Free lunches, policy errors and the secular bull
For now, the bull is fine. But we're monitoring for potential longer-term health issues.
Readers of this space know we have been in the “long-term secular bull” camp for over a decade, dating back to 2010 when we first mentioned the possibility that we’d begun one. We came within a whisker of losing the beast in March 2020, but right on schedule the Fed and Congress rode to rescue; the bull got treated and cured with a cocktail of asset purchases and bridge loans to the temporarily shut down economy. Markets have been a tear since, with Covid-lockdown-favored sectors in technology and biotech leading the way at first, and later the Covid-reopening cyclical/value stocks assuming leadership. Our call at Federated Hermes remains bullish, with the lead by value and cyclical names continuing, though in a choppier fashion as near-term economic news ebbs and flows. Yet, even as we approach our longstanding S&P 500 targets of first 4,500 and eventually 5,000, we’ve begun to focus in on the potential risks that the bull, once again, confronts a serious health issue.
Which brings us to the matter of free lunches and policy errors.
For risk asset investors, a “Free Lunch” or, more mundanely, a “Goldilocks Scenario” occurs when the funding rate for financing purchases of risk assets is far lower than the growth in the economy and nominal earnings would suggest it should be. The overly easy monetary policy this reflects makes risk assets look very attractive, as the economy is running so hot that earnings can’t help but explode, at least in nominal terms. Situations like this tend to be ephemeral in nature, as overheated economies historically have resulted in excessive price inflation, leading to tighter monetary policy and an economic slowdown. But they become a free lunch when there is no prospect in sight of a monetary tightening, allowing nominal earnings and asset values to continue to inflate until some outside force or “vigilante” puts a stop to the party, or until the Fed itself finally acts.
When Asian markets choked on their free lunch
One of the most memorable free lunches in the last 30 years was the southeast Asian bubble in the 1990s. Central banks there were pursuing very easy monetary policy, over-stimulating for growth. Because they’d pegged their currencies to the U.S. dollar, the currency vigilantes could not discipline the situation with currency pressures, so the markets kept running ever higher. It took five or six years for this party to end, when the currency market vigilantes finally took a run at the Thai Baht, the weakest of the herd of young tiger cubs. They drained the central bank there of currency reserves and broke the peg. The whole Thai market edifice collapsed. Most of the other southeast Asian tiger cubs fell like dominoes over the ensuing 18-month crisis.
Today in the U.S. at least, investors have once again been presented with a “Free Lunch” by the fiscal and monetary authorities. Congress is spending like crazy in the name of stimulus, with the word “trillion” rolling off our representatives’ tongues as smoothly as “billion” once did. Meanwhile, the Fed, convinced for better or worse that the deflationary forces that fueled the bull since 2010 remain fundamentally intact, and determined this cycle to continue policy ease until full employment is reached in all income cohorts, has declared repeatedly that its “not even thinking about thinking about raising rates.” With record levels of cash piled everywhere, and the psychological relief of the vaccines lighting the spark, economic growth is currently taking off like a rocket ship. Supply shortages, logistics challenges and reluctant-to-return workers are together leading to a sudden burst in inflation, from everything as far apart as gasoline, steel, food, suburban housing and entry-level wages. Nominal earnings are exploding with all this activity. Just two weeks ago, Federated Hermes raised its 2023 earnings forecast yet again, to $250 a share on the S&P. With discount rates on stocks being held artificially low by the Fed, this makes the S&P an attractive buy even at these levels, under 17x 2023 earnings when 21 to 22x is probably justifiable given the discount rate….
… If the discount rate, the yield on the 10-year Treasury, holds. By “hold,” we mean remain somewhere between current levels and 2.5%, our baseline forecast and a level, we believe, stocks could easily tolerate over the intermediate term. Rates can stay in this range through one of two ways.
- The first scenario, call it our base case “secular bull lives on” option, is the Fed is right, inflation quickly recedes to the targeted 2% pace, and there is no need for the Fed to tighten rates more than 100 bp or so. In this scenario, we’d see the bull heading considerably higher; we’d have to raise our longer-term S&P target beyond 5,000.
- The second scenario, “Policy Error,” is the Fed is wrong, inflation and nominal earnings accelerate, but the Fed does not react with tightening or at least tapering. This scenario would likely lead to a speculative blow off in the broader market, perhaps driving the S&P temporarily even higher than our base case as earnings explode against the artificially low discount rate on those forward earnings.
Unfortunately, the problem with the “Policy Error” scenario is that sooner or later, the free lunch would have to be paid for. The Fed would be forced to action by the bond vigilantes (if there are any left!), but by then, with inflation running well north of 3% sustainably, the only way to break the new inflationary cycle would be to hike rates dramatically and suddenly, causing a recession and with it, a precipitous market drop. The drop would be exacerbated by the degree of overvaluation likely in the aftermath of the bubble, and with selling begetting selling, the pullback in the S&P would likely, in our view, far exceed the normal 20% pullback we get from time to time in bear market corrections. And given all the angst about greedy Wall Street and its over-reliance on the Fed, don’ be surprised to see some major dislocations allowed to occur, this time around. Things could get ugly.
There’s time to decide
For now, we are inclined to give the Fed the benefit of the doubt, as we think there is still time to adjust policy. Even this week, policymakers began mentioning, at least, the word “tapering” and announced they have started selling corporate debt purchased through an emergency lending facility launched when the pandemic was spreading panic through financial markets—perhaps another step closer to taper. Importantly, whichever scenario we are in, the near-term outcome is likely to be positive for stocks. So, we’re sticking with our overweight call, leaning as I indicated toward the cyclical/value trade, and relying heavily on individual stock selection to be sure we are in inflationary winners.
We’re also hard at work studying historic bubbles, and have developed both inflation watch and bubble watch dashboards to try to stay ahead of which way this turns.
Said differently, we’ve still got our money on the secular bull. She’s been resilient so far. And, just in case, we’ve got health monitors all over her in the event she has another health scare.