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FIVE THINGS THAT MIGHT SPOOK MARKETS

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

BULLISH SETUP INTO YEAR-END

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Scott Brown, CMT, Senior Analyst, LPL Financial

The S&P 500 Index has gained more than 20% so far this year, making more than 50 record highs along the way. Certainly nobody should be upset with that return if that was all 2021 brought us. However, we see signs that there could be more gains to come in the final two months of the year. Seasonal tailwinds, improving market internals, and clear signs of a peak in the Delta variant all provide potential fuel for equities heading into year-end, and we maintain our overweight equities recommendation as a result.
 

LATE OCTOBER IS THE SEASONAL LOW

One of the most important points we believe investors should recognize is that there has been a sort of stealth correction going on throughout most of the summer, consistent with the historically weak period commonly referred to as “Sell in May and Go Away.” While the S&P 500 has returned more than 8% since the end of April, the average individual stock in the index suffered more than a 10% correction. Meanwhile, the average stock in the Russell 2000 Index (covering small cap equities), which is almost unchanged over that period, suffered a more than 25% bear market.

However, as shown in [Figure 1], late October has historically marked the seasonal low before stocks typically rally into year-end. In fact, the fourth quarter as a whole is by far the strongest quarter historically, on average, with the S&P 500 rising 4% and finishing higher nearly 80% of the time. November, meanwhile, is the strongest month of the year—both since 1950 and over the past decade. So, whether you believe that stocks have thus far followed the historical pattern of summer weakness that should be ending, or that the current price trend is so strong that it was able to buck the summer doldrums, we see ample reason to believe that seasonality has now turned from a headwind for equities to a tailwind.

Q3 EARNINGS PREVIEW: LESS UPSIDE

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

ANSWERING THE TOP DEBT CEILING QUESTIONS

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Last week, Congress was able to push back a fast-approaching deadline for raising the debt ceiling to December. Markets applauded the move with a relief rally. Despite decreased uncertainty in the near term, we may be confronted with the same problem again in a couple of months. This week we look more closely at the role the debt ceiling plays in government financing, what could happen if the debt ceiling is not raised in a timely way, and why market participants were skittish about the approaching deadline as we look ahead to December.

Democrats and Republicans struck a deal last week to raise the debt ceiling, prompting a relief rally in equity markets. While failing to raise the debt ceiling was extremely unlikely, if it had happened it could have potentially done considerable damage to markets and the economy. But even approaching the deadline when the government would no longer be able to meet its obligations was having an impact. The mere appearance of Democrats and Republicans playing politics with the deadline was weighing on markets and forcing businesses to prepare for the very unlikely, but still possible, outcome of a government default.

Unfortunately, we may have to do this all over again in December, and Congress does not yet seem to have fully learned from the 2011 debt-ceiling debacle that this issue is not to be taken lightly. Even if the current solution is just kicking the can for a couple of months, it does remove the immediate danger and opens up additional paths to address the problem well before the next deadline.

The important debt-ceiling debate will continue, although with a reduced sense of urgency in the near term. In this Weekly Market Commentary, we take a closer look at the debt ceiling and the potential consequences of failing to raise it.

13 QUESTIONS ANSWERED ABOUT THE U.S. DEBT CEILING

1. What is the debt ceiling?

The debt ceiling is the limit on how much the federal government can borrow. Unlike every other democratic country (except Denmark), a limit on borrowing is set by statute in the U.S., which means Congress must raise the debt ceiling for additional borrowing to take place.

2. Why does the U.S. do it differently?

The debt ceiling was originally created to make borrowing easier by unifying a sprawling process for issuing debt to help fund U.S. participation in World War I. The process was further streamlined to help fund participation in World War II, creating the debt-ceiling process in use today. According to the Constitution, Congress is responsible for authorizing debt issuance, but there are many potential mechanisms that could make the process smoother.

3. Why is it important to raise the debt ceiling?

The government uses a combination of revenue, mostly through taxes, and additional borrowing to pay its current bills—including Social Security, Medicare, and military salaries—as well as the interest and principal on outstanding debt. If the debt ceiling isn’t raised, the government will not be able to meet all its current obligations and could default.

4. Has Congress always raised the debt ceiling?

Yes, whenever needed. According to the Department of the Treasury (“Treasury”), since 1960 Congress has raised the debt ceiling in some form 79 times, 49 times under Republican presidents and 30 times under Democratic presidents. As shown in Figure 1, Congress has regularly raised the debt ceiling as needed. In fact, every president since Herbert Hoover has seen the debt ceiling raised during their administration.

EARLY THOUGHTS ON 2022

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

With the fourth quarter underway—historically the best quarter for stocks, by the way—2022 is fast approaching. While a lot can still happen between now and the end of 2021, we don’t think it’s too early to start thinking about what stocks might do next year. We see a favorable economic environment for stocks in 2022, consistent with prior mid-cycle expansion years and bolstered by continued earnings growth. The gains may not come easy, however, with a number of risks such as COVID-19-related supply chain disruptions, inflation, and higher interest rates.

WE START TOP DOWN

As 2021 winds down, we are starting to look ahead to 2022. As a starting point to begin forecasting stock market performance next year, we want to first assess the economic growth outlook and where we are in the economic cycle. If we are approaching the middle of an economic cycle that has at least a few more years to go (our view), then we believe the chances of another good year for stocks in 2022 are fairly high. Mid-cycle simply means we do not believe a recession is likely anytime soon—nor do we expect the big equity gains typically seen when the economy emerges from recession (those came last year). Looking back at the past 50 years, the S&P 500 Index was up an average of 12% during the 27 mid-cycle years we identified, with gains in 81% of those years.

We also acknowledge that stocks are up a lot and valuations are elevated (more on that below). The S&P 500 is up 16% year-to-date and 95% since the March 2020 low, which to us means the probability of another big up year in 2022 is relatively low. However, with the economy poised to grow (we expect above-average gross domestic product growth in 2022) the chances of solid gains remain high.

EARNINGS ARE A KEY PIECE OF THE PUZZLE

A growing economy is a great start, but stocks fundamentally derive their value from their earnings stream and earnings start with revenue. The environment for companies to grow revenue next year should be excellent with above-average potential economic growth and some pricing power from elevated inflation.

Historically, S&P 500 revenue growth is well correlated to nominal gross domestic product (GDP) growth. Nominal GDP growth is real GDP growth (inflation adjusted) plus inflation. Hypothetically, 4% GDP growth next year (consensus forecast of Bloomberg-surveyed economists) plus perhaps 3% inflation (consensus forecast for the increase in the Consumer Price Index) puts a 7% revenue increase in play. Without any change in profit margins (probably too rosy but let’s keep it simple) and some share repurchases to lower the share counts—a near 10% increase in earnings in 2022 looks to be within the realm of possibility, which is reflected in current consensus estimates shown in Figure 1. Significant earnings momentum is also bullish, with estimates having been raised significantly by analysts over the past six months, also shown in Figure 1.

TO Z OR NOT TO Z: WHY THE SHAPE OF THE RECOVERY STILL MATTERS

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

LPL Research is downgrading its 2021 U.S. GDP growth forecast from 6.25–6.75% to 5.75–6.25%. Growth is likely to come in at an annualized pace near 5% over the second half of the year. So, while expectations have been tempered, the recovery still has a lot of momentum, which is likely to extend well into 2022. In 2022 we may see economic growth exceed potential, creating a Z-shaped recovery— something we haven’t really seen since the early 1970s. What is a Z-shaped recovery and what might it mean for the Federal Reserve (Fed), inflation, and markets? We attempt to answer those questions below.

Early in the recovery, there was a lot of debate about what “shape” it would take. There were letters, such as V, U, W, L, and K, and shapes, such as a swoosh or a square root sign. The great recovery-shape debate has fizzled but still matters—for what’s ahead for the economy, for the still-raging inflation debate, for the policy debates taking place in Washington, and, of course, for the markets. And it turns out the debate centers on a recovery shape that wasn’t getting a whole lot of attention last summer: The Z-shaped recovery.

A STILL ROBUST RECOVERY HAS BEEN SLOWED BY THE DELTA VARIANT

The general shape of the recovery so far has been mainly driven by three forces: the COVID-19 pandemic, which provided a massive external shock to the economy that really had nothing to do with its natural cyclicality; historic fiscal and monetary stimulus put in place to get us through that shock and the rapid development of several effective vaccines. So far, these forces have given us a historically anomalous, deep V-shaped recovery: A steep drop and a surprisingly quick and robust recovery. The recovery has been quick enough that the U.S. actually topped the pre-recession peak in economic output last quarter, although we’re still likely below where we would have been right now if the pandemic hadn’t occurred.

The job market recovery has been slower. From 2011 to 2019, the economy created about 2.3 million jobs each year. Even 2019, the weakest year over that span, brought in more than 2 million jobs—a very strong number so deep into an expansion. Then in March and April 2020, the economy shed over 22 million jobs in just two months, with more than 20 million in April 2020 alone. We have regained just over 17 million of those jobs, but that still leaves us over 5 million short of the pre-pandemic peak.

The recovery has been slowed over the last several months by the spread of the highly contagious Delta variant and still sub-optimal vaccine rates. Behavioral changes in response to Delta, additional government restrictions, and strains on healthcare systems in regions with low vaccination rates have all taken their tolls, as has the impact of Delta on some East Asian trade partners, extending supply chain bottlenecks.

Consistent with our review of the potential impact of the Delta variant in our August 9, 2021, Weekly Market Commentary, we have seen the economy underperform expectations and are lowering our 2021 U.S. gross domestic product (GDP) growth forecast from 6.25–6.75% to 5.75–6.25%. The downward revision reflects expectations of growth slowing to around 5% annualized in the third and fourth quarters after coming in at about 6.5% in the first two quarters.

The slowdown from higher growth levels and recent data disappointments can make it easy to lose perspective on what those revised levels mean. For a sense of scale, the top three quarters of the last expansion were Q2 2014, Q3 2014, and Q4 2011, when the economy grew at an annualized rate of 5.2%, 4.7%, and 4.6% respectively. The prospective “disappointing” growth of the final two quarters of 2021 could still be near or above the peak growth level of the last expansion. In other words, despite the downward revision we believe the recovery still has a lot of momentum that we expect to extend well into 2022.

LOOKING AHEAD: TO Z OR NOT TO Z

A Z-shaped recovery is when the economy bounces back quickly and GDP jumps above its potential early in the recovery, before either settling back into the trend again, or potentially even falling back into recession—and we haven’t seen one in a long time. In [Figure 1], we see where the economy has been relative to its potential since the 1950s. Potential here is estimated by the non-partisan Congressional Budget Office (CBO), but it’s not something you can count. There are a lot of assumptions that go into views of economic potential and estimates do vary.

REVISITING OUR 10-YEAR TREASURY YIELD FORECAST

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Until recently, we expected the 10-year Treasury yield to end the year between 1.75% and 2.0%. Now, however, there are two key elements suggesting we are unlikely to see significantly higher interest rates by year end: The Delta variant’s impact on economic growth expectations, and the continued demand for U.S. Treasuries by foreign investors. As such, our new year-end target for the 10-year Treasury yield is between 1.50% and 1.75%.

Coming into the year, and into our 2021 mid-year outlook, we expected Treasury yields would move higher than current levels. Higher inflation expectations, less involvement in the bond market by the Federal Reserve (Fed), and a record amount of Treasury issuance this year were all reasons we thought interest rates could end the year between 1.75% and 2.0%. Now, however, there are two key elements suggesting we’re unlikely to see significantly higher interest rates by year-end. The Delta variant’s impact on economic growth expectations and the continued demand for U.S. Treasuries by foreign investors are likely to limit the upside in long-term Treasury yields. As such, we are slightly lowering our year-end forecast for the 10-year Treasury yield. We now believe the 10-year Treasury yield will end the year between 1.50% and 1.75%.

POLICY RISKS LOOM BUT CLARITY AHEAD

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Several policy-related risks loom in September and October that may lead to an increase in market volatility. The debt ceiling needs to be raised (likely by mid-October), the government needs to be funded to avoid a shutdown by the end of September, and the Democrats are trying to pass two major spending bills and will need to provide greater clarity on tax increases over the next several weeks. We believe the greatest risks come from the debt ceiling and taxes, but expect neither to have much near-term impact on the general trajectory of the bull market.

There’s always something going on in Washington, but with summer behind us, policy debates are heating up with an unusual number of high-profile policy issues looming for Congress and President Joe Biden in September and October. Those include the debt ceiling; the fate of the bipartisan infrastructure bill; clarity and potential progress on the much larger American Families Plan (AFP) spending package emphasizing Democratic priorities (also known as the human infrastructure bill); and, not to be forgotten, simply funding the government. These very well could be the peak policy months of President Biden’s first term, akin to the months leading up to the passage of the Affordable Care Act under President Barack Obama and the Tax Cuts and Jobs Act under President Donald Trump. This week we break down what market participants should be watching, possible sources of risk, and our expectations.
 

LOOMING DEADLINES FORCING THE ACTION

September and October aren’t important policy months simply because there’s a lot going on—looming deadlines are forcing the action. Keep in mind that Congress is notorious for not acting until the last possible moment and even pushing back deadlines whenever it can, as different members of Congress try to squeeze one more concession out of negotiations. This will create a lot of noise and increased uncertainty, but is unfortunately the norm for how Congress operates. While every maneuver may be of genuine political interest, as an investor, it’s important not to get too caught up in Congressional drama. Here’s a quick overview of where we are right now and what may be coming next:

• Bipartisan infrastructure bill – The bill, which includes about $550 billion in new spending over the next eight years and $1.2 trillion in total spending, was passed by the Senate on August 10. Since then, Democratic House leadership has been holding out on a vote, using the delay for political leverage to pull moderates on board for the larger spending package. On August 24, in exchange for voting in favor of the budget resolution needed for the AFP to progress, moderate Democrats were given a non-binding promise on infrastructure reaching the House floor for vote by September 27.
   
• American Families Plan – The August 24 budget resolution was needed for Democrats to pass a large spending package under the reconciliation process, which requires only a simple majority to pass in the Senate. The budget resolution set a soft target of the bill moving out of committee by September 15. To date, Democrats have remained vague on how the bill will be paid for, but the House Ways and Means Committee will need to provide a concrete proposal by September 15, assuming the timeline holds up. In other words, by September 15 we’ll start getting clarity on who is getting taxed and how much. That’s when things start to get interesting.
   
• Funding the government – A partial government shutdown takes place on October 1 unless a continuing resolution is passed to fund the government. That resolution would fund the government only for a limited specified time, at which point we do it all again. Often, the continuing resolution is made part of another bill that is hard to vote against, or it could get passed as part of the AFP using the reconciliation process.
   
• The debt ceiling – At some point, if Congress does not raise the debt ceiling the government would technically default on its current obligations. We don’t know exactly when that point will be, but it will likely come in mid-October. The government has been using extraordinary measures since early August to conserve cash so it can meet its obligations for as long as possible.

With deadlines forcing the action, what will market participants be watching? Primarily the debt ceiling and taxes. The two present contrasting risk profiles. Congress is extremely unlikely to let the U.S. default on its debt since it would likely have significant negative consequences for markets and the economy. On the other hand, Congress is very likely to raise taxes, driven by (slim) Democratic majorities in both chambers. But, based on history the immediate market impact is likely to be negligible, with the biggest risk around the hit to corporate earnings due to a higher corporate tax rate. On the other hand, taxes help contain deficits—it’s how you pay for what you spend, and for deficit hawks it’s preferable to borrowing. Best to spend wisely and tax lightly, but no president since 1960 has been able to achieve that except Bill Clinton. In the absence of that approach, paying for at last some of what you spend may be preferable to pushing the national debt even higher.

DEBT CEILING

The debt ceiling is the maximum amount of debt that the Treasury Department can issue. The Treasury uses the money it borrows to pay its obligations. The amount is set through Congress and has been regularly increased as needed over the years. The consequences of not raising the debt ceiling are far from trivial. Not only would the U.S. government not be able to cover its expenses, it would also default on its debt—which could send shockwaves throughout the financial system.

Through a bipartisan budget act in 2019, Congress suspended the debt ceiling through July 31, 2021, which allowed the government unfettered access to capital markets. As seen on the chart, when the suspension was enacted, total debt outstanding was $22 trillion—but current debt levels have risen to $28.4 trillion, which is the new debt ceiling level [Figure 1]. The debt ceiling will need to be raised soon or the U.S. Treasury will likely run out of its “extraordinary measures” to fund government activities. Treasury Secretary Janet Yellen recently said this would likely occur in October.
 

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