Daily Comment (September 1, 2022)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EDT] | PDF
Good morning! Today’s Comment begins with a discussion of the September effect. Next, we review possible headwinds in Europe. We end the report by examining the rivalry between the West, Russia, and China.
Wait, It Gets Worse? September is generally the worst month for equity performance. Known as the September effect, the S&P 500 has averaged a 1% seasonal loss for the month, dating back to 1928.
- There are many reasons for this decline but the theories most frequently cited are parents selling off financial assets to pay for their kids’ college tuition, investors adjusting portfolios after returning from vacation, and/or tax-loss harvesting from mutual funds. Despite the historical record, it is essential to note that this average is biased as September has been a harbinger of adverse market events. For example, the fall of Lehman Brothers, the collapse of Long-Term Capital Management, and the terrorist attack on the World Trade Center all happened in September. These events suggest that the historical average might not accurately reflect the month’s performance. In our view, the median provides the best picture of the long-term seasonal performance. In this instance the S&P 500 median performance for September (1.02%) outperforms both February (0.76%) and May (0.49%). That said, there are still several headwinds that investors should consider for this month.
- Hawkish monetary policy remains a threat to equity performance. The European Central Bank is scheduled to meet on September 8, while the Federal Reserve is set to meet a few weeks later. The central bank officials are expected to make substantial hikes in their benchmark rates at their respective meetings. Persistently low unemployment rates and stubbornly high inflation in both the U.S. and the euro area fuel the need for decisive central bank action. However, the more these institutions tighten, the higher the likelihood that these countries will fall into recession. The sell-off in August will likely soften the blow of the interest hikes from both banks.
- Another significant headwind comes from China. The country has implemented a new lockdown in Chengdu. The city’s new restrictions suggest that global demand and production could slow in September as the world’s second largest economy struggles to contain COVID.
- The latest PMI for China showed that manufacturing output contracted after the index fell to 49.4 from 50.2 in July.
Financial markets are full of smoke and mirrors, and therefore, what can look like a historical trend could be an illusion. Although there are plenty of reasons to be skeptical, we believe investment decisions should be based on facts rather than market myths.
European Risks: Headwinds in Europe will persist as business conditions in the region deteriorate due to tight monetary policy and elevated inflation.
- Traders ratcheted up their bets that the European Central Bank will be more aggressive after yesterday’s Consumer Price Index (CPI) report showed inflation hitting a new high in August. The latest CPI report for the eurozone showed that headline inflation jumped 9.1% from the previous year, while core inflation rose 4.3%. The price statistics suggest that inflation has spread into other sectors of the economy outside of energy and food. The yield spread on German and Italian bonds, a gauge for financial stress within the eurozone, has widened to 2.33%, closing in on this year’s peak of 2.42%.
- The strong CPI report places more pressure on the ECB to take aggressive actions to curb inflation. On Friday, Fed Chair Jerome Powell asserted that the Fed would keep rates elevated for longer. His statement led to a surge in the Euro Overnight Indexed Swaps due to concerns that the ECB would have to follow suit. Euro Overnight Indexed Swaps show that investors predict that the ECB will support a 75 bps hike in October.
- The European Union proposed new regulations on smartphone production to curb tech waste. Suppliers of smartphones will be required to provide at least 15 different parts for a minimum of five years after a phone is released. Additionally, the EU will require batteries to last through at least 500 full charges without deteriorating below 83% of their capacity. The new directive will hurt the profits of electronics firms as it will reduce the need for consumers to purchase new phones and make it more difficult for firms to profit from repairs. The new rules created by the EU will likely pave the way for a global benchmark and could force tech companies to change their business models.
- Elevated energy prices continue to slow down the European economy. German firms have begun cutting production to cope with costlier energy, and French manufacturers fear they could be next, barring assistance from the EU. Energy prices in Europe have risen 300% in 2022, and a sustained slowdown in manufacturing production threatens to push the region into recession.
- The latest Purchase Manager Index report for the eurozone showed that the contraction in factory output worsened in August after it slipped to 49.6 from 49.8 in the previous month.
2022 has not been kind to Europe, and we do not think this will change anytime soon. Tight monetary policy, elevated inflation, and the war in Ukraine will make it difficult for the region to avoid recession. As a result, we suggest that investors should be very tactical if they plan to invest in the area.
Tit-For-Tat: The back and forth between the West and its rivals continue to support our view that the world economy is moving away from global markets.
- The deterioration in the EU-Russia relationship remains a prominent risk. On Wednesday, the EU tightened visa restrictions on Russians, and there was even discussion about an outright ban. Although there is much resistance to a visa embargo, the move suggests that EU restrictions could target ordinary Russians. However, assuming this trend continues, we expect Moscow to ramp up its nationalistic rhetoric as it portrays the war as a Western attack on Russia. There is also evidence that talks about punishing Russia over its invasion within the EU could lead to more infighting.
- Ukrainian forces have taken a more creative approach in their counter-offensive against Russia. Although Russian troops have portrayed Ukraine’s new line of attacks as failing instantly, analysts theorized that those perceived failures might be strategic feints and misdirection to exploit Russian weaknesses If analysts are correct, the tactics will make it difficult to discern legitimate Ukrainian failures. It seems that Russia might also be suspicious. Moscow has asked media outlets not to report on the counter-offensive. Therefore, it will take some time before we can discern whether the new counterattack was a success.
- In addition to Europe and Russia escalation, the U.S. also made moves to target Beijing. On Wednesday, the U.S. ordered software company Nvidia (NVDA, $150.24) not to sell its AI semiconductors to China. The decision is another example of how the U.S. plans to contain the growth of its Indo-Pacific rival through export controls. These restrictions on U.S. exports will encourage Beijing to invest in its domestic industries while denying American firms a vast export market. Nvidia warned that the new rules would cost it millions in revenue.
- On an unrelated note, Taiwan has shot down a Chinese drone over the Kinmen Islands. Although there is no sign that China will retaliate, we suspect the shooting of drones may serve as a pretext for escalation in the future.
Rivalries among major powers pose the most considerable long-term risk. The last time we saw similar developments was in the run-up to WWI. Although we are not forecasting a large-scale war, we believe that global tensions could force countries to accelerate the trend away from globalization.