Stocks the be-all and end-all of US policy

Via GaveKal:

US equity valuations are stretched. On pretty much whatever valuation measure you care to look at, whether EV/EBITDA, price to earnings, price to cash flow, price to book or dividend yield, US equity markets are somewhere between their 90th and 99th percentile.

At the same time, sentiment and technical indicators are signaling that US equities are somewhere between “frothy” and “leaning too far over their skis” (and yes, those are technical terms). For example:
• For the MSCI US, the 30-day RSI is close to 70.
• The MSCI US is bouncing along its upper Bollinger band.
• The S&P 500’s put-to call-ratio indicates that sentiment is extremely bullish.
• The S&P 500 is trading at more than one standard deviation above its 200-day moving average.

The bottom line is simple: as things stand, US equities are overvalued and technically stretched. This is hardly the most encouraging backdrop. And on top of everything, there is an additional complication: yields are now rising.

As the US economy gradually gets back on its feet following the Covid lockdowns, it looks as if long-term yields will head back to the 2-3% range that prevailed before the pandemic.

But when long bond yields last hovered between 2% and 3%, the dividend yield on the US equity market stood at 2%. Today, the dividend yield is 1.5%.

Looking back through history, when valuations were stretched, technical readings extreme and yields on the rise, investors generally did well to conclude that “discretion is the better part of valor” and head for the exit.

Historically, this has been a challenging set of conditions. However, is there a chance that “this time is different”?

What is different this time?

In a nutshell, what’s different is the US Federal Reserve. The chart below shows the monthly increases in the Fed’s balance sheet.

And just in case that doesn’t make things clear enough, the table below details the eight biggest-ever month-on-month expansions in the Fed’s balance sheet.

The Federal Reserve is continuing to inject vast amounts of liquidity into the system:

December 2020 saw the eighth largest expansion in the Fed’s balance sheet on record. And this occurred at a time when (i) US equity markets were making new all-time highs, (ii) US equity market valuations were reaching dizzying heights, (iii) bubble-like behavior was all too obvious in the cryptocurrency space, the electric vehicle space, and in the listings of SPACs, (iv) non-energy commodities appeared to be on the point of breaking through to a five-year high, and (v) inflation expectations were moving above 2%.

In short, we had a whole set of conditions that in the past would have caused the Fed to snatch away the punch bowl. But instead of calling time on the party, the Fed was spotted emptying a bottle of Everclear into the mix. Why?

Behind the Fed’s surprising liquidity injections

Reviewing the wild market moves of March 2020, Randal Quarles, the Fed vice chair for supervision explained:

“It may be that there is a simple macro fact that the Treasury market being so much larger than it was even a few years ago… that the sheer volume there may have outpaced the ability of the private market infrastructure to support stress of any sort there… There is thus an open question about whether there will be an indefinite need for the Fed to participate as a purchaser to support market functioning.”

Reading this, my reaction was to ask whether the need for ongoing intervention from the Fed really was the open question Quarles made it out to be. At least, if it had been once, then surely the Fed’s injection of US$141bn in December has now settled the answer. For there is only one logical reason for the Fed to have grown its balance sheet in December 2020 to the extent that it did: to prevent an even bigger sell-off in the US treasury market than the one we that actually saw. This, incidentally, could help to explain why, in spite of rising US treasury yields, the US dollar has struggled to stage any meaningful rebound.

Staying with the “Quarles dilemma”, the question for 2021 becomes this: will the Fed look to be even more proactive and try to cap bond yields? Or will it will intervene at the margin to prevent sudden dislocations in the bond market, but by and large allow long bond yields to creep higher?

Given the amount of debt the US government needs to roll over in the coming quarters, this is not a purely academic question. As former Senate minority leader Everett Dirksen once said, “a billion here and a billion there, and pretty soon, you’re talking real money”. Except that when it comes to US debt rollovers, nowadays the numbers are in the trillions, as the chart overleaf shows (a hat tip to my friend Luke Gromen for this; his reports are a must-read).

Rolling over enormous amounts of debt may not be that challenging when the world is operating at half speed, and the demand for capital from companies—whether to finance inventories, expand capital spending, or make payrolls—is limited. But what about when the world reopens?

The 2021 reopening

Before the rollout of vaccines even starts to have a real impact on economies’ ability to reopen (see Darkness Before Dawn? The Covid Vaccine Outlook), there does seem to be some good news on the Covid front.

First, across much of Europe the weekly increases in the number of people testing positive seems to be coming “under control” and perhaps rolling over. Even in the UK, increases may now be topping out. Second, while the autumn and early winter saw a dramatic surge in European cases, the number of deaths did not flare up in proportion. In percentage terms, the second wave of the last few months has been a lot less deadly than the first last spring.

When economies reopen, the boom in consumption will be epic

In the US, the situation is not quite as encouraging, with the weekly increase in total deaths continuing to make new highs. However, as in Europe, a smaller proportion of those who get infected are dying. Catching Covid, it seems, is now less of a death sentence than it was last April.

Given that new cases may be rolling over in many countries, Covid appears less deadly than a few months ago, and vaccines are arriving, then the odds are favorable that by summer the developed world will have mostly reopened.

If so, a consumption boom of epic proportions seems likely. People cooped up for months will cut loose, and after 2020 saw the biggest-ever rise in consumer net worth they will have the cash to splash. In this respect, the recession of 2020 could not have been more different from that of 2008.

If excess liquidity is no longer going into stock markets, won’t that be bad for equities?

And as consumers let rip, businesses will scramble to rebuild inventories, which after months of supply chain disruptions are looking severely depleted.

This will all be great news for economic growth in 2021 (see A Boost From US Restocking). But will it be great news for equity markets? To the extent that the market’s current rise is being fueled by excess liquidity, it stands to reason that any diversion of this excess liquidity into other uses—financing inventories, capital spending, or increased consumption—will be a drag on future equity market returns. Marshallian Ks and all that…

Except, of course, that the Fed may inject even more money in order to (i) fund the likely increase in the US budget deficit as incoming president Joe Biden aims to make a splash (see Biden’s Spending Plan), (ii) help the US government roll over its large stock of maturing debt, and (iii) provide the working capital the private sector will need as it gets back on its feet.

All together, that sounds like a lot of money. This brings me to the key risk of 2021.

What if the Fed does too little?

In all their recent declarations and actions, Fed governors have made it very clear that the Fed can be counted on to prevent major disruptions in fixed income markets, and perhaps in equity markets as well. Clearly, this message has now been incorporated into valuations. Real rates on both US government and corporate debt currently stand at record lows. And US equity valuations are hovering somewhere between the top 10% and top 1% of previously recorded valuations (depending on the measure you pick).

This leaves the Fed facing a problem. The path it must tread to achieve its goal of avoiding major market disruptions is getting steeper and steeper.

The US$1trn injection that was needed at first quickly became a US$4trn injection. In due course, it will become an US$8trn injection.

Investors are betting that the Fed will continue to provide all the liquidity anyone could want

In turn, this means investors face a quandary. If the Fed does too little, US bond yields will likely continue to creep higher. If the Fed does too much, the US dollar will most likely tank (see A Debate On The US Dollar). Either way, US treasuries will remain an unattractive investment for non-US investors, who will face the prospect of either losing on the capital, or losing on the currency—and perhaps on both.

In any event, given the current valuations and technical signals, investors should be aware that a bet on US equities at this juncture is very much a bet on the Fed doing “enough” or “more than enough” to provide the liquidity that will be needed over the coming year by the US government, the US consumer and global corporates. Judging by the Fed’s rhetoric and its recent actions—notably its December balance sheet expansion—this bet makes sense. However, if there is any indication that the Fed is doing “too little”, or that it plans to stop being so generous with its paper and ink, equity markets are likely to take a sudden—and very nasty—turn for the worse.

David Llewellyn-Smith

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