As I write this today (6/14), the S&P is up 13% YTD and at an all-time record high. The S&P recovered from its sharpest sell-off in the S&P (down 4% in three days ending 5/12) since late October of last year. This was driven by inflation data that continues to come in stronger than anticipated. Interestingly, the 10 year treasury yield has declined from 1.75% on 3/31 to 1.49% today and sits at levels from last March.
Statement from Fed officials continue to stress that the current surge in inflation metrics is “transitory” and it seems the market is willing to believe it judging by the decline in treasury yields. Headline CPI now stands a +5.0% and core CPI now stands at +3.8% on a y/y basis. We, however, continue to believe that though some of the increase in inflation is due obviously to “base effects” like oil prices going negative at one point last year, the increase we are seeing in wages is only going to get worse. Some of these wage increases are being affected by the inability to hire enough workers due to generous unemployment benefits, Covid safety concerns and inadequate childcare. But let us not forget that unemployment before the pandemic was at its lowest levels at 3.5% since the 1960s. As a result, average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build. McDonald’s is currently using signing bonuses to attract workers.
These wage pressures are only going to get worse as global economies open up and we head towards the holiday season.
The rise in shelter prices is notable with owners' equivalent rent (OER) up 0.31% in May, the largest increase since June ‘19. Given the number of people moving from large cities to suburbs given new work from home flexibility, we find this interesting. OER is over one quarter of CPI, and larger than food and energy combined given housing costs is a big component of the average consumers budget. This increase in OER potentially means home prices which are now up 13% y/y and increasing at the fastest pace since 2005 is offsetting higher vacancy rates in big cities.
The drivers for the stock market record highs remain the same: 1) the Fed balance sheet hit a new record of $7.95 trillion and is up 11% y/y after being up 77% last year, 2) money supply is up a record 18% y/y (peaked at 27% in Feb) vs a peak of 10% during the GFC, 3) vaccinations continue and 4) the macro data is strong with S&P EPS now forecasted up 50% in 2021, and 5) the employment picture continues to improve with weekly jobless claims below 400K for the first time since the Pandemic. Looking forward, the Biden administration is trying to pass another $4 trillion in stimulus ($1.8 trillion American Families Plan and $2.2 trillion Infrastructure Plan.)
But the central banks of both Russia and Brazil have raised rates multiple times while England joined Canada to become the two G7 central bank to start tapering. Russia, Brazil and Turkey, are among the 14 central banks that have raised their main interest rates so far this year. In total there have been 22 rate hikes this year already. Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy."
We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting at the latest. The Fed continues to reiterate their belief that inflation is “transitory” and say they will not be raising rates through 2023. We believe that inflation data for the next several months will force them to change their stance. Stimulus has been incredibly important during this last decade for markets and when it needs to be dialed back (tapered) due to inflation concerns, this could be an issue as we have seen in the past. The Fed purchases of $40B a month in mortgage-backed securities in particular seems to make no sense. “The housing sector has more than fully recovered from the downturn,” Chairman of the Fed, Jerome Powell, said last month at a press conference.
In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.
In a world with declining inflation since 1981 and especially since the Global Financial Crisis (GFC), bond and equity portfolio returns have both been very strong. Following the GFC, the Fed and other governments around the globe bought bonds to drive down interest rates. By December of 2020, there was over $18 trillion in government debt with a negative yield to maturity as bond returns were super-charged by Central Banks around the globe. With 10-year treasury yields hitting a record low of 0.5% in August of 2020, this in turn drove very strong returns in the equity markets, especially in long duration assets like technology stocks.
Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally. Any concerns about inflation due to the easy money policies following the GFC have been wrong. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. This has enabled the Fed to expand its balance sheet for over twelve years from $900B before the financial crisis to $8.0 trillion currently. The Fed is currently buying $80B in Treasuries and $40B in mortgage-backed securities per month until there is “substantial further progress” in meeting its goals on employment and inflation. Annualized, this is $1.4 trillion or 7% of GDP in further stimulus from the Fed expected in 2021.
Core/headline PCE and CPI are between 3.1-5.0% in the US. US GDP growth following the GFC from 2010 to 2019 averaged 2.3%. This was the slowest recovery following a recession since World War II. As a result, companies continued to cut back on capacity expansion to match the lower-than-expected growth. In 2020 following the pandemic, capex was cut back particularly hard as many companies just tried to survive the unprecedented drop in prices. As a reminder, oil got to NEGATIVE $35 dollars per barrel at one point. However, US GDP growth is expected to be ~7% in 2021, the fastest since 1984 at 7.2%. World GDP growth is expected to be 6%, the highest since 1976, after falling 3.3% in 2020. We believe, this surge in GDP growth combined with low capital expenditures will lead to a persistent, not “transitory”, increase in inflation.
The Fed may need to act in a more disruptive manner than in the past when they do act. Historically, the Fed has acted to preemptively head of off inflation. With their new policy of waiting to see inflation before acting, there is a real risk of them having to reverse policy rapidly versus the gradual pace seen in the past when they do act. If inflation, turns out to be much stronger than expected, a rapid tightening in policy might be needed and with valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles with a higher risk of a sharper slowdown in future growth. This is obviously not a near-term concern but worth keeping in the back of your mind.
Money Supply (M2) is up 18% y/y vs. a prior record of 14% set in the 1970s, and a high of 10% during the GFC and 10-year yields are at 1.5% after starting the year at 0.9%. When rates moved up from 1.39% to 1.52% on February 25th with an intraday high of 1.61%, a 7-8 standard deviation event, the S&P was hit for 2.4% and gold was hit for 2% and the commodity index was down 0.3%. This is a problem for portfolio managers if both bonds and stocks sell-off together. There are four large investors that like to have close to a fixed ratio between bonds and equities: balanced mutual funds, US defined benefit pension plans, the Norwegian oil fund, and the Japanese government pension plan. These four alone accounts for ~$8 Trillion in assets.
Driven by stimulus, the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x. This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds which has driven up valuations of the entire market but especially of technology stocks. We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 driven by rising inflation. The trailing S&P500 PE during this time went from 20x to 7x despite earnings rising 50% from 1972 to 1974. The trailing PE today is 30x. The PE is also being held lower by record profit margins and buybacks. Inflation is likely to eat into margins along with the higher corporate tax rates being proposed.
But both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell seem to be changing their stance on the impact of monetary policy on the economy and the stock market. Earlier this year Treasury Secretary Janet Yellen urged lawmakers to “act big” and not worry about deficits for now, given low interest rates on that debt. However, on May 4th, she said “interest rates will have to rise somewhat to make sure our economy doesn’t overheat.” Federal Reserve Chairman Jerome Powell has also consistently pushed back on the need to even think about raising rates. However, at the Q&A for the FOMC meeting on April 28th he said, “You are seeing things in the capital markets that are a bit frothy, that’s a fact…I won’t say it has nothing to do with monetary policy, but also it has a tremendous amount to do with vaccination and reopening of the economy.” The Q&A following the Fed meeting this week could be very interesting.
It is estimated that by the end of Q1 of 2021, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been curtailed during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19, and an all-time high of 15% in 1975. This rate is currently at 15%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand.
There are many signs of a bubble, but bubbles can continue for longer than anyone suspects. Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market. Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets. Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement. When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics.
Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke. Roughly 4000 other internet related companies went out of business which dragged down Amazon with it. Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s. This does not mean that investments in this space cannot get crushed if history is any guide.
In Q1 of 2020, while the market went down 20%, we were profitable in large part due to our shorts that we used to hedge against the coronavirus risk. Our hope is that our shorts will outperform when this bubble breaks as well and enable us to cushion against a correction much like they did during the emergence of COVID-19. In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment.
We advise investors to be careful with the market at all-time record highs and all-time valuation highs going into the Fed meetings coming up between now and year-end. The question is not IF the Fed tapers but WHEN they taper. History has not been kind to the market when the Fed balance sheet has shrunk in the past.
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.