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September has once again lived up to its reputation for volatility. In many ways this had to be expected as equity markets have experienced one of the longest runs of stable returns and minimal drawdowns in history. However, the timing of this recent volatility should not surprise many, as most of the positive tailwinds that have carried the market to these levels are starting to fade away, setting up what could be a difficult period for capital markets.
Global central banks are the most important factor that have helped elevate recent returns. To their credit, they learned from the mistakes of the global financial crisis where indecision and delay exacerbated things – this time, right from the beginning, the banks did everything they could to help the markets and the economy. But all good things must come to an end, and 18 months after the start of the pandemic, it is time for central banks to begin to remove some emergency measures.
This isn’t a bad thing at all. Central banks need to begin to normalize policy to prepare for the next crisis. But it is a change from the recent normal and means that central banks may be less accommodating for the next while. This action resulted in bond yields moving higher across the curve and has led to a change in sector leadership.
The growth/value trade has been a subject of much debate over the last few years. As growth has dominated in a period of ever lower bond yields, with the threat of inflation, has this turned? Will the rally in energy be the trigger to get this going once again? The energy sector was a victim of the climate movement, but the resulting cuts to production may be setting us up for a bull market in the commodities as we are already seeing shortages in both natural gas and heating oil. The resulting price increases is also adding further ammunition to the inflation argument as higher costs will undoubtedly flow through to the price of goods.
What no one really expected in September was the China risk. Consistently over the last year, China has been working to extend their influence over the capital markets, which has caused many to question if China is at all investible. Their constant clampdown on social media and other growth sectors became a secondary concern as their largest construction company ran into liquidity issues. Evergrande was never going to be a Lehman moment, but it had the potential to leave some scars. For the moment, this risk has faded to the background, but it can’t be ignored and has the potential to flare up once again.
What could prove to be the biggest risk to the markets in the near term is earnings season. With the advent of quant funds gaining a greater market share, we have seen companies that beat earning expectations gain versus those that don’t. But as easy comparable estimates fade, huge beats will be harder to achieve. We have already seen some notable companies miss these expectations, and the risk is that the next month will be filled with negative earnings revisions.
One of the biggest reasons for earning misses has been the broken supply chains. Covid lockdowns and pulled-forward demand for goods did immeasurable damage to the concept of “just-in-time” inventory models. Companies continue to scramble for components, such as semiconductors, in order to produce goods. As indicated by the surge in used car prices, the automotive sector has been one of the hardest hit. Until this is fixed, we must expect inflated prices of goods and services and squeezed margins. Whether this is temporary or permanent is still up for debate, but it’s another headwind to markets.
The year has already been a huge success for many investors as markets are near all-time highs, but with supportive measures being pulled back and the risk of earnings disappointments, the risk/reward going forward is looking less attractive than it has in past months. Markets have been due for a correction or volatility for a while.
However, this is by no means the end. There remains a record amount of “un-risked capital” that is looking to be allocated and buy the dip. Investors should be prepared for a pullback, but also be aware that these are opportunities. As a famous investor once said, “The stock market is the only store in the world that when things go on sale, buyers run away screaming.”
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
Notes and disclaimer
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All data sourced from Bloomberg unless otherwise noted.
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