How much pessimism is too much?

It’s time for Halloween, and that means my younger son and I have been watching a marathon of scary movies. For him, the more frightening, the better — although I do draw the line at some of the really gory ones. For example, “Texas Chainsaw Massacre” is verboten in our house, despite its cult status. Our annual Halloween movie marathon has caused me to wonder, “What is it about humans that makes them want to be scared? Do humans somehow enjoy being afraid?”

I’ve thought a lot about this in the last few weeks. I’ve been traveling and presenting, and have had the opportunity to interact with clients and financial professionals. It seems as if they want to be fearful — they’re all worrying about downside risks, but they’re ignoring the upside risks. I can understand the desire to be objective, to not miss risks because one is too optimistically biased. But what I am seeing now is a real pessimistic bias that is causing investors to focus on fear but not opportunity. Just last week, CNBC released a poll showing that only 31% of Americans believe it is a good time to invest in stocks, which is the lowest level since 2016.¹

To help us see the broader picture, I’ll summarize both the downside risks and the upside risks that I see today.

What are the downside risks?

There is a long list, of course, but I’ll focus on a few of the concerns that have come up most in my recent meetings with clients.

The potential for policy error. This is the risk that investors seem to worry about most. We all know that central banks have the power to end economic cycles by tightening too soon and too quickly, choking off economic growth. There is a very real fear that the Federal Reserve (Fed) could send the US into a recession — dragging other countries with it. This fear persists even though the Fed has done everything it can to demonstrate that it is not hawkish and that it will be patient.

Persistently high inflation. There is concern that inflation will not be transitory after all — but “transitory” is far from a precise definition. I think some believed “transitory” meant a few months, but it looks like this burst of inflation could last longer, probably until about mid-2022. Fed Chair Jay Powell said as much last week: “Supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages.”² But this is far from “permanent” inflation — there are a number of forces such as innovation and demographic trends that I believe will exert downward pressure on prices over the longer term.

COVID-19 variants. The strain inspiring fear right now is the Delta Plus variant, and with good reason. Despite a relatively high vaccination level, the UK has recently seen a large increase in new COVID-19 cases, and Delta Plus is being blamed for the spread. There is concern among health officials that it may be more contagious and, even worse, resistant to existing vaccines. Now, we’ve been here before — there were concerns that the Mu variant would be super-contagious and that existing vaccines wouldn’t protect against it. That proved to be wrong. We will of course follow this closely, but we need to recognize that even in a worst-case scenario, we are not going back to the dark days of early 2020 when the pandemic was new to the world and we hadn’t developed any defenses for controlling it.

US recession. There’s a general sense in the US that a recession is in the offing, which surprised me given this is such a strong job market for employees (they are so optimistic they are quitting their jobs in droves). A recent CNBC poll shows that 47% expect a recession over the next 12 months, while 79% say the economy is fair or poor.³

China downturn. There is also concern that China policymakers’ increased regulation will cause China’s economy to deteriorate, dragging down the global economy with it. What’s more, I continue to hear market watchers say that, because of this heightened regulatory environment, China has become “uninvestable.” These types of statements scream to me that there may be a very significant buying opportunity.

What are the upside risks?

I see quite a few upside risks that many investors seem to overlook.

The fight against COVID-19. The world is getting more successful in containing COVID-19 as the level of vaccinations around the world rises. For example, we’ve seen very substantial progress in Asia in just the last several months, with 69.94% of Japan’s population now fully vaccinated and 70.15% of South Korea’s population fully vaccinated. A number of emerging markets countries have also made significant progress, with 53.97% of Brazil’s population fully vaccinated; and 56.56% of Turkey’s population is now fully vaccinated.⁴ If no dangerous variants develop, then the world should continue to normalize toward pre-pandemic life.

A steady hand by the Fed. Powell spooked markets last week when he said, “The risks are clearly now to longer and more persistent bottlenecks and, thus, to higher inflation.”⁵ But what markets seemed to overlook was that he also said the Fed will “look through” that higher inflation in order to give the economy more time to heal. If the Fed were to keep rates lower for longer, choosing not to hike until late 2022 or early 2023, that would be more dovish than expectations.

Inflation that moderates more quickly than expected. Expectations for a brief rise in inflation are fading. But now that many are expecting a longer-term bout of inflation, it will be easier to beat those grim expectations. Supply chains won’t get back to normal overnight but supply chain bottlenecks could ease as there are fewer assembly line shutdowns due to COVID, semiconductor production ramps up, and the backlog of container ships in US ports is worked through.

Heightened regulation in China ends sooner than expected, and economic growth re-accelerates. The end of this period of regulatory reform in China may soon be in sight. That doesn’t mean current policies will be rolled back, but China policymakers may choose to forego much more in the way of regulation, as they will likely want to analyze the impact of the new reforms on the economy and markets. That could be a positive for the economy and help it to re-accelerate. In addition, investors may quickly realize that China is very investable.

Gridlock on taxes. Gridlock might not sound like an upside, but in this case, Congressional gridlock might mean that Corporate America avoids a much-anticipated tax increase. I believe that would be a real positive for stocks as most investors have assumed some tax hike.

Earnings surprises. Revenue and earnings could continue to positively surprise as they have for the 23% of S&P 500 companies that reported as of Friday.⁶ I think that will be the case for the third quarter, although admittedly I am more cautious about the fourth quarter.

Conclusion

So what does this mean for investors? As I mentioned at the beginning of this piece, only 31% of those polled by CNBC say now is a good time to invest in stocks, the lowest since 2016.⁷ That is music to my ears. Fears are high, expectations are low, and investors are fixating on all the downside risks. From my perspective, that simply means that the upside potential is higher.