George Soros once observed that “at market extremes, price becomes it’s own fundamental.” Stated differently, price can also influence fundamentals in a reflexive feedback loop. From our perch, once the price of any asset starts to increase (or decrease) at an accelerating rate, it is a warning sign that the trend might be mature. Price action in the US technology sector using the NASDAQ as a proxy has become non-linear (chart 1) and there is a very large gap to the primary trend. We are not suggesting that it is over, but does suggest caution at least in a tactical sense.
As we noted earlier this week there has also been a widening divergence between price and fundamentals (earnings). Moreover, the leaders now trade on fairly heroic multiples of profits and sales. Of course, the common retort is that zero interest rates warrant a higher valuation multiple. That is true, but there are also no new reasons to own equities, only extensions of the existing prevailing bias that support price.
Overnight at the Jackson Hole event Fed Chair Powell confirmed that the Fed will modify its mandate to an “average inflation target” over the cycle. That was well telegraphed and anticipated. However, it is not obvious how the new inflation target regime or reaction function will work in practice. Afterall Powell suggested that the FOMC will not provide specific time frames for the calculation of the average, which suggests that the new target does not provide any additional transparency or clarity. What we do know is that it the bias would be to allow inflation to run above target (hot) if there has been a phase of well below average inflation.
In contrast, the shift in tone on the labor market appeared more substantial. In summary, the Fed will now focus on the shortfall from full employment instead of deviations from that level. Of course measurement of what constitutes full employment is also fiendishly difficult. The natural rate of unemployment is difficult to estimate in history, let alone in real time. As Cam Crise noted, the Fed has essentially replaced a symmetrical reaction function with a one-sided one. That is a profound shift.
From a practical perspective the change in the policy framework probably doesn’t change anything for markets in the immediate future. On the interest rate front the Fed Funds rate is likely to remain anchored near zero for a considerable period. Following the 2008 crisis rates did not move for seven years. In the financial repression era following the Great Depression rates were pegged near zero from the mid-1930s to the mid-1940s. Clearly that period was also affected by World War II and active suppression by the Treasury and Federal Reserve. But zero interest rates remained in place despite rising inflation later in the period. The shift in policy framework might justify additional QE at the September meeting, but the big picture point for the policy reaction function today is that the Fed is likely to accommodate higher inflation or not hike rates until well after consumer prices start to rise.
Investors ought to be wary of higher inflation volatility and real yield suppression as it tends to have an important influence on equity valuations. Historically, higher inflation volatility has coincided with a wider equity risk premium or gap between the equity earnings yield and bond yield and it is the main threat to equity prices. That said, inflation is ambiguous for equities. In a demand pull inflation or moderate inflation environment companies with pricing power can maintain profit margins. However, in a cost push episode, or in phases of deflation caused by falling demand (the tails of the distribution) equities tend to perform poorly. It is also notable that the equity risk premium has remained elevated over the past decade relative to the trend in consumer price inflation volatility or in spite of the current monetary policy regime (chart 2).
The final point to note is that it is not clear that central banks can engineer higher consumer price inflation. As we noted earlier this week, higher inflation is more likely to rise after there has been a reduction in excess capacity and a decline in unemployment. To be fair, the pivot to sustained aggressive fiscal policy accommodated by monetary policy has the potential to achieve this shift. However, inflation is a lagging indicator and it will likely take at least another 2-3 quarters before it starts to affect consumer prices and short rate expectations.
Tactically, the beneficiaries of plentiful liquidity and zero rates have already materially outperformed sectors that benefit from higher rates. Price has also started to rally at an accelerating rate. We are sympathetic to a rotation from growth/technology into value sectors like banks given extremes in relative valuation, crowded positioning and beliefs. However, it is probably still too soon to anticipate a durable rise in consumer price inflation, fixed income yields and a sustainable rotation into value equities. That said, the existing reasons to own equities, particularly growth equities, are well appreciated and price has started to rise in a non-linear fashion. There is likely to be a correction or consolidation over the coming weeks. But the key cyclical risk to equities would be earlier than anticipated inflation and a rise in the discount rate. That is still a long way off.
As we noted last week, once the price of any asset starts to increase at an accelerating rate or in a parabolic way it is at least a warning sign that the trend is mature. Price in the major technology and consumer discretionary sectors in the United States had taken on a non-linear character over the past few weeks and in a parallel similar to the 1999/2000 stock splits by some of the poster children of the rally was also a red flag. To be clear, we do not necessarily believe that that major trend is over, but there were a range of behavioral, tactical and fundamental signs that the leadership stocks had gotten ahead of themselves. As we also noted, there are no new reasons to own equities, only extensions of the existing prevailing bias that supports price. There are a few big picture points to note.
First, the good news is that the combination of sustainably low core inflation and excess capacity suggests that the Fed will continue to maintain a (near) zero interest rate policy for the foreseeable future. The modification of the Fed’s mandate last week introduced asymmetry into both the inflation and unemployment targets which is a profound shift. From a practical standpoint, the change in the policy framework alter anything for markets in the immediate future, but it might be used to justify additional QE at the September meeting. It is also likely a signal about medium term or terminal rate expectations even when actual inflation starts to rise. Stated differently, Fed policy drives the availability of money and credit and the Fed is worried about inflation and inflation expectations remaining below rather than above the desired 2% low. As a result, financial conditions are likely to remain extremely accommodative even after the economy starts to recover in 2021.
Second, through the cycle the economy drives earnings per share and the full opening of the economy should eventually drive a recovery in equities with leverage to the recovery as opposed to the “stay-at-home” or liquidity beneficiaries. The direction of earnings should re-accelerate in the final quarter of 2020 and into 2021. Clearly a full recovery likely depends on the progress of COVID-19 treatment and vaccine (for the economy to full re-open) however, the key leading indicators of earnings such as the ISM new orders are consistent with a strong rebound in year-on-year EPS. Of course, similar to 2009/10 that is also a function of the base effect in the June quarter 2020 (chart 1).
Third, on the negative side, our quarrel is not with the direction of the earnings recovery, but how much is already in the price. As we also highlighted last week, there is a very large divergence between price, beliefs and trend earnings. S&P500 earnings per share peaked at $174 in January this year. Current earnings at the end of August were $130 and are expected to grow to $165 in 2021 and $192 in 2022. The challenge is that the S&P500 is trading at 18 times 2022 earnings which is a 9% premium to the 75 year average and our estimate of equilibrium. Of course, a zero interest rate policy combined with unlimited QE have almost no precedent. Therefore, it is challenging to argue what the appropriate valuation multiple is in the current regime. Japan and European equities are empirical examples of markets where zero rates don’t justify higher valuation multiples. However, if the United States achieves higher nominal growth and a robust earnings recovery, zero rates and unlimited QE are likely to warrant higher equity prices.
From our perch, the key downside risk for equities will be when there is a phase of genuinely higher inflation and inflation volatility that would lead to a rise in the discount rate. Historically, higher inflation volatility has coincided with a wider equity risk premium. On the positive side, as we noted recently, the key driver of inflation is likely to be a reduction in excess capacity or unemployment. Inflation is a lagging indicator and it should take at least 2-3 quarters before consumer prices rise enough to threaten short rate expectations or risk asset pricing.
Of course most asset markets are already priced for the existing low rate and inflation regime to persist indefinitely. Sovereign fixed income markets, in particular, offer no compensation for inflation risk or diversification benefit for investors. The “growth” sectors of the equity market would also be vulnerable to an unanticipated rise in the discount rate. In contrast, value sectors of the market such as banks might offer both upside and diversification when the regime shifts away from zero rates and unlimited QE. Tactically, however, we fear that the current regime will persist and the correction overnight reflects a reversal in positioning following a strong rally rather than a change in the underlying trend.