Weak September doesn’t spell the end for the equity rally

Global and US equities both hit fresh record highs at the start of September. But it was downhill from there.

The MSCI All Country World index lost 4.1% over September, the first monthly decline since January and the largest fall since March 2020. The decline also erased index gains for the third quarter overall, with the index falling 1.1%. Japan, our most preferred equity market, was the only major market in positive territory, delivering a total return for the MSCI index of 2.8% amid optimism over the potential for renewed fiscal stimulus under a new prime minister. There were also sector winners, including a 9% rise in global energy stocks, one of our preferred sectors, which was helped by an 8.5% rise in oil prices. Growth sectors were harder hit by rising yields, losing 5.2% versus a 3% decline for value. The yield on the 10-year US Treasury ended 22 basis points higher on the month, at 1.49%.

Equity market sentiment was hurt by a combination of worries over growth, central bank policy, fast-rising yields, and the US fiscal impasse. But we believe that such concerns over overdone, and we expect the rally to resume.

Central bank policy remains supportive for growth, while persistent inflation is not a major risk, in our view. The Fed stressed at its last meeting that a tapering of bond purchases would remain contingent on continuing positive economic data and did not presage an immediate hike in interest rates. In addition, while the Fed pointed to an increase in inflation risks, Chair Jerome Powell said these “will abate” and that “inflation is expected to drop back toward [the] longer-run 2% goal.” We don't see energy price inflation forcing major central banks to tighten prematurely or undermining consumer spending. We think the recent rapid rise in fossil fuel prices is due to transitory factors. For crude, supplies were disrupted by an unplanned fall in OPEC+ output in August and by Hurricane Ida. The impact of both is already fading, and OPEC+ exports rose again in September. While prices for natural gas and coal are likely to stay elevated amid low inventories, we expect them to decline next year, as we think Russian, South African, and domestic Chinese supplies will rise after this year’s supply disruptions.

Equities should continue to rise, despite a further increase in yields.

We see the 10-year Treasury yield reaching 1.8% by the end of the year as central banks continue to tighten or talk about tightening. However, this should be regarded as mostly a reflection of positive economic news, rather than fears over persistent inflation. We continue to see progress toward economic normalization as the global vaccination drive weakens the link between infections and hospitalizations or deaths. The Fed has expressed increasing confidence in the recovery, while activity indicators remain strong. For example, the US ISM manufacturing PMI rose back above 60 in September. Based on data going back to 1997, three-month rises in 10-year US yields of under 100bps have been associated with positive equity performance—with only larger and swifter moves disrupting stocks. Over the third quarter, 10-year yields have risen by 7bps.

A resolution of the US fiscal impasse remains likely. Tense budget negotiations are common in the US, and both parties have an incentive to avoid being responsible for market turmoil or—in the worst case—a technical default.

A continuing resolution on the government budget passed on the last day of September pushed back the threat of a government shutdown until December. History also shows that markets typically cope well with shutdowns. Since 1980, the US has experienced 14 government shutdowns, with an average duration of seven days and a maximum duration of 34 days (December 2018). Market implications have been limited, with the S&P returning 5% on average over the period from four weeks prior to the start of the shutdowns until four weeks after their end. An actual technical default on US Treasuries is an extremely low-probability event at this stage, given the magnitude of the potential impact. For more read our latest Risk Radar on this subject.

To summarize, September marked a weak end to a generally positive third quarter. Overall, the quarter was marked by rising confidence about progress toward economic normalization, along with belief that inflation pressures will prove transitory. We think this positive sentiment will return as recent headwinds abate and the focus shifts back to the outlook for solid economic growth and strong earnings. We continue to advise investors to buy winners from global growth.

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