September is here, the economic recovery is cooling and stock valuations remain at their highest levels since the dot-com bubble in the late 1990s. Investors should prepare themselves for a riskier ride.
There are certainly a number of recent indicators suggesting that the recovery is losing some fizz.
The Federal Reserve’s latest Beige Book, a report on economic conditions in the United States, released this week, noted that the Delta variant and continuing supply problems are weighing on the economy – even as the central bank is preparing to withdraw monetary stimulus and potentially raise interest rates.
The report follows a disappointing labour market survey earlier this month. U.S. employers added just 235,000 positions in August, below expectations from economists and a sharp slowdown from robust job growth in June and July.
The Bank of Canada also weighed in this week, leaving its monetary policy unchanged amid a 1.1-per-cent decline in economic growth in the second quarter (on an annualized basis), raising questions about the state of the Canadian recovery.
“We’ve made downward revisions to this year’s Canadian and U.S. growth rates,” Avery Shenfeld, chief economist at CIBC World Markets, said in a note. “The road to better times is anything but smooth these days.”
The revisions are by no means disastrous. CIBC expects that U.S. domestic demand, which excludes inventories and snarled net trade, is still on course to reach its prepandemic trend in the third quarter. It’s also forecasting that U.S. real gross domestic product (or GDP after inflation) will rise by 5.6 per cent in 2021, with Canadian growth trailing only slightly at 4.9 per cent.
Still, financial markets appear to be sensing some disappointment.
Bond yields, which raced higher earlier in the year in anticipation of robust economic activity and an end to extraordinary monetary stimulus, have been retreating over the past several months. The yield on the 10-year U.S. Treasury bond is back to mid-February levels just above 1.3 per cent.
Commodity prices have also stalled, suggesting subsiding demand. Crude oil is down nearly 10 per cent since July. Copper is down more than 9 per cent from recent highs in May, and lumber has slumped 74 per cent over the same period.
Within the stock market, the so-called reopening trade – which focuses on companies that stand to benefit from a fast rebound in travel and tourism – has faded. Air Canada’s share price has fallen 17 per cent since early June, and some U.S. airlines have pushed back profit expectations amid rising COVID-19 cases.
“I think the market is worried about future economic growth. We are at a period where things are still growing but the rate of change is slowing,” Kevin McCreadie, chief executive officer at AGF Management, said in an interview.
Recent growth has been exceptional. U.S. second-quarter GDP, for example, increased by a dazzling 6.5 per cent, at an annualized pace, as the economy bounced back from severe lockdowns in 2020. U.S. corporate earnings for the S&P 500 surged 95.6 per cent in the second quarter, year over year, according to Refinitiv. That marks the best performance since the fourth quarter of 2009.
“You’re never going to see a quarter like that, year over year. Earnings are going to grow, but much, much slower,” Mr. McCreadie said.
Sector performance within major indexes suggests that investors are already tempering their enthusiasm with more interest in safer bets.
Within Canada’s S&P/TSX Composite Index, defensive utilities, staples and telecom sectors have risen by an average of 5.3 per cent over the past three months, as of Thursday. Conversely, economically sensitive energy, materials and consumer discretionary sectors have fallen by an average of 6.5 per cent over the same period.
Within the S&P 500, utilities have been the top-performing sector since the start of August, edging past the information technology group that contains the likes of Apple Inc., Microsoft Corp. and Nvidia Corp.
However, the overall level of the stock market suggests that a cautious outlook for the economic recovery is not priced in.
Despite a recent pickup in volatility in recent days, the S&P 500 is just 1.9 per cent below its record high on Sept. 2 – and it is up 18.7 per cent year-to-date. More remarkably, the index is 32 per cent above its high point in early 2020, before the pandemic slammed the U.S. economy.
One result of this fast rebound is that stocks have become expensive relative to a number of popular ratios, including trailing earnings, forward earnings and enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization).
Equity valuations, according to a note this week from Binky Chadha, chief strategist at Deutsche Bank, “are historically extreme on almost any metric.”
So what happens from here?
Stock market direction is notoriously difficult to get right in the short term. But a number of experts believe that the easy gains of the past year will likely give way to a more challenging environment.
Mr. Chadha noted that steep valuations don’t necessarily mean that stock prices will fall.
“Historically, valuation ‘corrections’ in equities happened in slow motion,” he said. That is, stock prices rose by less than earnings grew, in a process that occurred over three years, on average.
However, the risk of a market correction increases as the earnings cycle matures. Even without a correction, Mr. Chadha believes, stock market returns could be lower than average, or even negative, over the next five years.
Bank of America U.S. quantitative strategist Savita Subramanian is also expecting muted returns through next year, though her concerns rest on how the market reacts to tighter monetary policy from the Fed. Higher interest rates, in particular, could derail the rally and hit growth stocks particularly hard.
In other words, investors could be facing an uncomfortable path ahead: A continuing economic recovery could spell an end to monetary stimulus, while a faltering recovery could drag on corporate earnings growth.
Add September to the mix – often seen as a volatile month for stocks – and the bull market just might see a few jolts.
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