September brought cooler temperatures to much of the country and cooler investor sentiment to the markets. The month is often associated with weakness for the stock market, and it has delivered on that reputation, with the S&P 500 index experiencing the first 5% pullback of the year and the 10-year Treasury note yield popping back above 1.5%. We have been waiting for a market correction as a number of important risks have built under the surface. We would bucket key risks facing the economy and markets into three categories: 1) economic slowing; 2) supply chain disruption and inflationary pressures; and 3) policy. We continue to analyze and monitor these risks and are sticking by our assessment that the economic recovery will endure, and the stock market will be higher 9–12 months from now, warranting a continued overweight to equities.
Third-quarter U.S. economic data disappointed. The Delta variant interrupted a robust economic recovery, and for the first time since the onset of the pandemic, economic data dramatically missed expectations (a positive number indicates economic data coming in above consensus expectations, whereas a negative number indicates disappointment versus expectations). August and September nonfarm payrolls missed Bloomberg median consensus estimates by an average of 400,000 jobs per month. Weak consumer activity in the third quarter led our economics team to revise down our 2021 full-year GDP forecast from 7.5% to 5.8%.
Growth in the next-largest economy—China—has also been disappointing. It is very possible that China did not grow at all in the third quarter, an economic performance that, outside of the pandemic, would be the weakest since 1999. Monetary and fiscal policy has tightened as well as the regulatory environment, which I discuss later. The country has also adopted a zero-tolerance approach to COVID-19, resulting in a strict response function from policymakers for even a single case detected in some cities, and weighing on activity.
Nonetheless, there is good news for the path forward. For one thing, the recent disappointing data have reset expectations a bit lower, setting up the fourth quarter to surprise to the upside more easily. We also retain an above-trend GDP forecast for 2022 of 4%, which provides a favorable backdrop for equities to outperform bonds. COVID is increasingly moving to the rear-view mirror. Vaccinations have accelerated globally, particularly in nondeveloped parts of the world previously unable to obtain sufficient supply (Figure 2). Even more encouraging are the possibilities stemming from the development of oral antiviral drugs. Merck & Co.’s recent trial results for its experimental oral drug aimed at treating the virus were so successful in reducing the chance of hospitalization or death in at-risk patients that they ended trials early to apply for emergency use authorization as soon as possible. Vaccinations for children ages 5–11 could be authorized in the U.S. as early as this month.
If, in fact, the COVID crisis that has dominated the global environment for the past two years does recede, we see continued above-trend economic growth as our base case scenario for at least the next two calendar years. That said, here are the key areas of risk—outside of the global health arena—that could derail this outlook.
Please see important disclosures at the end of the article.