Market Views: How will inflation and tapering affect US equities?

The Federal Reserve has announced the beginning of its much-discussed tapering soon. Adding in the effects of inflation and supply chain disruptions, does this mean US equities are set for a drastic correction in the short term?
Market Views: How will inflation and tapering affect US equities?

Strong corporate earnings have sustained the bull market's momentum on Wall Street. How long can the upward movement in the markets continue? 

The question is a live one because tapering is looming. After the Federal Reserve announced on Nov 3 that it will reduce monthly bond purchases by $15 billion from December, the S&P 500, Dow Jones Industrial Average, and Nasdaq 100 all closed at record highs.

But that didn’t last long. The market lost steam with the three major indices surrendering almost all gains in the past few days, in the midst of above-target inflation and supply chain issues that continue to hang above traders’ heads.

On Wednesday, new inflation figures for October saw the US Consumer Price Index (CPI) surge to a higher-than-expected 6.2%, the highest in 31 years, with the core inflation rate excluding volatile food and energy prices going up 0.6% to 4.6%, the highest since 1991. The news prompted 10-year Treasury notes to climb back to the 1.5% level at 1.57%.

Moreover, Fed chair Jerome Powell’s four-year term ends in February next year, leaving people wondering if the Fed will hike interest rate sooner than 2023.

This week, AsianInvestor asked fund houses what they think will happen next for US equities in the short term, and stocks or sectors they believe will perform well under a longer horizon.

The following responses have been edited for brevity and clarity.

Grant Bowers, senior vice president, lead portfolio manager, Franklin US Opportunities Fund
Franklin Templeton

Grant Bowers

The US economy appears to be entering the mid-stage of this economic cycle. We anticipate continued growth in to be coupled with bouts of market volatility as investors reflect on the duration of higher inflation rates, increased fiscal stimulus and Fed tapering. While the current economic backdrop appears robust, supported by healthy consumer spending and strong business balance sheets, we acknowledge that meaningful corrections can occur at this point in the economic cycle.

Yet we believe any corrections could provide attractive openings for investment in select sectors and securities. We continue to view the US equity market as an attractive place to invest. While company valuations are near the higher end of the historical range, fundamentals appear to be supportive. We believe high-quality businesses that have sustainable earnings and cash flow along with competitive positioning and pricing power should fare well as we look into 2022.

We continue to focus on what we consider high-quality businesses with sustainable growth drivers that may not be reflected in current valuations. Many of these investments are levered to strong secular growth themes that we believe will deliver consistent performance throughout the market cycle. As we move from an analog-based world to a digital one, numerous investment opportunities are being created across all sectors. In financials, the rise of many fintech companies creates new options for consumers. Meanwhile, in the healthcare sector, biotechnology and genomics companies have shown tremendous promise with new and innovative treatments and cures.

Chang Hwan Sung, director of solutions research

Chang Hwan Sung

With tapering from the Fed looming in the United States, we have seen some leading economic indicators decelerating. Specifically, weakness was concentrated in consumer sentiment surveys, while business surveys, manufacturing activity, and housing indicators remained resilient.

Demand for credit remains weak despite abundant availability and easy financial conditions. Thus far, the strong money supply growth of the past few years is channeling into financial assets rather than consumption and investments. As the fiscal impulse begins to wane in 2022, private sector demand needs to make up the slack, but evidence in the economy thus far suggests this may be a challenging transition.

Therefore, while we remain today in an expansionary regime, these developments increase the likelihood of a cyclical peak in the near term. When global market sentiment begins to discount a deceleration in growth more broadly across both fixed income and equity markets, our framework will transition to a more defensive asset allocation stance.

We remain tilted in favour of (small) size and value. In addition, we are tilted in favour of momentum, which currently captures value and smaller-capitalisation equities, therefore concentrating risk in cyclical factors and reducing factor portfolio diversification relative to the past few years. In terms of sectors, we have a more positive view of industrials, materials, energy and financials, at the expense of utilities and consumer staples.

Michiel Plakman, head of global equities

Michiel Plakman

The market is probably suspicious that the Fed is actually behind the curve and that these numbers provide clues as to whether the Fed needs to raise rates more quickly than currently anticipated at the end of 2022, or early 2023.

The US equity market tends to move from a focus on earnings during results season to more focus on the macro environment when results are behind us. After November it is quite likely that the focus shifts back to the US macro environment, and that the market stalls for a while.

We think the concerns about rising inflation will be with us for some time, as we will not have more guidance from the Fed on rates until next year. We think it is unlikely that Fed chair Powell will take much action before he may be re-appointed.

In such an environment, we think that uncertainty prevails and that more defensive growth sectors in consumer discretionary and healthcare will continue to do well. The same holds for financials as people will continue to anticipate that higher inflation numbers may lead to earlier Fed hikes, and the potential for a steepening yield curve. These same concerns are likely to continue to put a lid on the performance of the US staples and utilities sectors. We also do think that companies in the industrials sector will continue to be negatively affected by the ongoing supply chain disruptions. The technology sector’s performance will be very sensitive to the direction of long-term rates.

Jason Kotik, senior investment director, equities, North America

Jason Kotik

We don’t spend time worrying about the short-term impact of tapering. It’s economic developments and corporate performance that will determine what happens to US stocks. If the present rally rages on, it raises the prospect of the market topping out before declining. As policymakers turn off the taps, companies with pricing power and orderly supply chains should shine. Disciplined stock picking will become of even greater importance.

As an active, long-term investor, we focus on company fundamentals. Despite choppy markets amid supply chain disruption and a surge in the Delta variant across states, companies’ third-quarter results and forecasts reassured investors that things aren’t getting worse.

Allied to the reopening of several Southeast Asian nations, where many companies have manufacturing operations, it supports the view that inflation and supply problems are temporary — albeit with opinions varied on how long they last.

Consumers are in robust financial health on the whole, having paid down household debt and increased savings during the pandemic. As the cycle normalises, we expect investors to refocus on companies with good sustainable growth prospects. This is something we have focused on all along and will continue to.

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