Markets to the Moon

Since the onset of the pandemic, investors have been tracking the progress of recovery through insights from macro indicators and the development of vaccine efficacy. The Fed’s invisible has been supporting the markets despite the Covid storm in the background.

This September has kept investors on the toe. For one, the S&P 500 has fallen more than its September average. Nonetheless, the equity market is still at an elevated level and appear unshakable. In addition, global central banks remain accommodative in their liquidity inflow into the economy, shaping the stock market upward.

Is the Time Coming?

The chatter of a correction and pullback is getting louder. As a market strategist, Pika World believes that it is a matter of time and not whether the stock market will correct. Looking back, we have seen how index can double since bottoming around March 23, 2020. The echo that correction is long due is more pronounced as the music has been playing for perhaps too long for a comfortable pace.

As in our Pika World Commentary last week, searching for a trigger has been an uphill task. A confluence of factors might be a more useful starting point of analysis. Pika World believes that the current equity market is priced for perfect execution of monetary and fiscal policy with healthy progress in vaccination and thus is vulnerable to any setback.

While we see that a pullback is gaining momentum, Pika World remains confident that the economy remains sound in our mid-cycle transition notion, stated out in our earlier editions. Also, the bull market should be intact.

Think Tank Ideas

Yes, we see a growing number of Covid-19 hospitalization and consumer confidence is dwindling. There is also a rise in geopolitical risk after a long period of calmness since President Biden’s inauguration. The US departure from Afghanistan remains a stigma, and the ongoing China’s regulatory crackdown unnerved investors.

Now, we are confronting yet another uncertainty: the debt-ceiling fight that has become a drama since the then-President Obama era.

With these headwinds at the front, the closer reach towards fiscal and monetary tightening weighs heavily on the equity market. But, more importantly, economic indicators have shown mixed signals and tilted towards a slowing growth narrative as the economic expansion engine is fading more than anticipated.

Government spending and tax policy form the heart of a fiscal policy framework. With government spending in limbo due to debt ceiling fights, tax policy projection is pushed to the frontline outlook. There is a growing consensus that some form of tax increase is coming, and the repeal of Trump’s tax benefit does not bode well for the market.

Is the idea of Correction New?

Pika World does not believe that the correction or pullback narrative is new to investors. However, whether it is information overload or a reluctance by market participants to consider the headwinds, the playbook of buy-the-dip strategy means investors have been turning a blind eye and care less about economic setbacks.

Then why now?

Uncle Powell has been successful in giving assurance to market participants that inflation is transitory. This tame the rise of long term Treasury yield that had caused a sell-off to long-duration stocks, especially those found in Nasdaq. The latest inflation reading from CPI and PPI has indicated that we might reach a peak and see a moderation in the subsequent month.

It matters for investors that money is still accessible and dampened any concerns about asset bubbles and financial stability, thus providing a fertile ground for the stock market.

Hugging the Bears

The next few months will be a pivotal era. Bears have been pushing to defy the construct of a bull market. There is now further ammunition for correction triggers. Fiscal and monetary policy are likely to tighten simultaneously, and lawmakers are still wrestling on President Biden’s $3.5 trillion infrastructure spending bill for months.

Undoubtedly, his idea of an expansive social safety net and climate crisis management policy could raise taxes for corporations and particular households. While Pika World believes that the final package could shrink given moderate Democrats leverage in negotiation, there is still a need to find a financing package to support the bill. And the search through tax increases threatens the bull market and support the bears’ case.

Regardless of the noise, Pika World is setting sight on Auntie Pelosi’s September 27 infrastructure vote. On the backdrop is Auntie Yellen stressing that the US could default on its national debt in the coming October unless Congress is ready to increase the federal borrowing limit. These two political timetables is yet another stress point for the markets.

Earlier in the year, Pika World recognizes the concern, and in our mid-term outlook, we re-iterate that the risk is low. However, with the new development, we see a heightened risk since the risk of default are much higher than those seen in 2011 as the political economy complicates sensible policy framework in Washington.

The past debt-ceiling scare had caused a 4% decline in the S&P 500 and was quickly regained when, after negotiation, reached a conclusive consensus, which the 11^th hour often brings buying opportunity.

Politics in Play

And since we are on the political economy discussion, there is also no certainty that President Biden will retain Uncle Powell as the Fed Chairman. However, if he does, Pika World thinks it will help in his bipartisan negotiation. There are also numerous Fed positions to be filled by President Biden administration that requires careful tip-toeing.

Ranging from political fights from taxes to debt ceiling and a possible Fed composition change, one will wonder why market participants remain cool. And that points to the sea of liquidity that has assured investors to by-pass near term downside risks for a stable medium-term outlook.

Our Friends: Central Banks Chiefs

Although Pika World expects global central banks’ assets to grow less aggressively as we reach the mid-cycle transition phase, we remain confident that it is unlikely to see any reduction.

Collectively, the assets held by the Fed, European Central Bank and Bank of Japan had swelled to a record sum of $24.5 trillion by the end of August 2021. This is a sharp climb of $16.2 trillion before the pandemic. Yearly growth of the assets and fallen to 17% since end-August from the peak of 58% seen in February, but the growth pace is still strong.

Moving Ahead As One

The Fed had almost fabricated the All-In Rally. If it is taken away, then valuation will be seen as overly stretched if interest rates normalize, an expectation we see in early 2023.

The inflation picture looks more calming given a cooling August macro data. To highlight is that the Fed has been looking away from metrics such as CPI but more focused on inflation expectation. This was discussed in our earlier writing, where we share that the three-year inflation expectation had risen to 4%, as mentioned by New York Fed.

Terrible news is seen as a bull engine for the market thus far, and if the market shows any temper, perhaps the Fed may take a slower momentum in tightening. The concept of the wealth effect is a vital component in monetary policy which states that consumers tend to spend more when their assets increase. And fall in asset prices such as equity market valuations hurt retail investors and can potentially pull back the healthy retail sales environment.

As we remain nimble in navigating more dynamic economic, social and political forces confronting the equity market, Pika World remains confident that the economic recovery is well on track.