Significant Crosscurrents Prior to Q3 Earnings

Equity markets have been struggling with a number of short-term risk factors.  None at this point (hopefully) seem to threaten the big-picture outlook of a solid global economic recovery. But when markets significantly front-run positive fundamentals (as they have), even modest risks can cause temporary setbacks.  We remain short-term cautious, and expect the recent correction phase in equities to persist until investors regain confidence in the durability of the global economic expansion. We expect growth to remain robust in the coming months and for investors’ concerns to gradually ease.

Notably, sentiment has pulled back meaningfully from the heights seen earlier this year. Such large declines can coincide with sizable risk-off phases if a recession or large growth scare develops, but we expect neither. The decline in sentiment reflects a combination of stretched valuations and an underlying nervousness about the durability of the economic recovery. In addition, some investors are starting to worry about stagflation, in view of the peaking in economic growth measures and the spike in inflation.

We share the concern about high valuations, as there is considerable downside in risk asset markets if the economic outcome turns negative. We neither expect such an outcome, nor a stagflationary environment. Growth prospects remain solid, as demonstrated by last week’s robust PMI surveys in most of the major developed economies. We expect inflation to prove sticky and ultimately problematic. The inflation threat will not be a lasting issue for financial markets until bond market sentiment sours significantly, which central banks are doing their best to avoid. They have achieved notable success so far; bond yields remain far below nominal GDP growth and even below the rate of inflation.  There are no meaningful roadblocks to solid global economic growth providing the pandemic continues to recede. We remain upbeat on corporate earnings (although third-quarter results may be mixed) and bearish on bonds, implying stocks will outperform bonds once near-run risk factors diminish. Nevertheless, valuations warrant greater caution toward equities than the earnings outlook and accommodative monetary conditions might suggest.

The near-nonstop advance phase since November 2020 has ended, and there has been notable churning and correcting in many stocks during recent months. There are short-term risk factors that are causing investor concerns such as prospects for a tapering from the Fed, negative economic and policy developments in China, peak U.S. economic and earnings growth, and political chaos. We would be much more concerned if central banks decided that the inflation upturn was indeed durable and they needed to restrain economic activity. That risk is not likely anytime soon.  Equity prices have moved ahead of improving underlying corporate earnings, such that stocks are still overbought at a point when some short-term threats have developed. None of these threats are cyclically threatening. Thus, while some near-term caution is warranted, our constructive cyclical view on the global economy points to continued upside for earnings and underlying support for stocks over bonds.

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