenges potential changes in fiscal and/or monetary policy and slowing pace of future earnings growth. You can watch the full interview in the video above, but I’ll touch on a few highlights here.

Markets have soared on the tailwinds created by aggressive fiscal and monetary policies, which have in turn helped bolster the economic recovery from the COVID recession. Now that the U.S. is in expansion mode, the probability increases for a shift in Fed policy starting with the tapering of its asset purchase programs. We saw a mini “taper tantrum” this past March as the 10-year yield reached 1.75%, but the benchmark bond rate has since dropped meaningfully to a range of 1.2-1.3%. We would expect to see higher rates over time, particularly once tapering begins, but the insatiable appetite of investors for yield could limit the impact.

Additionally, we are approaching a period where we would expect fiscal policy to shift to neutral and potentially become a headwind for equity markets. Spending on infrastructure and other domestic measures, if passed, would take time to implement while the impact on the economy will likely be gradual. However, corporate and individual taxes are likely to rise with these bills, which would cause a more immediate impact from an earnings and investment perspective.

Earnings results in Q2 showed nearly 90% growth over a year ago, with a record number of companies beating estimates for profits and sales. Across industries, firms hit familiar themes in analyst calls, from re-opening momentum and improving operating leverage on the positive side, to negative notes on supply chain constraints and input price pressures. Increases in stock prices were muted in reaction to the good news on earnings, possibly a reflection that earnings surprises are currently baked into elevated stock values. Continued upward revisions for earnings are critical for the stock rally to continue, given there’s a fair amount of optimism in current valuations. The S&P 500 Index has little room for error when trading at more than 20-times forward earnings estimates.

The path of least resistance for stocks is to continue higher, particularly because alternatives are limited, but it’s likely that future returns will be harder to come by. Returns in the bond market may be even more challenging to achieve. Investors have been spoiled over the last 30 years with rising equity values and falling interest rates. A traditional 60% equity/40% bond portfolio has generated 18% annually since the financial crisis and 11% over the past 30 years. But given current valuations in the equity and bond markets, investors should adjust their expectations when these lofty returns of the past become more difficult to repeat.

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