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Stagflation Fears Lead to Market Pullback

The S&P 500 saw its seven-month winning streak end in September as the index dropped 4.8% for the month. Every sector declined with the notable exception of energy, which rose 9.3%. The last and only other time the S&P 500 Energy sector was the only sector up in a month was June 2008 (at that time a barrel of crude oil was trading for nearly $140 while today it is trading closer to $75 a barrel). Despite the weak September performance, the S&P 500 recorded its sixth consecutive quarterly gain leading to a year-to-date gain of over 14%. Bonds also fell during the month producing a flat quarter and negative year-to-date returns.

Several factors were cited for the September decline: the China Evergrande crisis, the Federal Reserve’s hawkish shift, Congressional drama and a global energy crisis, among other things. Central bankers who’d thought this year’s rise in inflation would wind up being a short-term phenomenon aren’t sure how long transitory pressures will persist. Strategists who’d predicted another strong quarter of economic growth are cutting estimates because of supply-chain bottlenecks and the highly contagious Delta variant of Covid-19. Economic data have also been falling short of expectations.

The divergence between business activity and price indices globally hints of stagflation, a term rarely heard since the 1970s. The Organization for Economic Co-operation and Development (OECD) inflation forecast for both 2021 and 2022 has risen sharply since June. On Tuesday, Fed Chairman Jerome Powell said in prepared remarks before testifying to Congress, that inflation will stop when supply chains are healed, or the Fed will make it stop, an indication that the Fed will be willing to raise interest rates if needed to halt the rise in inflation.

Right now, there are five questions weighing on investor’s minds.

1. What is the future path of inflation?

2. When will supply-chain bottlenecks be resolved?

3. What is the true growth rate of our economy?

4. How will market behavior change after the Fed stops buying bonds (it is currently buying $120 billion each month)?

5. What will third quarter earnings look like, and what guidance will company managements provide?

Most earnings reports will begin in two weeks, starting with the financial sector. Many companies have already cited concerns about freight delays, wage pressures, lack of employees, and transportation costs. Demand is robust, but margin pressures and a lack of finished goods could lead to weaker than expected earnings or reduced guidance.

Investors are also concerned about potential tax increases. Two weeks ago, the House Ways and Means Committee released 881 pages of a proposed bill that would make changes to the tax code impacting income, estate, and gift taxes. The bill would reduce the estate tax exemption from $11.7 million to $6.02 million effective January 1, 2022. The top marginal Federal income tax rate would increase from 37% to 39.2% in 2022. The maximum capital gains tax would increase from 23.8% (including the Obamacare 3.8% surtax) to 28.8% effective for sales after Sept. 13 of this year. The tax on dividends would increase from 20% to 25%. The corporate income tax would increase from 21% to 26.5%. This is just a proposed bill and will undoubtedly be subject to many edits before or if it is ultimately voted on by Congress.

In the face of these uncertainties, it is wise to remember that you own shares of outstanding businesses whose employees work hard every day to improve their profitability and thus their ultimate value. While stock prices may diverge from the companies’ underlying value in the short run, in the longer term those intrinsic values will be reflected in the market value of the stock.

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