When was the last time the S&P 500 experienced a correction greater than 5%? October of last year. Which month has delivered the worst S&P 500 performance, on average? September. If that makes you nervous, you are unlike many investors, who appear to have returned from the August break in good spirits.
Those spirits are understandable: Bond yields remain low and equity markets are still near record highs. Volatility is subdued. Global coronavirus cases appear to be plateauing. Economic data has softened a little since we reached “peak growth” early in the summer, but it remains largely expansionary—and softer data is acceptable as long as it removes some of the inflationary threat to central banks’ accommodative stance. Exhibit A is the market’s response to the disappointing U.S. jobs number that was recently released.
Still, there are a few reasons why volatility is likely to pick up over the coming weeks and months, and they have nothing to do with stock market history.
At the online Jackson Hole conference, with memories of the 2013 “Taper Tantrum,” U.S. Federal Reserve Chair Jerome Powell was careful to distinguish a slightly hawkish take on asset purchases from a more dovish take on rates. He also balanced comments about the “clear progress toward maximum employment” with a more downbeat assessment of the unemployment missed by the headline data, and made it clear that this currently weighs more on Fed decision-making than inflation—sometimes I wonder if the Fed has evolved from a dual mandate (employment and inflation) to a singular mandate (employment).
That explains why the disappointing payrolls put a question mark next to tapering this year. Nonetheless, the unemployment rate continues to fall and average hourly earnings continue to grow, substantially beating economists’ forecasts for the second month running. Other surveys still point to tightness in some areas of the labor market. There remains scope for pressure to grow on central banks to rein in asset purchases sooner rather than later.
On the virus, while the mid-year Delta variant spike appears to be levelling off, as we anticipated, the move to the northern hemisphere fall season presents new potential risks: schools, workplaces and leisure facilities reopening, more indoor socializing, waning vaccine protection. Pockets of Delta or other variants of concern could still necessitate some restrictions, potentially dampening sentiment.
Policy Headline Risk
Perhaps the largest and most immediate bump in the road is political.
Here, the issue is not so much the U.S. debt ceiling, which is due to be breached sometime in October—that has the scope to cause some drama, but the overwhelming likelihood is that lawmakers will agree to move it. We see more uncertainty around the potential for a bruising battle within the Democratic party over how to get President Biden’s fiscal stimulus packages through Congress.
A bipartisan $550 billion infrastructure bill has passed through the Senate, but before they vote on that bill in the House of Representatives, some on the left of the Democratic party also want senators to pass a partisan $3.5 trillion budget reconciliation proposal, including wide-ranging spending on social and green-investment programs and substantial increases in corporate and capital gains taxes.
Lined up against them are a number of Democrat moderates who argue that the party should vote through the smaller, bipartisan bill in the House while separately working on, and very likely trimming, the partisan budget reconciliation package.
The moderates, particularly in the Senate, have a lot of sway. To pass the partisan budget bill, the Democrats cannot afford to lose more than three votes in the House or a single one in the Senate. Democratic Senator Joe Manchin of West Virginia has already said he wants the party to “hit the pause button” on the budget proposal and other Senators also appear to be wavering in their support. The tussle could boil over around a September 27 deadline set by House Speaker Nancy Pelosi to vote on the bipartisan bill.
This has the potential to surprise the market on the stimulus package’s size, its scope, and the balance of funding among borrowing, capital gains tax, corporation tax and personal tax. Its shape, particularly in the first iteration out of the House, could be determined by the preferences of fringe representatives, which is likely to make it bigger and more expensive than the final version that makes it through Congress. That potentially creates a lot of interim headline risk.
Calm Before a Storm?
Our current view is that the demands of electoral politics will result in a smaller budget, which ultimately translates into tax hikes at the more modest, balanced and market-friendly end of the scale.
We also believe that a renewed spike in coronavirus cases is unlikely to derail the economic reopening and that central banks are likely to remain generally accommodative. These dynamics should continue to feed into GDP and earnings growth, and support for risk assets.
But any one of these assumptions could easily be challenged as we move from summer to fall, narratives change and investors shift their focus. In the U.S., we have a phrase for a news event that suddenly throws the result of a November election into doubt—an October Surprise. It is therefore apt that Capitol Hill wrangling stands out as the major wildcard that could cause a September or October Surprise for the equity market—almost a year since its placidity was last disturbed.