Montag & Caldwell Strategies Commentaries Private Client Group People About Contact Us M&C Celebrates A 75 Year History Search for: Quarterly Market Commentary Posted by M. Scott Thompson September 30, 2021 The Case for Growth at a Reasonable Price The four key pillars that have powered the market’s advance since the pandemic lows – extraordinary monetary accommodation, massive fiscal stimulus, vaccinations, and rising profit estimates – all remained supportive during the third quarter, helping to fuel a modest 0.6% gain for the S&P 500 Index – its sixth straight quarterly advance. The broad market index is now up 15.9% year-to-date. However, the impact of each of those pillars has begun to diminish, making the road ahead a bit more uncertain and challenging. The equity markets are no longer in a “rising tide lifts all boats” environment. Instead, we have been witnessing rolling rotations in and out of various sectors and style boxes. This churning beneath the surface had been masked by the relative calm displayed by the biggest of the mega caps, at least until this past month. The first issue weighing on the market was the resurgence of Covid cases due to the spread of the Delta variant this past summer. While this had the effect of slowing economic momentum, it should not jeopardize the recovery, and in fact we are starting to see signs that the economy is gathering renewed strength as cases have rolled over. A second issue has been a significantly gummed up global supply chain that is resulting in delayed product arrivals, severe shortages of key components, and rapidly rising freight costs. These two issues have had the effect of pressuring near-term profit forecasts for the first time in over a year, and could lead to broader disappointments as we proceed through the upcoming earnings season. A third and bigger issue for the market pertains to the inflationary pressures we’ve all observed lately – in everything from home and auto prices, to labor costs, fuel and many other commodities – and the implications those have for monetary policy. Federal Reserve Chairman Jerome Powell has been arguing these pressures would prove to be transitory, and indeed some elements, especially those directly related to the reopening of the economy, should prove temporary. However, even Mr. Powell was recently forced to acknowledge that these pressures have been more severe and longer lasting than he initially hoped. To the extent these pressures continue to fuel rising inflation expectations, the Fed may be forced to begin pulling back on its accommodation sooner and more aggressively than originally planned, which would then have the potential of slowing the economy’s growth, if not killing it altogether. We continue to believe the underlying drivers of a self-sustaining economic expansion are in place, especially as Covid recedes and we can increasingly return to normal. The U.S. consumer is in great shape, supported by rising job growth and wages, an improving balance sheet, and excess savings. Business investment is also on the rise, boosted by rising profits, shrinking spare capacity and a necessity to boost productivity to counter inflationary pressures. Lastly, while we are currently in the throes of negotiations on Capitol Hill over the ultimate size and scope of President Biden’s spending plans, we expect government deficit spending to remain an ongoing support to the economy for the foreseeable future, though not nearly to the same magnitude that we have seen in the past 18 months. Key threats to this outlook would be significant tax increases and burdensome regulations that stifle the economy. We currently forecast 6% real GDP growth this year, down from our prior 7% forecast due to the summer, Delta-related slowdown, which has led to falling estimates for third quarter GDP. The Atlanta Federal Reserve Bank’s latest GDPNow estimate for third quarter real GDP is 2.3% growth. We expect a rebound in the fourth quarter and first quarter of 2022 fueled by receding Covid cases, reaccelerating auto and housing production, and inventory restocking. Meanwhile, inflationary readings are likely to remain elevated for quite some time, likely well above 3% for Core Personal Consumption Expenditure (PCE) deflator, the Fed’s preferred measure, through year-end at least. We expect S&P 500 EPS to hit a record $200 per share in 2021, a gain of over 40% from 2020’s depressed level and an increase from our prior $190 forecast. Looking ahead to 2022, we believe $220 is possible, which would be another double-digit gain. Stocks may remain volatile in the near term as corporate profit outperformance becomes more challenged and as investors contemplate the imminent start of Fed tapering along with the possibility of higher interest rates next year. After remaining subdued for much of the summer due to the growth slowdown and a dovish Fed, a material rise in bond yields, sustained high inflation, and reduced central bank purchases would likely lead to renewed rotation away from the pricier secular growers back to cyclical reopening beneficiaries and more reasonably valued growth issues. Indeed, we saw a hint of that as the September quarter came to an end. To illustrate this point, the following chart highlights the valuation profiles of both the large growth and large value Russell indices – and in particular, the valuation gap between the two. The Russell 1000 Growth index, which is comprised of many of the more over-valued, over-owned secular growth winners that re-rated higher off the Covid lows, has mostly maintained its lofty valuation profile thanks to low bond yields. However, it has become increasingly more concentrated with the top five companies in the index representing a greater than 37% weight. We expect that many of these names will continue to appreciate in line with earnings growth, but could enter a period of relative underperformance versus the more unloved and undervalued cyclical growth stocks – resulting in a rationalization of position weightings within the growth index. We expect this dynamic to lead to a rotation from growth at any price towards growth at a reasonable price. We continue to believe a proper balance of high-quality cyclical and secular growth stocks in our Client portfolios is appropriate at this time given the many uncertainties related to Covid, fiscal and monetary policy, and bond yields. We remain highly convicted in those stocks whose positions were strengthened as a result of this pandemic and are therefore poised to perform well as the economy fully reopens and returns to a more normal state. These stocks remain reasonably priced and are expected to deliver above-average profit growth in the year ahead even as the effects of the reopening and massive stimulus begin to wane. 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