Stocks: September Better Than Feared, But Headwinds Remain
October 2024
With the S&P 500 already higher by 19.5% year-to-date and this being a presidential election year, September kicked off many prognosticators, us included, voicing concerns that the month could live up to its historical billing as a challenging one for U.S. stocks. With the benefit of perfect hindsight, however, there was nothing to fear but fear itself, as the S&P 500 turned out a 2% gain during the month, while the S&P Mid Cap 400 and S&P Small Cap 600 eked out 0.9% and 0.6% returns, respectively. At month-end, over 75% of S&P 500 constituents were trading above their 50- and 200-day moving averages, a sign of broad market participation and a bullish market ‘condition’ leaving us relatively constructive on U.S. large cap stocks as October begins. That said, many hurdles remain between now and year-end.
The resiliency of the broader U.S. equity market and its ability so far to buck the trend of poor historical performance in September and October in presidential election years is most welcome. While we expect a customary year-end lift, as the November through January time frame has historically proven to be the best consecutive three-month stretch for U.S. stocks, we aren’t out of the woods just yet. Negative seasonality in election years often persists into the back-half of October and is one reason to be on guard for a pullback in the lead-up to the election in November. But U.S. stocks have historically performed best amid divided government, which we see as the most likely election outcome.
Aside from seasonality and political uncertainty, rising Treasury yields and the quarterly earnings season could also potentially act as near-term hurdles for stocks. Yields on U.S. Treasuries rose sharply to start October as economic and labor market data forced investors to revisit their expectations of U.S. economic growth, inflation and, in turn, just how aggressively the Federal Open Market Committee (FOMC) may be willing or able to cut the funds rate in the coming months. Yields rising for the ‘right’ reason, i.e. an improving economic growth outlook, should be supportive of further gains for cyclical stocks/sectors, but valuations come under pressure and Treasury bonds would become greater competition for capital should yields rise much above current levels with the 10-year yield around 4%.
Lastly, while it’s no different than it is at the start of any other quarterly reporting season, it’s worth mentioning that over half of S&P 500 constituents report this month and will be barred from repurchasing their own shares until after posting quarterly results. Consequently, corporations, which have been an active market participant and significant buyer of their own shares year-to-date, will be unable to step in and opportunistically prop up prices should volatility ramp up and their own shares drop. Taken together, these potential market headwinds aren’t reason enough to reallocate out of stocks and into less risky assets, in our view, but are reason to temper expectations over the coming weeks, albeit with the knowledge that investors will likely be well served to lean into any near-term weakness in U.S. stocks in preparation for a year-end relief rally.
Emerging Markets Making A Strong Case For Investor Capital. Historically, exposure to Chinese stocks has been a source of volatility for equity portfolios with high peaks and deep drawdowns expected, but from our viewpoint, the China rebound theme can be accessed without concentrating exposure to EM behind the Great Wall. Last month, the MSCI Emerging Markets Index advanced by 5.7%, more than doubling the S&P 500 in September, a welcome advance with gains broad-based and not just driven by China, as 20 of the 28 countries represented in the index generated a positive return on the month. Underlying market breadth also improved with 80% of the stocks in the EM Index finishing the month above their 200-day moving average, a three-year high and a marked improvement from 52% at the start of the month. When drawing parallels to China, the MSCI Emerging Markets Index may not present the same rock-bottom valuation but does trade at a relatively attractive 12.1 times forward earnings with earnings growth over the next year projected to be approximately 31%. That earnings growth estimate will likely prove to be too high, in our view, but we still see a path to substantial year-over-year earnings growth in the coming year as central banks make monetary policy less restrictive. This should help relieve some of the strain on emerging market currencies, allowing EM issuers to pay down debt at a lower cost while improving global liquidity that will need to be deployed, potentially into riskier asset classes with a higher expected return, such as emerging market stocks. A tectonic shift in investor sentiment due to China’s stimulus and the promise of further action to come has generated sizable returns for investors in EM in a short period of time, but a period of consolidation or sideways prices allowing emerging market stocks to digest the gains from recent weeks with breadth remaining at/near current levels should set up a sustainable trend higher.
China’s Stimulus Efforts Are A Good Start, But Skepticism Is Still Warranted. Country leadership within the MSCI Emerging Markets (EM) Index made an about-face in September as China announced a long-awaited wave of stimulus measures aimed at rebooting the economy, a series of moves that pushed the nation’s equities to make up for lost time, with the MSCI China Index jumping 20.7% during the month. The September surge in Chinese stocks propelled China into second place in the MSCI EM country rankings year-to-date between first-place India and third-place Taiwan, and the MSCI EM Index has closed what was a wide performance gap versus global stocks in a big way, with a 17.1% year-to-date return, while the MSCI All-Country World Index returned 19% over the same time frame. The parabolic move in Chinese stocks has investors rightfully asking: “is this another head fake to be sold, or a sign of more upside to come?” While the break above year-to-date highs for Chinese stocks shouldn’t be ignored, the initial surge can be chalked up largely to short-covering as short interest in the some of the most heavily traded Chinese indices and fund proxies was closing in on 5-year highs midway through September. Prices of Chinese stocks appear to now be pricing in a pronounced policy pivot and potentially even quantitative easing (QE) out of the People’s Bank of China (PBoC), tethering their hopes to the belief that additional stimulus of some sort is still in the pipeline as promised by regulators, but whether or not there will be additional measures aimed at reviving the Chinese consumer will be the true test of the government’s resolve. Investors should not easily be convinced recent stimulus efforts will be successful, or sustained for that matter, and we would like to see the MSCI China index sustain recent gains over the coming weeks/months as a sign that institutional investors are finally willing to buy and not just rent exposure to stocks tied to one of the least shareholder friendly nations in the world. While we remain China skeptics for now, the country’s stimulus efforts serve to raise the floor on global growth to some degree which should improve sentiment surrounding EM broadly, leaving us relatively constructive on emerging market stocks and bonds.
