US equities back at record levels, what next?

It’s done it again. The S&P 500 is back at record levels, with the more than 6.0% drop back from early September highs down to early October lows now in the rear-view mirror. The index is currently set to end the week around the 4550 level, an eighth consecutive day in the green during which time the index has rallied nearly 5.0%.

One notable aspect of the recent rally from September lows for the S&P 500 is that it has been driven primarily by gains in so-called value and cyclical stocks (stocks that have a closer relationship to the health of broader economic conditions). For much of the past decades, most of the gains enjoyed by major multi-sector US indices like the S&P 500 has been driven by gains in tech and so-called growth stocks; whose valuations rely disproportionately on expectations for future earnings growth rather than actual earnings (thus why their earnings multiples are very high). That’s because the winning macro trade of recent weeks has been to bet on “reflation” – i.e. commodities, inflation expectations and bond yields all moving higher as confidence build that strong growth will result in higher long-term inflationary outcomes (some economists call this demand-pull inflation, which is the “healthier” type of inflation to see), and so stocks also broadly gain given that very same economic optimism.

Indeed, by the time the IMF had released its quarterly World Economic Outlook (or WEO) at end of September, the consensus amongst market participants and economists seemed to have coalesced around the idea that; yes, growth is slowing due to the biting of some downside risks (supply chain disruptions and bottlenecks, raw material shortages, rising Covid-19 infections, spiking energy costs), and yes, these factors are driving up inflation in the medium-term, but the underlying economic fundamentals remain strong; consumer demand is above pre-pandemic levels in most economies, aided by the fact that following “forced saving” during the pandemic and large fiscal stimulus, consumer are generally in a healthier financial position right now than they were before the pandemic. Moreover, given the ongoing strong demand from consumers across the developed world, labour is in high demand, which is set to keep wages elevated (which in turn feeds into strong demand). This was pretty much the message of the IMF; growth is moderating and there are a few headwinds, but growth is set to remain well above the historic trend for a while yet (for the US, trend growth is somewhere around 2.0%).

When commodity prices and bond yields are rising, this is a headwind for stocks whose valuation depends to a much greater degree on expectations for future earnings growth rather than earnings right now. This is why the Nasdaq 100 index, which has admittedly recovered well from September lows, has not been able to emulate the S&P 500 (and Dow) in printing record levels again this week. Another reason for the divergence in the latter part of this week is that we had some weaker than expected earnings from important tech names Snap and Intel, which has weighed across the sector. The former warned of a hit to global digital advertising revenues due to recent privacy-related changes made by Apple across its devices, while the latter missed sales forecasts as the global shortage of chips held back sales of the company’s processors. The earnings from these Tech names come in contrast to the general tide of earnings coming in stronger than forecast for most S&P 500 companies that have reported thus far. 

As more earnings are released over the coming weeks, we are likely to see more companies talking about how the various disruptions/shortages/bottlenecks plaguing global supply chains are hitting sales/margins, which poses a downside risk to the equity market. However, most analysts agree (hope) that these problems will resolve themselves before long (one would hope we aren’t still talking about supply chains in 2023), and there has been very little to suggest that companies struggling to pass on increasing costs to the consumer. That means margins remain at very healthy levels. As long as the theme of strong margins aided by price-taking consumers remains the case for the rest of the earnings season, that ought to keep a floor under equities.

But back to the macro, can we see the “reflation trade” continue?

It seems as though inflation in most developed nations is going to remain historically elevated for quite a while yet and it is clear that much of this inflation has to do with the many supply-side problems noted above, meaning that if growth was to slow sharply, this wouldn’t necessarily drag inflation down with it (not immediately anyway). As a result, we have also seen market participants bringing forward their expectations for rate hikes from the world major central banks (i.e. according to US money markets, we are no likely to see two 25bps rate hikes from the Fed next year). At the moment, market participants seem to be of the view that a more front-loaded hiking cycle is the appropriate response to the inflationary backdrop (hence why stocks have continued to rally) and will likely in the end mean terminal interest rates won’t have to go as high to get inflation under control/prevent future economic overheating.

However, inflation expectations in the US are now reaching levels where you could argue that they have become “de-anchored” (5Y breakevens are now close to 3.0%, suggesting markets expect CPI to average nearly 3.0% over the next five years, well above Fed forecasts and the bank’s 2.0% target). The Fed believes that inflation expectations can become a self-fulfilling prophecy, thus, if they continue to rise, this actually raises inflation risks. Thus, if inflation expectations continue to rise, the Fed may in the coming months be faced with a dilemma; do they turn more hawkish to dampen long-term inflation expectations, but as a result, sacrifice growth and progress back to full employment, or do they tolerate inflation that is significantly above target and prioritise growth and the recovery to full employment?

If the Fed does shift hawkish in 2022, and interest rate hike expectations are brought even further forward, the current market feeling (or consensus) that Fed policy is appropriate/economically optimal (we can confidently say markets think this because stocks wouldn’t be at record highs otherwise) may well crumble and may instead be replaced by fears that the Fed’s policy stance is overly hawkish, thus putting a downer on longer-term growth and inflation expectations. If a hawkish Fed shift does trigger a substantial drop in long-term inflation expectations and pushes up real yields (thus the impact on nominal yields would be unclear), you could see something more akin to “recessionary” trade taking place. This would likely entail a stronger dollar and weaker stocks.

But the above is a big if; what is inflation expectations stabilise and the market’s expectations for the Fed’s tightening timeline remains broadly in line with where it is right now? This may end up as more of a “goldi-locks” situation for stocks, i.e. one where growth is decent, inflation is deemed as under control and, as a result, the Fed doesn’t need to be too hawkish, a situation which is likely to be positive for stocks.