Stock Market Hurdles : Some Pushed Back, Some Less Than Meets the Eye

The stock market's rally may very well continue over the next several weeks, despite headlines highlighting hurdles still to be faced.  The Fed's tapering has been pushed back to November-December at the earliest.  A default on the Chinese Evergrande company's foreign bond interest payment won't be known for a month.  And, expectations for Q321 corporate earnings are high, although down from the extraordinary surge in Q221.  While a government shutdown stemming from failure of Congress to hike the debt ceiling by Friday is a possibility, it will be only temporary if it happens.  In the background, US data will likely confirm a moderation in economic growth but with inflation remaining high.  Also in the background will be the Democratic spending/tax bill.  It is not clear how this will turn out, with disagreement among Democrats about its particulars and size. 

As for increasing the debt ceiling, news reports say the Democrats could pass the necessary legislation by themselves.  But, they want the Republicans to take some of the heat from voters concerned about higher debt.  The Republicans, however, oppose suspending the ceiling for a year, presumably because doing so would hide the increase in debt needed to pay for the Democratic spending/tax bill.  So, there may be gridlock to the deadline, but it should be resolved either with or without the Republicans. 

From the little that is known so far, the Democratic spending/tax bill could be a net drag on the economy at first.  Higher taxes and increased subsidies to low-income people will hit first, while most of the infrastructure spending apparently won't begin until 2023.   The near-term effects will depend on the drag from higher taxes versus the boost from low-income subsidies.  Since this is not clear, passage of a bill similar to what the Democrats have proposed will likely have only a modest impact on the stock market initially. 

What's striking about the Democratic proposal is its similarity to the goals of Chinese President Xi.  Xi wants a more equal distribution of wealth and a breakup of the market dominance of large corporations, according to a WSJ analysis.  The means to achieve these goals are different between the two.  Xi wants the government to intervene more in the economy ("steer flows of money, set tighter parameters for entrepreneurs and investors and their ability to make profits, and exercise even more control over the economy than now") and for wealthy people to share their wealth.  He also "eliminates" people who could oppose his program.  The government would determine the direction of the economy and allocate resources accordingly.  The Democrats want to rely on higher taxes, subsidies to lower-income people, and more regulation.  The risk in both approaches is that individual initiatives will be stifled, economic growth hurt, and resources mis-allocated.

Xi may have two events in mind regarding implementation of these ideas, according to analysts.  He wants to establish his program in time for the 20th Party Conference in November 2022, where he plans to be re-elected for a third term as president.  Further ahead, he wants China to dominate the world by the 100th anniversary of the Chinese Revolution in 2049.  Both goals imply that China's actions will be an issue for the market for many years to come.

The market expects about 25% (y/y) for Q321 S&P 500 corporate earnings.  This is down from close to 90% in Q212 (helped by base effects), but is still strong.  The macroeconomic evidence supports this kind of expectation.  Real GDP slowed on a y/y basis, although is still above trend.  The Trade-Weighted Dollar is not down as much as in Q221.  Along with a moderation in non-US economic growth, it suggests earnings from abroad should not provide as much of a boost as in Q221.  Similarly, there could be some shrinkage in profit margins, as labor costs sped up.

                                                                                                                                          Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.6                 +1.7                             3.2           2.3               46.2

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            5.3 *               70.5                 -3.0                              4.4           3.7               61.0                                                    

         

* Based on the Atlanta Fed Model's latest projection of +3.7% (q/q, saar).