The Fed just unleashed a big, hawkish signal to markets. Photographer: Samuel Corum/Bloomberg
A reminder of hawkish intent before post-New Year’s exuberance went too far isn’t all bad.
New Minutes for a New Year
2022 has received one last kick from 2021, and traders in the stock market don’t seem to like it. The Federal Open Market Committee last met to consider monetary policy on Dec. 15. Everyone knows what they decided. But the minutes of that meeting, with much more information on how the decision was made, didn’t come out until 2 p.m. Wednesday in New York. The effect on both bond yields and share prices was immediate, with the former surging while stocks sold off:
Why such angst? There’s a lot in the minutes, with much useful information for students of the economy and monetary policy. You can find the full version here. For those less interested in such studies, the passage of three sentences that accounted for more or less all of the market reaction read as follows:
it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures.
This commits the central bank to nothing, but the notion that there were hawks on the committee who thought that the Fed should reduce the size of its balance sheet (in other words, start to sell off its huge bond holdings in a move that, all else being equal, should raise yields) came as an unpleasant surprise. Those words are there for a reason. The Fed thought it a good idea to plant a reminder of hawkish intent just as markets were ramping up again after the New Year break, and it seems to have worked.
That signaling isn’t all bad news for markets, as it implies that the Fed sees strength in the economy. If growth is plentiful, there is less need to pay up for the few companies with reliable strong growth, and more reason to stack up on those that look cheap and have value that can be realized in good times. So the stock market saw a sharp switch away from the growth style and toward value stocks. According to Bloomberg’s FTW (Factors To Watch) service, value has now made up almost all of its losses to growth since the beginning of 2020:
We have been here before, of course. The entire story of investing since the 2008 crisis has involved repeated alarums in the bond market, as investors take fright at the possibility that the Fed will really allow rates to rise this time. It hasn’t happened yet, and the central bank has good reasons to avoid the risk of letting the cost of money rise too far or too fast. But yet again, we have to confront the serious possibility that this time will be different.
A Happy New Year, So Far
The minutes created as much excitement as they did because the first new data of the year, reflecting events after the FOMC met, suggest that the case for hawkishness is strengthening. A stronger economy, and particularly a stronger labor market, is great news on many levels, but it removes any lingering justification for the central bank to be accommodative.
At least one data point, however, hints that the battle against inflation may have turned. The ISM supply managers surveys have consistently shown elevated worries about inflation, and were the first significant indicators to signal a reason for alarm early last year. So the “prices paid” index reported by manufacturers was remarkably healthy. It dropped from 82.4 to 68.4, for the biggest one-month decline in more than a decade. It also fell below the average forecast reported to Bloomberg by the most since the survey started 20 years ago. This was a very surprising big improvement, which suggested that supply constraints must have eased significantly:
It’s always possible that one data point can later prove an outlier or fluke, of course. Meanwhile, the monthly survey by Automatic Data Processing Inc. of private sector employment in the U.S., published Wednesday, produced another very strong result that came as a big surprise. It suggested firms hired 800,000 people last month, double the forecast:
Again, fluke results do happen. The ADP survey is often out of kilter with the official data, and December’s circumstances, with a holiday season colliding with the advent of a new virus variant, make it particularly hard to gauge what is going on. But on the face of it, if jobs are climbing like this, any reason for more support from the Fed goes out the window.
The JOLTS data on job openings for November also arrived this week, showing a slight reduction in the number of vacancies (implying very slightly reduced upward pressure on wages), and yet another rise in the number of people voluntarily quitting, which suggests a continued tight labor market:
All the data so far suggest a somewhat stronger economy than had been feared. The labor market figures make it much easier for the Fed to get more aggressive on inflation. And even though the ISM number implies relief to the bottlenecks is on the way, sufficient concern remains that omicron will cause fresh ones, particularly in China. That’s unlikely to change the Fed’s calculus for now. We can all look forward to the first Payrolls Friday of the year.
Perspective on 2021
Last year was a really good one for risk assets in general, and U.S. stocks in particular. We all know that. But just how good can we say it was? The last few days have been full of attempts to put 2021 into context. This may be too much [expletive deleted] perspective, to quote Spinal Tap, but I think it’s useful.
The following charts are from Milliman Inc. and look at the combined value of stocks and bonds in the U.S. compared to gross domestic product. The financialization of the economy moves on apace, and the ratio has more than doubled since the trough of the Great Financial Crisis. It surged more than ever before during the pandemic year, and kept rising in 2021:
Viewed separately, we can see that the growth of investment assets detached completely from economic growth in the two years since the pandemic hit:
As bond yields rose last year, the increase in the face value of bonds was entirely driven by increased issuance. That brings us to measures of debt, which again show startling developments. The following chart is from Bianco Research, run by Bloomberg Opinion colleague Jim Bianco, using data from the Fed:
The massive amounts of debt issued in 2020 to tide through the pandemic have been cut back — but debt is still as big in relation to the U.S. economy as it was on the eve of the GFC. Financial repression is likely to stop a repeat of the events of 2008, but these numbers show that a lot will be needed.
What of last year’s return? We know that returns were influenced by the Covid selloff in the spring of 2020. But Andrew Lapthorne, chief quantitative strategist at Societe Generale SA, points out that if we look at the last three years’ performance (excluding the Covid selloff altogether), it has been slightly better than the three-year return up to March 2000, the conclusion of arguably the greatest bull market on record. This is true whether we use the S&P 500 or the broader MSCI World:
Both runs started after the Fed had induced a market decline (the “irrational exuberance” rate hike by Alan Greenspan and the threat to carry on reducing the balance sheet “on autopilot” by Jerome Powell). We know what happened in March 2020, but this does not prove that a dot.com-style market crash awaits us now. Beyond the outsized returns, these two episodes in financial history appear to have little in common. Importantly, this three-year run, unlike any other equivalent period with comparable returns, hasn’t been driven by corporate earnings:
It makes far more sense to view this particular rally as a creature of the extraordinary financial conditions created by the pandemic, and the liquidity that flowed to keep the economy going. Hence the concern generated by the Fed minutes.
Lapthorne also suggests that the developed-versus-emerging framework has outlived its usefulness, owing to the dominance of the U.S. within the developed world, and China in emerging markets. As in geopolitics, the choice or conflict that matters is between the U.S. and China. In 2021, U.S. stocks did excellently, Chinese stocks terribly. The developed world outside the U.S. and the emerging one outside China had almost identical returns, of about 10%:
Returning to the U.S., how expensive are stocks really? If we take the earnings yield (the inverse of the price/earnings ratio) and subtract the current rate of inflation, we find that it has just dropped below -3% for the first time:
Bianco has published this series going back 70 years, in an exercise revealing that real earnings yields never stay this low for long. This implies that soon enough, either earnings yields will rise (and share prices fall), or inflation will increase. The critical point is that a lot of money is still riding on the notion that this dose of inflation will prove to be short-lived or, as we used to say, transitory:
On the most basic valuation measure of all, the ratio of price to sales, the U.S. stock market entered this year at a fresh all-time record, with the S&P 500 selling for more than three times revenues:
And if we turn to the most followed and most controversial long-term valuation metric, the cyclically adjusted price/earnings multiple produced by Professor Robert Shiller of Yale University, we find that his latest update (available here), shows the CAPE at its second-highest level in history. Stocks have only been more expensive than this for a few months at the very top of the internet mania in 2000:
Shiller always publishes his CAPE estimates jointly with his measure of 10-year interest rates. Those are far lower now than 22 years ago, and that justifies paying a higher multiple for stocks. But just how much? Shiller has his own crude measure, which is the Excess CAPE Yield — the number that results from subtracting the 10-year Treasury yield from the CAPE earnings yield. This has been a decent predictor of subsequent relative performance, as this chart shows:
To be clear about the relationship here, the higher the Excess CAPE Yield, the greater the subsequent return of stocks relative to bonds. The current level of the ECY suggests this is an unexciting time to buy stocks, but that they should beat bonds over the next 10 years, as they usually do. Back in 2000, when the CAPE yield was below the bond yield, this measure accurately predicted a dreadful decade for stocks. So things do look better for stocks, relatively, than they did 22 years ago. But the key point, which can get forgotten, is that this is a relative judgment. The ECY is quite consistent with both bonds and stocks doing terribly over the next decade, but bonds doing the worse of the two.
In perspective, the exercise backs up one the conclusion that most of us were probably expecting. Risk markets can keep doing this, as long as the bond market gives them permission by keeping yields low. As for so long, the critical question remains whether yields can remain so low. And that explains the excitement over what the FOMC members said to each other three weeks ago.
I have been writing this jet-lagged, which I hope isn’t too obvious. To quell the urge to sleep, I’ve been listening to the “Loud” playlist on my iPod Touch (yes, I still have one of those.) It’s a collection of jangly guitar music, mostly from my teenagerdom, and keeps me awake nicely. Some recommendations from it: We Used To Wait and Rebellion (Lies) by Arcade Fire, Echo Beach by Martha and the Muffins, I Want To Be Adored by The Stone Roses, Going Underground by The Jam, Message In a Bottle by The Police, Since You’ve Been Gone by Rainbow, Unfamiliar by Ride, and Waterfront by Simple Minds. All the videos I’ve linked are live versions, so they’re worth looking at if these songs are to your taste. At least they should keep you awake.