Since we do not expect the U.S. economy to enter a recession any time soon, it is more likely that any market correction would likely be temporary, and potentially offer investors a better entry level to invest in U.S. equities.
Global Market Strategist
The U.S. equity market has had a good 2021. S&P500 and NASDAQ are up 18.7% and 17.0% year-to-date respectively, hitting record highs on multiple occasions while only seeing a 4% intra-year correction (Exhibit 1). However, the U.S. equity market has lost some momentum since the start of September and concerns are rising that a larger correction is on the way. While we cannot predict when such a correction would come, there are several possible triggers that investors should watch out for. Given the current rich valuations in U.S. equities, investors could be more sensitive and may want to take profit in their equity allocation. It should be stressed that these are not our core scenarios, but worth considering in portfolio construction.
The first is a sharp rise in U.S. Treasury (UST) yields. Even though we see higher yields as a reflection of more resilient economic growth and they are historically correlated with positive risk asset returns, a rapid increase in bond yields in a short space of time can still bring pressure to U.S. equities, especially the growth sector.
What could cause UST yields to spike? If inflation remains stubbornly high and the market is once again taking a more hawkish view that aggressive price rises are here to stay, then this could squeeze the longer end of the yield curve higher. The Federal Reserve (the Fed) could be forced to bring forward its policy rate increase in order to cool inflation pressure.
The Fed’s actions could also induce market volatility. It has indicated that it would like to start reducing its bond buying in 2021. We think November would be a more sensible time given some of the uncertain factors mentioned below. However, if the Fed decided to announce a taper at its Federal Open Market Committee meeting next week, this could catch the market by surprise and lead to volatility.
The second trigger could be a rapid deterioration in growth outlook. A rise in severe COVID-19 infection cases could once again pressure healthcare services and force governments to return to more draconian lockdown measures, impeding the recovery of the services sector, and lead to earnings downgrades. The services sector growth has already slowed modestly in recent weeks, but this is likely to be transitory as new cases are starting to peak.
Another near-term risk to growth could be the impact on economic and market sentiment from the fiscal negotiation on U.S. President Joe Biden’s USD 1trillion infrastructure plan and the USD 3.5trillion budget deal. There is also the need to raise the federal government’s debt ceiling so it can continue to borrow, keep government functions running and avoid a default. A government shutdown, which last took place in December 2018, could threaten the recovery, especially during COVID-19 when the public needs government services. The possibility of higher taxes on corporate profit or investment income could also undermine market sentiment.
EXHIBIT 1: S&P 500 INTRA-YEAR DECLINES VS. CALENDAR YEAR RETURNS
DESPITE AVERAGE INTRA-YEAR DROPS OF 14.0%, ANNUAL RETURNS WERE POSITIVE IN 24 OF 33 YEARS
We need to be clear that a market correction is not the same as a market downturn. A correction is usually shorter and smaller in magnitude. A downturn, or a bear market, is typically triggered by economic and corporate earnings recession. Since we do not expect the U.S. economy to enter a recession any time soon, it is more likely that any market correction would likely be temporary, and potentially offer investors a better entry level to invest in U.S. equities.
The challenge in preparing for a market correction is that the two triggers we discussed earlier are essentially two opposite scenarios. One is for the economy to overheat and bond yields spiking to reflect much more hawkish inflation expectations. The other is a weaker growth scenario.
We believe a well-diversified portfolio continues to be the optimal way to prepare for future market volatility. While international equities are still positively correlated with U.S. equities, other developed markets, such as Europe and Japan, as well as Asian equities, are operating with a different economic backdrop that would see more resilience in the face of a U.S. market correction. Chinese onshore equities have a relatively low correlation with U.S. equities and can provide additional diversification benefits.
For fixed income, developed market high yield corporate bonds are also exposed to some of the economic risks we mentioned earlier. Yet, their overall volatility is lower than equities. Asian and emerging market fixed income also provides high yield opportunities.