With stock indices still near all-time highs, seasonality and high caseloads of the Delta variant are setting the stage for a potential market correction. From a top-down view, equity valuations appear stretched, while at the same time ultra-favorable monetary policy is nearing its peak as the economy normalizes back to trend GDP growth near 3%.
After an initial post-recession bounce, economic growth usually moderates. September is historically a tough month for market bulls, and the broad market has not seen a 5% correction since October of last year, which is bringing out some bearish warnings on U.S. stocks. When the indices keep going up but are supported by only a few mega-cap tech names, investors get nervous as market breadth eventually reverts to a normalized mean. August 2015 is an example of breadth collapsing and a sharp correction that followed.
As global economic growth remains resilient, investors should also prepare for a more hawkish central bank framework. The ECB said yesterday that it had decided to move to “a moderately lower pace” in its pandemic emergency purchase program (PEPP) from the roughly $95 billion a month level it has run at since March. The ECB is turning upbeat on the economy as they are signaling it can handle less support. In contrast, the U.S. Federal Reserve and the Bank of England have said they plan to start tapering asset purchases this year. Central banks in Canada, New Zealand, and Australia have already started tapering.
The unwinding of monetary support reflects an improvement in financing and economic conditions. However, an improving economy usually brings more cost pressure and inflation as demand rises and labor markets tighten. Supply chain bottlenecks, which have left carmakers and other manufacturers short of chips and other materials, could last longer and feed through into stronger-than-expected wage increases. With persistent and extensive labor shortages, an acceleration in wage growth is likely to be the focal point of corporate profitability for the remainder of the year.
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