Economic and Earnings Concerns Begin to Weigh on Stocks

Wall Street’s imperviousness to bad news, which enabled stocks to double in value from their pandemic panic lows, may be starting to crack.

When the Federal Reserve signaled in September that it would soon tighten monetary policy by curtailing asset purchases, the stock market took it well, but not for long. The S&P 500 rose modestly for a few days before reversing course, pushing the index more than 5 percent below the high it set earlier in the month, which amounted to its biggest drop for the year.

Despite that setback, the market managed to eke out a 0.2 percent gain for the third quarter.

A stingier Fed is not the market’s only concern. Inflation, dismissed until recently by the Fed as a transitory artifact of the pandemic, is coming to be seen as more persistent as the prices of goods, services and labor increase. What is being acknowledged as transitory, though, is the jolt to economic growth and corporate profits provided by several trillion dollars of added spending by Congress.

With a number of threats to prosperity becoming harder to ignore, many investment advisers have become less enthusiastic about stocks. They are revising return expectations down and recommending exposure only to narrow niches.

“We’re not bullish today at all,” said David Giroux, head of investment strategy at T. Rowe Price. “What really drives the market is earnings growth,” he said. “We can’t repeat some of the things we’ve done this year. Earnings growth may slow in ’22, maybe dramatically.”

After being a colossal boon for the economy, fiscal stimulus — in the form of enormous federal spending — may now prove to be three problems for the stock market in one. Government expenditure focused on the pandemic that boosted growth is ebbing. There is a broad consensus that taxes will rise soon to help pay for that spending. And, because many people took direct stimulus payments and invested them in the stock market, stocks ran up faster than they would otherwise.

The positive effects of so much stimulus may have run their course, as domestic stock funds tracked by Morningstar lost 0.6 percent in the third quarter, with portfolios that focus on financial services among the few clear winners.

The SPDR S&P 500 E.T.F. Trust, which tracks the index and is the largest exchange-traded fund, returned 0.6 percent in the quarter, beating the average actively managed mutual fund.

The very fact that many investors until lately have seemed untroubled by the perils facing the economy is what some find troubling.

“There is complacency in a lot of things,” said Luca Paolini, chief strategist at Pictet Asset Management. He enumerated some of his worries: “‘Inflation is temporary.’ Maybe. Maybe not. Six months ago, consumption was booming. People had money and time. Now they have less money and less time. Earnings momentum has peaked, clearly, relative to six months ago. I’m concerned the market isn’t pricing in deterioration in the economic outlook.”

By some measures, stocks are as expensive as at almost any time in history. The S&P 500 trades at about 34 times the last 12 months of earnings. Sarah Ketterer, chief executive of Causeway Capital Management, worries that corporate profits face numerous headwinds and that their impact on stocks could be especially high with valuations so rich.

“Inflation is up, economic growth is down,” she said. “The supply chain disruption phenomenon is global, creating cost increases and margin pressure.” Companies in many industries have reported trouble sourcing some commodities and important components of manufactured goods, such as semiconductors, hindering production and making what they do produce more expensive.

Rising prices have sent interest rates in the bond market higher, driving down bond prices and keeping a lid on bond funds in the third quarter. The average one rose 0.2 percent, dragged down by a 2.9 percent decline in emerging-market portfolios.

“I’m hard pressed to find an area of costs that haven’t gone up, and this may continue for some time,” Ms. Ketterer said. “No one knows how long it will take to unravel the tangled supply chain situation.”

The situation seems most tangled in Asia, where many raw and intermediate materials originate. China has been the source of several worrying recent events, including power cuts that have impeded manufacturing, and financial instability at the China Evergrande Group, a giant, heavily indebted developer.

Some specialists in Asian markets see little chance of Evergrande’s woes spilling over to the wider Chinese financial system, let alone beyond. Matthews Asia, a mutual fund manager, said in a note to investors that mortgage lending standards in China are fairly tight, with large down payments required and the packaging of loans into securities sold to investors minimal.

“Evergrande’s problems are unlikely to cause systemic problems and the likelihood of this devolving into a global financial problem is minuscule,” Matthews’s analysts said. But they added that restrictions could be placed on the property sector in coming quarters.

Saira Malik, head of equities at Nuveen, an asset manager, likewise does not expect Evergrande to become a global problem, but she cautions that it is not China’s only problem.

“The government is focusing on social issues, and some of that is leading to moderation in the growth rate” of China’s economy, she said. While more expansive central bank policies would be helpful, she added, “we think China could get worse before it gets better.”

Funds that focus on Chinese stocks got worse in the third quarter, sinking 13.8 percent. International stock funds in general lost 2.9 percent.

As prices and risks in stock markets at home and abroad rise, the opportunities for strong, relatively safe gains shrink.

Mr. Giroux said he is “buying what the market is concerned about in the short term,” such as stocks in managed care providers, which are trading at a discount to the market because earnings growth has been subdued.

He said he would avoid smaller companies, as well as companies that have benefited from fiscal stimulus programs, including automakers, heavy industrial companies and semiconductor manufacturers.

Ms. Malik, who said she is “moderately bullish” overall, prefers smaller companies and European stock markets. She also likes makers of office software, such as Salesforce and HubSpot, and high-quality consumer cyclicals like Nike.

Mr. Paolini also favors European stocks.

“The case for Europe is quite solid,” he said. “Vaccination rates are high; the Covid story is over,” yet government stimulus continues across the region, so “they don’t have the same fiscal cliff as in the U.S. and U.K.”

His other recommendations include financial stocks, which tend to benefit from higher interest rates, and drug makers.

Ms. Ketterer thinks there is more potential for pandemic recovery stocks to appreciate. In particular, she expects Rolls-Royce, which makes jet engines, to benefit from an operational restructuring, and Air Canada, which cut costs during the pandemic and has a strong balance sheet and little competition, to do well as travel picks up.

Ms. Ketterer remains resolute about trying to pick winners when there may not be many winners to pick.

“What do we do?” she said. “We’re not going to hide. We don’t want to be in cash, and we don’t want to be in bonds if rates are rising.”

Mr. Giroux said he doesn’t care much for bonds or cash — money-market funds — right now, either. He favors bank loans, floating-rate securities created by bundling loans that banks have made to corporate customers. They yield close to 4 percent, and that could increase if market interest rates rise. Default risk is mitigated because bank loans have a high place in corporate capital structures.

The troubles in the stock market lately are barely a blip when viewed on a chart of the phenomenal last 18 months, so a single-digit percent return may seem meager. But it may start to look generous if the time has arrived for investors to learn to live with less.

“The risk profile for equities over the next three to five years is not as good as it was a year ago because valuations are high, sentiment is good and earnings growth is likely to slow,” Mr. Giroux said. “We pull back on risk assets when things feel pretty good, and right now things feel pretty good.”