UNDER CONTROL

January 7, 2021

Against most odds, the world created, in less than a year, not one, but several highly effective and safe vaccines to control the worst global health crisis in 100 years. Some vaccines were found using conventional technology with modern tools but the two winners emerged from novel research techniques that carry significant potential for the future of vaccine and other medical research.

The timing for these effective vaccines is fortunate given recent trends in Covid-19 cases in large parts of the world. The light at the end of the tunnel is not a runaway train, rather proof that we will get this minuscule beast under control and that normal life will soon resume.

Debates and financial bets are on regarding how our lives will have changed. For investors, the most significant consequences of the pandemic are

• the almost complete takeover of the debt market by world central banks and its impact on economies and valuations for most financial instruments and
• the potential early relabelling of gigantic government-provided precautionary funds into discretionary spendable money.

There is almost unanimous agreement that equity markets are very richly valued. This overvaluation is considered “justified” (by no less than Jerome Powell himself) by “lower for longer” interest rates dictated by central banks effectively in control of financial yields across most developed financial markets and, now, by the latent economic boom stemming from the humongous amount of money eager to be unleashed in the real economy.

A recent KKR analysis contains two charts that sum up equity and fixed income valuations: equity market metrics are all historically extended except when considering interest rates, themselves having been set at historically low levels by the central banks. In effect, the economy and financial markets are under the control of central bankers who justify the extended valuations they created with a pledge to maintain their support almost indefinitely.

U.S. short-term rates have been near zero during previous crisis but 10Y Treasury yields are at an 85-year low below 1.0%…

…and well into negative territory in real terms even with very tame inflation. Unlike during previous instances, the current negative real yields are not the result of spiking inflation but are clearly Fed engineered.

Entering 2021:

• the amount of fiscal help showered on Americans and Europeans is staggering with a large proportion unspent and standing by in zero-yielding bank accounts;
• the current U.S. Administration just added another $900 billion to the bounty and the coming Administration seems set to keep the money ball rolling;
• the Fed has committed to very loose monetary policies as long as unemployment is not back near pre-pandemic levels and inequalities not correcting; inflation risk has been tossed under a heavy rug;
• vaccines are already being hastily dispensed leading to a likely normalization of economic activity around mid-2021, earlier than authorities anticipated;
• as a result, excess consumer savings are topping $930 billion in the USA, 6.4% of annualized consumption expenditures, before any additional measures; in the Eurozone, the savings rate doubled to 24.6% between Q4’19 and Q2’20; in September 2020, the Chinese’s savings rate was 5% above its December 2019 level;
• Moody’s reckons that cash holdings at nonfinancial companies grew to a record $2.1 trillion at the end of June, up $500 billion (+30%) YoY; Factset calculates that companies in the Stoxx Europe 600 will end 2020 with short-term liquidity ratios at 172%, up from 159% at the end of 2019.
• the U.S. Treasury’s General Account has $1.2 trillion of discretionary funds waiting to be spent, excluding any additional sums voted by Congress;
• in all, “discretionary” funds that could be unleashed into the U.S. real economy in 2021 total nearly $3.5 trillion or 17% of the U.S. $21T GDP.

Not to play second fiddle, Jerome Powell’s Fed has committed to be unrelenting in its asset bulimia and keep policy interest rates floored until we get sustained “above target” inflation, now loosely defined as somewhere above 2.0% for some undefined period of time which most people see only after 2024. Chicago Fed President Charlie Evans stated on January 5 that a move to 3% inflation “would not be so bad.”

Given the gigantic amount of sovereign debt accumulated in the economy, the Fed and other central bankers know the importance of low interest rates. A rate choke on many private borrowers and all governments would threaten the recovery, possibly leading to a recession authorities now have few tools to combat.

As a result, economic agents (corporations, individuals, governments) can now finance investments with historically low, sometimes negative real rates, for as long as 30 years in the USA and Europe.

As the world returns to normal life, these unique investment incentives will undoubtedly result in a lot of the disposable money being put to use one way or another in the real world, not mainly in financial assets like in 2020. The virus has not killed animal spirits.

Hence a strong and lasting economic boom is entirely possible, world-wide, fueled by consumers dissaving, corporations investing and governments spending, the latter being solidly focused on ensuring a return to normal life, particularly for the populations that suffered the most from the pandemic such as essential workers, minorities, the elderlies and the less educated, lower waged segments who proved so helpful (and underpaid) to society in 2020.

How big a boom? Nobody really knows, depending on how vaccination goes and how economic agents actually dispense with their respective bounty. But we know that authorities, unlike post 2009 Eurozone, will not get in the way, at least in 2021 and possibly in 2022 as well. Austerity is out.

Nominal GDP is thus set to grow at rates unseen in quite a while.

• Goldman Sachs, one of the most bullish sell-sider, has U.S and world nominal GDP rising 7.0-8.0% in 2021 and 5.0-6.0% in 2022. The last times the world experienced such high nominal growth rates were in 2010-11, 2003-08 and the late 1980s.
• KKR, one of the most sophisticated buy-side investor, is also very optimistic, seeing world nominal GDP rising 8.0% in 2021 and 6.6% in 2022. U.S. nominal GDP is seen jumping 6.9% in 2021 with quarterly growth rates possibly reaching double digits in Q3 and Q4 while Europe should grow 6.3% and China 9.2%.
• Both GS and KKR are significantly more optimistic than the current consensus and they both have upped their forecasts recently.

U.S. Business Sales growth is intimately tied to nominal GDP growth suggesting that Business Sales could rise at near double digit rates around the middle of 2021 and into 2022, substantially faster than during the last 10 years.

This, in turn, could translate into S&P 500 aggregate revenues also rising at near double digit rates. S&P 500 revenues and profits could be growing at rates unseen since the 1990’s as Ed Yardeni illustrates:

Note the different scales on this next chart: profit growth rates tend to be twice Business Sales’:

Current bottom-up consensus estimates from Refinitiv/IBES are for S&P 500 EPS jumping 22.5% to $169.46 in 2021 and another 16.6% to $197.62 in 2022. Most seasoned investors will discount such forward estimates given sell-side analysts’ proven optimism but the current exceptional environment could make them unusually prescient this time around.

From the top-down, KKR sees S&P 500 EPS reaching $174 in 2021 and $203 in 2022. Fiera Capital’s rapid recovery scenario has EPS hitting $180 in 2021 followed by “an extended period of robust, above-trend growth”. The links between nominal GDP, business sales, S&P 500 revenues and profits justify such strong forecasts.

For equity investors, the earnings part of the equation seems bullishly under control for at least the next 2 years: a strong, broad and sustained earnings tail wind.

Bond investors need to wonder if, amid such strong synchronized world growth, central banks will be able to keep longer-term interest rates under control. Central bankers’ strong resolve will clash against other powerful forces vying to push long-term rates upwards:

• yield curves naturally tend to steepen early in a new cycle as inflation expectations rise;
• real yields are already historically too low and make little sense for investors seeking absolute positive real returns;
• term premia need to eventually normalize, if even to 2011-2018 low levels:

• inflation pressures will intensify, particularly if economies boom in a synchronized manner;
• foreign investors will now need to consider their currency risk investing in USD securities;

Five-year forward inflation expectations are back to the 2.0% range but, at this point, that primarily reflects oil prices recovering to the $50 level.

In reality, core inflation has weakened during the pandemic…

…but some of that may be due to the temporary collapse of demand for services while rising demand boosted goods prices:

Eight months into the pandemic, Americans’ real expenditures remain down 2.6% YoY but that’s because spending on Services (65% of the total) is down 6.7%. Meanwhile, demand for Goods jumped 4.9% for Non-Durable Goods (22%) while demand for Durable Goods (13%) exploded 12.1%.

Upon reopening and normalizing, regular and pent-up demand for Services will meet a much reduced offering as many service providers and their employees went out of business in the past year. Restaurants were especially hard hit but U.S. eating-out costs are nonetheless up 3.8% YoY, about in line with grocery prices where demand rose. Meanwhile, 25 states have increased their minimum wage in 2020 and an equal number will do so in 2021.

In such a context of strong demand, reduced capacity and rising costs, can we reasonably expect bruised service providers not to take advantage of their pricing power? A simple return of core Services inflation to the mid-3% with core Goods inflation steady at 1.5% would take core CPI to 3.0%.

Perhaps demand for Goods has been fulfilled for a while and Goods inflation will ease post pandemic. But Goods are but 25% of Core CPI and only a return to Goods deflation would bring core inflation back below 2.0%. Some macro issues such as high unemployment and excess capacity in some sectors will act as drags on inflation. On the other hand, the USD is down 4.3% from its 2019 average and seems set for more weakness which would pressure import (goods) prices, many already subject to increased tariffs and higher supply chain costs.

Strong demand can quickly impact prices:

• The S&P CoreLogic Case-Shiller National Home Price Index is up 8.4% YoY in October, the highest annual rate of price growth since March 2014. Lumber prices have more than doubled since 2019, reaching their highest level since 1986. The National Association of Home Builders estimated earlier this year the spike in lumber prices increased the price of a single-family home by over $16,000.
• Major appliance prices are up 17.2% YoY.
• Fast food restaurant prices are up 5.9% YoY.
• Used car prices are up 10.9%.

Meanwhile some categories that deflated in the past year could well reflate rapidly with resuming demand:

• Apparel prices declined 5.2% YoY, women’s are down 6.9%.
• Away from home lodging, down 10.8%.
• Motor vehicle insurance, down 6.0%.
• Airfares, down 17.0%.

Rising inflation risks will add up to the other fundamental factors pressuring long-term interest rates, testing central bankers’ resolve and capabilities as well as investor confidence. While floored policy rates, sustained institutional demand for yield and demographics will help, bond market volatility should increase and spill over to equities as forecasts of an emerging upward structural move in rates are spreading among both sell and buy-siders.

Goldman Sachs sees U.S. 10Y Government yields reaching 1.3% in 2021, 1.65% in 2022 and 1.85% in 2023, all assuming inflation never exceeds 2.2%. KKR is even more restrained seeing 10Y T yields at 1.25% and 1.5% in December 2021 and 2022 respectively with inflation not “sustainably above the Fed’s two percent
goal until around 2024.” Fiera Capital’s Rapid Recovery scenario has 10Y rates at 1.4% at the end of 2021 with inflation at 2.0%.

In the last 20 years, outside of recessions, 10Y T yields fluctuated between 50 and 250 basis points below nominal GDP growth rate. Using GS forecast of 4.2% nominal GDP growth in 2023-24, the odds are for 10Y yields north of 1.7% at some point during the next 3 years. An ugly and potentially disrupting bond bear is looming.

The strong earnings tail wind could thus confront a sharply steepening yield curve with potential impacts on the flow of funds (bye-bye TINA) and, importantly, equity multiples losing their ultra-low interest rates cushion.

KKR reckons that equities are “near-term overbought” but it nonetheless displays a fair value estimate of 4,050 on the S&P 500 for 2021. KKR’s strategists expect “the equity risk premium to stay near current levels of 5.0%, which is approximately 50 basis points lower than the post-GFC average of 5.5%, but above the lows of 4.2%.”

The Equity Risk Premium is presumed to measure investor risk aversion compared with capital-safe 10Y Treasury yields. KKR’s assumption that the ERP will “stay near current levels” rests on nothing more than its most recent 10-year average, itself being well above its previous 10-year average, itself having been well above its previous 20-year average…

The chart above shows the long-term relationship between 10Y T yields and the ERP, itself a function of 10Y T yields, but it also shows how forecasting P/Es with ERPs is a rather perilous exercise. Even during periods of big drops in yields, the ERP remained boxed within a fixed range (like 25 years!) for some other reasons that only really sophisticated strategists can explain, always post facto.

Meanwhile, the really unsophisticated Rule of 20 keeps providing investors with a very stable measure of valuation risk through all kinds of interest rate and inflation eras. The R20 P/E (actual P/E + inflation) almost invariably fluctuates between 15 and 25 with a Fair Value median of 20, where the valuation upside equals the valuation downside. Moreover, the R20 P/E always returns to its “20” mean, a reflection of investors’ ever shifting risk aversion around an “equilibrium” value.

KKR does not expect any contribution from rising multiples going forward “as we expect NTM P/E multiples to stay roughly flat at 21.2x.” A prudent call given the experience of the last 100 years and the fact that the R20 P/E is 23.5 using KKR’s 2021 estimates for earnings ($174) and 2.0% inflation, the latter carrying some upside risk but “not before 2024”. Goldman Sachs’ inflation expectations are also anchored at 2.1-2.2% through 2024.

In all, everything seems to be under control: the Fed pins policy rates at zero and manages markets rates low enough to boost the economy, and inflation stays smartly stuck around 2.0%.

The Rule of 20, using 2.0% inflation, would put the S&P 500 Index Fair Value (R20 P/E = 20 – inflation) at 3130 using KKR’s $174 estimate for 2021 (3240 using Fiera’s $180), rising to 3655 two years from now assuming EPS of $203 and steady 2.0% inflation.

Over the past 50 years, extreme overvaluation per the Rule of 20 has persisted for more than 2 years only 4 times, twice during badly-ending speculative bouts (Nifty-Fifty and Dot.com) and twice during periods of slowing inflation and lower interest rates. This time around, we seem to have both the speculative fever and potentially rising inflation and rising market interest rates.

The best hope here is that booming earnings will more than offset everything else. This will only become reality starting in the second half of 2021.

Beyond fundamental factors such as earnings, interest rates and inflation, liquidity and technical factors also impact equity markets. To be sure, excess liquidity will remain until growth in the real economy really kicks in and begins to absorb financial liquidity. Faster economic growth fosters higher money velocity. Excess liquidity is then sucked away from financial markets to feed real world transactions.

Money velocity will truly accelerate if and when people elect to start spending some of their discretionary funds. The most recent trends and surveys suggest that this will await better news on the health front. Real consumer expenditures are down 0.15% sequentially in October-November and indications are that December sales were on the weak side.

Americans dissaved earnestly between April and August but elected to keep the savings rate more than 5% above its pre-pandemic level since. Spending fatigue, fulfilled demand and/or precautionary behavior, temporary or not? Nobody really knows, but I posit that Americans are generally avid and creative consumers and that the “vaccine miracles” will restore confidence and animal spirits. We should know around mid-year but with the Blue Wave now official, more money is likely shortly coming into Americans’ pockets. Hence the reflation trade.

The corporate sector could also set money velocity in motion. Business Inventories are down 4.0% YoY while Sales are up 2.2%. The inventory to sales ratio was down to 1.3 at the end of October, back to its 2014 level and 7% below its pre-pandemic level. This strong corporate pent-up demand will boost manufacturing in coming quarters. Markit’s U.S. Manufacturing PMI for December “posted 57.1 in December, up from 56.7 in November, to signal the steepest improvement in the health of the U.S. manufacturing sector for over six years.”

Also, corporate officers have been quick to restore capex to pre-pandemic levels (red line is March-November average). Truly unique financing terms coupled with reshoring/near-shoring/regionalizing initiatives following the pandemic and the U.S./China trade war favor stronger capex.

The U.S. output gap was 3.5% in Q3’20. While this sounds deflationary, let’s recall that the U.S. was in a negative output gap position in Q4’19 for the first time since the turn of the century. The extended output gap disappeared in Q4’17 when core inflation was 1.6%. By the end of 2019, core CPI was 2.4%, up 50% in two years.

Markit’s December manufacturing PMI reports also revealed that

• The rise in input prices was substantial and the fastest since April 2018, driven by raw material shortages and supplier price hikes. Firms were able to partially pass on higher costs, however, as selling prices increased at the sharpest rate since May 2011. (USA)
• Higher raw material and transportation costs placed upward pressures on input prices. The latest increase in overall cost burdens was the steepest since October 2018. Sharp rises in operating expenses and resilient demand conditions led to the fastest increase in selling prices for over two years. (Canada)
• Latest data showed that operating expenses rose to the greatest degree since November 2018 with rates of inflation sharp across the bloc. Selling prices were subsequently increased for a third successive month and to the greatest degree since February 2019. (Eurozone)
• Manufacturers in China registered a sharp and accelerated increase in average input costs in December amid reports of greater raw material costs, particularly for metals. Notably, the rate of inflation was the steepest recorded for three years and led to a quicker rise in prices charged by manufacturers. (China)
• There were further reports that rising raw material prices placed sustained pressure on average cost burdens across Japanese manufacturing firms in December. Input prices have now risen for seven months in a row, with the rate of inflation quickening to the fastest since January. Output prices meanwhile, increased for the second time in three months, albeit fractionally, as firms partially passed on higher input costs to clients. (Japan)

Services PMIs suffered from renewed lockdowns but nonetheless:

• The rate of cost inflation accelerated again and was the fastest since data collection began in October 2009. The rate of charge inflation eased from November’s recent peak, but remained sharp and quicker than the series trend. (USA)

All this to say that even though central bankers and governments currently seem to be in control, there are reasonable odds that they may lose control if consumers get into a spending spree while corporations simultaneously restore inventories, boost capex and successfully pass on their sharply rising costs.

Amid a stronger than expected world economy and rising inflation, pressures on long-term rates might prove difficult to fight, especially if the market decides to test the Fed’ presumed dependable backstop.

Equity investors are currently assuming that most everything is under control, allowing good visibility well into 2022 and beyond. Such confidence is currently worth 400 points on the S&P 500 (to R20 P/E of 20).

But we know that speculation is rampant amid most asset classes (read Jeremy Grantham on this). Any correction could surprise a greedy and inexperienced bunch, potentially aggravating the downdraft beyond the rather common 10% annual drawdowns.

This next chart suggests that we may not be in a Dot.com type bubble when valuations went ballistic and public participation was much, much higher than now. People using taxis and going to barber shops less frequently, stock market conversations and tips may not travel as well nowadays…

…or they actually do anyway through social media but the wagering is done in the options market as David Hay, CIO at Evergreen/Gavekal shows in his latest piece, Take Profits!, well worth reading, though preferably not around your bedtime. SentimenTrader adds that”the concern is that hedging activity, in the options market or elsewhere, has become scarce. The Equity Hedging Index (EHI) is now in the lowest 6% of all readings since 1986.”

With the virus shortly getting under control, the economy under control and corporate profits about to explode, investors should remember the old saying “buy on the sound of cannons, sell on the sound of trumpets”. Unless one feels the Fed fully understands what’s going on and has financial markets really under control, one should make sure its own exposure to extended markets is also under control.

Corporate insiders seem to be doing just that as David Hay illustrates using this Bloomberg chart via Danielle DiMartino Booth:

It is thus important to closely follow the consumer, money supply and bank deposits as well as some key technical indicators, most of which being currently bullish although generally very extended.