It looks like the Fed started the end of globally coordinated easy money yesterday.
This morning the Bank of England raised rates this morning, with a surprise 25 basis points. That's the first major central bank to raise rates. The European Central Bank telegraphed an end to its pandemic/emergency asset buying program by March. The Bank of Japan decides on policy tonight.
That said, emerging market central banks have already been moving on rates for much of the year. These are central banks that don't have the luxury of representing 90% of the world's foreign currency reserves (like the U.S., UK, Japan and Europe). They couldn't afford to sit around, waiting and watching inflation. They had to act.
Mexico, South Korea, South Africa, Chile, Brazil, Czech Republic, Hungary, New Zealand, Norway, Poland, Russia, Turkey — all have been raising rates to fight inflation and to defend against capital flight.
So with major central banks joining over the past 24 hours, the change in direction of global monetary policy is probably official now.
With that, as we've discussed, a higher rate outlook makes the high multiple stocks most vulnerable, which includes the no-earnings/ innovation story stocks.
For perspective on today's losses in the big indexes, let's take a look at the sector performance on the day.
As you can see, money moved out of technology (high multiple stocks) and consumer discretionary (a beneficiary of stimulus). And into financials and commodity related stocks (materials). This is the "growth to value" rotation we've been talking about. It's early days.
This afternoon markets rallied following the Fed decision, where Jay Powell guided to a faster end of QE, and three rate hikes next year.
We expected that the Fed might double the cuts to its bond purchases. They did. We expected that the move would open the door to a rate liftoff as soon as March. It did.
While June remains the most probable month for liftoff, the Fed Chair indicated that they could liftoff when bond purchases are ended, which would be March.
On the face of it, this all sounds like a more hawkish Fed communication today than even expected.
But markets liked it. Why?
Because the Fed is forecasting a very shallow rate hiking cycle. That's because they remain arrogant enough to forecast an inflation rate that will reverse (from 7%) and land close to their 2% target, by next year.
With that, maybe the biggest message that markets came away with today: The Fed will not become inflation fighters.
Of course, that may or may not happen. But that was the takeaway today.
If you believe Jay Powell, you expect a hot economy to continue to strengthen, with a Fed that will perfectly thread the monetary policy needle, to produce just 2.6% inflation from a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) — all while keeping the Fed Funds rate under 1% — and over the coming years, never needing to exceed the Fed's long-term target Fed funds rate of 2.5%.
That would be magic.
But remember, the Fed cares more about shaping expectations than they do about forecasting. They have a good record on the former, and a bad record on the latter. What matters most for markets, in the near term is the former. With that, markets go up today. And if we look back at the analogue of 2014, when the Fed was tapering its last round of QE, stocks went up. Only after the Fed actually made its first interest rate hike, in late 2015, did the path become tougher for risk assets.
With the Fed meeting tomorrow, bets were increased today that we could see a first rate hike as soon as March (about a 35% chance).
And the market is now pricing in an 80% chance of a hike by June. It was a 50% chance yesterday.
Over the past six weeks, the consensus view in a Reuters economist poll has gone from the view of: no rate hikes until 2023, to a rate hike in Q4 of next year, to a rate hike in Q3 of next year.
That view will likely get pulled forward again tomorrow.
Let's take a look at real estate, for some insight into what this might mean for record high prices.
The above chart is the Case-Shiller Home Price Index (index of 20 major cities).
It's 47% higher than the pre-financial crisis peak.
Does that mean its a bubble? No. Even though money is easy, and the Fed is pumping liquidity into the mortgage bond market, it doesn't mean that risk in the housing market has elevated.
You can see in the graphic below, the risk profile is very different, which aligns with the current environment of high creditworthiness (low debt service, high savings) and stringent lending standards (post-financial crisis).
The real estate bubble that popped in 2006 was primarily driven by credit agencies AAA stamping high risk/high yielding mortgage portfolios. With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments. And with that insatiable demand, mortgage brokers and bankers were incentivized to keep sourcing them and packaging them. So, whether it was fraud or incompetence (or both) somehow the ratings agencies survived.
Bottom line, this housing environment looks much less vulnerable to rate hikes.
What looks likely, in the face of a rate tightening cycle, is that real estate prices just stay persistently high, and even continue higher — driven by multi-decade high economic growth, massive new money supply floating around, and a very tight labor market. And at higher rates, it will just cost more to live.
Consider this above chart of Australian housing prices. Pre-Global Financial Crisis, the fundamentals of the Australian housing market were every bit as dislocated as U.S. housing (housing price to rent ratio, home price to income ratio), but they didn't have a bust – it just kept going.
We have the big Fed meeting this week, which will conclude on Wednesday.
Given the posturing by Jay Powell a couple of weeks ago at his congressional testimonies, we should expect the Fed to speed up the timeline on ending QE.
Remember, at the Fed's November meeting they projected an end of QE by June.
The path to June came from their plan to taper bond purchases by $15 billion a month.
If they decide on Wednesday to double those monthly cuts,we would then have a timeline to end QE by March.
This matters because it's very, very unlikely that they would raise rates before ending the bond buying program. With that being the case, the recent telegraphing from the Fed would suggest that March would be the earliest the Fed would begin the liftoff of interest rates.
What does the interest rate market think? The market is pricing in about a 30% chance of the March scenario, and about a 50% chance for a May liftoff.
Now, with this in mind, remember on Friday we looked at the inflation spikes in 1973-1974, and the hot inflation of the early 80s. In both periods, the Fed had to ratchet rates above the rate of inflation to finally get it under control.
In the current case, they are nearly seven percentage points behind. And if they aren't positioned to start raising interest rates (from the zero line) until March, at the earliest, the inflation situation is going to be left to only intensify.
Still, even if they begin an aggressive hiking campaign in March, with a 50 basis point hike, they will still be in a stimulative position for quite some time — which will continue to stoke inflation.
If we look back at the past five tightening cycles by the Fed ('87, '94, '99, '04 and '15), the Fed has averaged about 50 bps a quarter.
Keep in mind, the Fed will be tasked with bringing inflation under control, without killing the economic expansion. Given the current position, it will be a tough task. The trajectory looks like 2023 could be a tough year.
The optimistic scenario, within the market, is driven by the idea that supply chain bottlenecks will be worked out, and naturally relieve inflation pressures.
The less optimistic scenario, while acknowledging the chance for a normalization on the supply side, we can't ignore the boom on the demand side, driven by $5 trillion of new money supply added over the past twenty months, a "reopening" economy, and hot job market.
The inflation data came in hot this morning, as we suspected.
Here’s what it looks like with some historical perspective …
This is early 80s-level inflation. The last time we had this degree of inflation, the effective Fed Funds rate (the rate the Fed sets) was 14.45%. Today it’s 0.08%.
What was the Fed Funds rate when inflation peaked in 1980 at nearly 15%? 17.6%.
What about the spike in 1974-1975? Inflation started to come under control, only after the Fed ratcheted rates up above the level of inflation. In late summer of ’74, inflation was running 11.5%. The Fed took rates up to 13%.
So, with the Fed currently at zero and inflation running at (least) 6.8%, this is going to be painful battle. The Fed is way, way behind. Double-digit inflation continues to look like the most probable scenario.
With this in mind, I want to copy in an excerpt from my note back in March, where we looked at this chart from Bank of America, which gives us a visual on the record extreme divergence in the performance of deflationary assets, relative to inflationary assets over the past 30+ years.
Excerpt from Pro Perspectives, March 26: “Are we seeing the turning point, driven by the unimaginable catalyst of profligate monetary and fiscal action, combined with a global supply crunch and pent-up demand from a global pandemic?
If it is, it would have good company, historically, in terms of major events. If we look back at the periods where inflation assets outperformed deflation assets by 15 percentage points or more, we find three:
1941 – End of the Depression and big government spending through The New Deal. Inflation ramped up to double digits in 1942.
1973 – Oil crisis. Inflation ramped to double digits in 1974.
2000 – Bursting of the dot com bubble. The Fed prevented a spike in inflation, through rate hikes, but crushed the stock market and created recession.
Again, these are historic periods where inflation assets outperformed. It looks like we are in the early stages of another one: buy inflation assets.”
For October, the headline number was a 0.9% monthly change in prices. If we extrapolate that out over twelve months, we have double-digit annual inflation.
The November number is expected to be hot as well, at +0.7%. And that leads us into next week's big Fed meeting, with expectations that they will announce a faster taper and project a timeline toward a rate hike as soon as March.
The question becomes, assuming conditions hold, how aggressively will the Fed go after inflation? Economic expansions tend to end when the Fed kills the patient.
With that said, if we look at the Atlanta Fed model, it continues to hold up well.
For Q4, the model is projecting almost 9% growth.
If this number were to hold up, we could see 6% economic growth for the full year 2021. That would be the fastest growth since 1984.
Yesterday we compared the current period to 2014, where the domestic and geopolitical noise was high, and the Fed was ending its QE response to the financial crisis – and setting the table for the rate liftoff.
I failed to mention another very important event in 2014: the Thanksgiving evening oil market surprise. This is when OPEC pulled the rug on oil prices, with a well-timed announcement that they would not defend the price of oil with a production cut.
This event turned out to play a very key role in the Fed’s ability to follow through, in the coming years, with its rate “normalization” plan.
What started as a slide in oil prices back in 2014, turned into a crash with OPEC’s influence. And over the next year, as you can see in the chart below, oil traded down from over $100 to below $40 — ultimately bottoming out at $26 in 2016.
What does this have to do with today?
Oil prices are important.
Though the Fed always likes us to believe that their assessment of inflation, excludes oil prices (which they argue are too “volatile” to consider), they have a very clear history of acting when oil prices make a dramatic move (higher or lower).
In this 2014 analogue, the Fed went from tapering and ending QE in 2014, to telegraphing and executing its first rate hike in nine years (in December of 2015). And from there, they were telegraphing four additional rate hikes in 2016.
But oil kept collapsing. A month into 2016, oil had fallen another 35% to the high $20s. That sounds great for consumers (cheap gas). But it also came with mass bankruptcies in the U.S. shale industry, and therefore threats to the creditors of the industry. And it came with heavy deflationary pressures in the economy. Stocks melted down, having the worst start to a New Year on record.
With that, just one month after the Fed pulled the trigger on its first rate hike, they had to take the four rate hikes that they were projecting for 2016, off of the table. And quickly, they were back in the defensive.
I revisit this scenario: 1) for the similarities between the current period and 2014 (excluding oil prices), and 2) to acknowledge a (low probability) scenario where oil prices could crash (undermanipulation) and completely reverse the outlook on inflation, Fed policy and the economy. It’s far from the high probability scenario, at this stage, but it’s possible.
We had a broad bounce back in global markets today (stocks, commodities, currencies and yields).
Thus far, both the virus variant and the U.S. government's response to the variant has been tame. That's good news.
After all, much of the ugly price action in markets over the past two weeks originated from a headline that dropped on Thanksgiving evening about the new variant.
But there is plenty of other noise for markets to interpret: the continued infighting on Capitol Hill, over the debt ceiling and the next massive spending bill. Add to that, U.S./China and U.S./Russia tensions have been bubbling up.
Is this all bad for stocks?
We don't have to look too far for the answer. This sounds a lot like 2014. In fact, it sounds exactly like 2014 – including the presence of a scary virus (ebola).
What did stocks do in 2014? In the face of all of the worry, stocks rose 11%.
What also happened in 2014? In late October, the Fed finally ended its financial crisis QE response. That set the table for a liftoff of interest rates.
Again, the 2014 analogue continues to sound similar to the current period.
So, what happened in 2015?
With an anticipated tightening cycle coming, stocks went sideways for much of the year (including a 13% correction). The Fed started the liftoff of rates in December. It wasn't welcomed. By late January (2016), they were walking back on their rate path projections.
Bottom line: In the crisis era (both Great Financial Crisis and Great Health Crisis), where the Fed has crossed the line in the sand, and become directly involved in key asset markets, Fed policy has been, and will continue to be, the dominant catalyst for markets.
Last week we talked about the flip-flop by Jerome Powell on inflation. He flipped from inflation-denier to inflation-fighter, all over the course of just a morning congressional testimony.
Just like that, the market is now beginning to talk about a March rate hike.
On that note, we'll hear from the Fed next week, where they will likely layout a (new) timeline for that possibility.
As we discussed last week, this new interest rate tightening cycle will be bad news for the high-flying, high-valuation growth stocks — particularly, the "no EPS" stocks.
Many of these stocks that have been valued by Wall Street on a multiple of sales (not earnings) have already taken a beating in just the days since Powell's flip-flop.
The big asset manager, GMO has a good chart that describes the impending fate for these stocks …
In this chart, we can see the percent of companies in the Russell 3000 Growth Index that have negative earnings. It's a record high. As we can also see, things don't tend to go well at these levels (the red circles).
What else is at a record extreme? The ratio of growth stock performance (outperformance) relative to value stocks.
This all sets up for a rising rate environment, driving money out of growth and into value. The catalyst, a Fed tightening/inflation fighting cycle), is here.
We talked about the prospects of getting a hot jobs report this morning.
And we talked about the risk it would represent to "high multiple" stocks (namely, high-growth tech stocks).
So, what were the big numbers?
The unemployment rate came in at 4.2% (a big drop) – along with a big drop in the underemployment rate.
The jobs report was indeed hot. That's despite a softer payroll number, which will likely be revised higher (as the past four have), and is trending at more than double pre-pandemic levels.
Remember, the Fed has given us a condition for rate hikes. It's "maximum employment." This level of employment the Fed calls "maximum" (or full) hasn't been quantified, but if we go back through 70 years of history, there are only five periods in the U.S. economy where the unemployment has been lower.
It's a pretty good bet that the Fed has met its objective on employment. We already know they have exceeded their objective on prices (price stability). So, this report should seal the deal for a faster path to Fed rate hikes.
With that, the very high multiple, high growth tech stocks did indeed get punished today. Why? Higher rates tends to bring about lower valuations. When Wall Street analysts start plugging in a higher a discount rate (interest rate) into their cashflowmodels, they will get a lower price target (in some cases, much lower).
This, as the Nasdaq closes today at 36 times trailing-twelve month earnings – and 30 times forward earnings. The average P/E on the Nasdaq over the past 14 years is 20.
