Lots to worry about ... fueling the bull forward
Still room to run, with a tilt toward cyclical companies with pricing power.
Of late, the always present bull-market worry list (a Wall of Worry is the fuel that feeds all bulls) seems longer than usual. Even optimists like ourselves sometimes have our dark moments—or worries that seem worse than most. As we’ve now powered through our longstanding 4,500 S&P 500 forecast, marching in step toward our more recent upwardly revised 4,800 year-end target, now seems like a good time to run through the worry list and see which if any could prove fatal. And more importantly, to check for potential milestones on the horizon that could lift us out of our constructive stance toward greater caution—or maybe even full retreat.
- Worry 1: Delta+ For nearly two years now, the Covid-19 virus has been full-out at the head of the worry list, and rightfully so. Even at this stage, where the world economy has proven its resiliency to carry on through Covid and its second, third and fourth waves, its ability to upend the market, or at least the more cyclical end of the market where we continue to recommend overweights, remains ever present. The newest one, even as the delta outbreak fades, is called “Delta +.” So, we continue to monitor the virus numbers, and equally the reaction to them. Our observation is that each renewed outbreak or variant is both less deadly and importantly less disruptive to the economy’s growth, and we expect this trend to continue. A combination of rising herd immunities through both vaccinations and infections, improved diagnoses and treatment options, and growing public confidence in those options, will in our mind prove a steady favorable breeze at our backs as we move through the remainder of this year and all of next. For markets, from “worrisome” to “less worrisome” is a positive.
- Worry 2: Peak Everything A bear friend of mine, who is often quite convincing, recently hit me with this objection to stocks. “We’re at peak everything. Peak economic growth. Peak earnings growth. Peak Fed accommodation. And peak valuations!” All of this is technically true, though in our view, based on the wrong framework. The “peak everything” argument rests on a very traditional framework for understanding growth and even Fed policy. In this traditionally built narrative, we recently had a recession and now are entering the peak of the economic cycle as growth slows. Our framework, as our regular readers know, is different. We saw the dramatic drops in activity in 2020’s second quarter and the equally dramatic rebound that began in the subsequent third quarter as not a normal cycle at all, but rather an artificially induced stop, then restart of the global economy. In this framework, we see growth in the economy and corporate earnings as part of a longer, steadier trend that is unlikely to have sharp peaks and valleys, at least over the intermediate term. For example, while GDP is likely to grow 5% against last year’s artificially depressed number, it will only translate to a more mundane 2.5% or so annual pace since the sharp deceleration we experienced in 2018. Likewise, though this year’s earnings forecast of $205 per share would represent a 20% growth rate off 2020, it only represents an 11% annualized expansion off 2018. So, we think focusing this time on the “slowdown” in the growth rates as a precursor to an overall cyclical downturn is quite wrong-footed. Rather, we are focusing on the continuing strong growth and earnings ahead, which even as we speak, continue to be shifted higher for next year as we move through the present earnings season. Though not this year’s hyperbolic advance, the latest upwardly revised estimate for next year is now $223 (ours is $230), a still healthy 9-12% move off this year’s “peak earnings.”
- Worry 3: Stagflation Stagflation, an economic condition that includes both inflation and recession, is the latest market bugaboo. The inflation part of this we get and are completely on board with; the recession part we’re not. Regarding inflation, our view continues to be that supply problems will continue to impact much of the economy through 2022. Carbon energy and commodities, underinvested in for nearly a decade, will remain in short supply well into next year. Supply chains will continue to struggle as port capacity and throughput issues will take months, not days, to fix. And labor shortages across much of the economy will continue to bite. All of this is likely to result in rising prices for both commodities and for labor, making inflation far less “transitory” than the Fed has advertised. A recession, however, seems hardly in the cards. Of course, in a more traditional cycle, as the economy comes off the floor, both corporations and households remain fragile, burdened by highly levered balance sheets that take years to repair. However, in this cycle, balance sheets across the economy actually are in terrific shape, with still unheard-of levels of cash balances everywhere. With the Fed determined to keep rates low until every last worker either gets hired or finally admits they’re not really unemployed because they’re not actually seeking work, conditions should continue to remain pretty buoyant, particularly as corporations reinvest their record earnings and consumers spend their wage gains and pent-up savings. So, a recession alongside the present inflationary environment seems for now, at least, one of those worries that will fade over the months ahead as continued solid economic growth numbers are registered.
- Worry 4: Taxes Higher taxes and the impact on spending and corporate profits have been on the worry list all year, though we’ve continuously advised holding this worry off till it begins to actually sing. For one, we’ve thought the impact on earnings off the rebound from Covid would swamp any impact we could imagine from tax hikes. And two, we’ve been skeptical on just how much of a tax hike the sharply divided Congress could actually agree on. Both moderating forces on the tax worry remain very much in place, and all indications at present from D.C. are that the final deal will be significantly watered down and less worrisome than the original plan. Our guess when all is said and done, we might have to cut our earnings numbers for next year by $5 to $10—a negative but not fatal. Our bigger worry, frankly, is that President Biden’s broader reversal of President Trump’s supply-side reforms could result in secularly lower growth in 2023 and beyond; at some point, we’ll need to factor this in but right now, we see it as unlikely to impact stocks significantly.
- Worry 5: Policy Error This worry we think is the most legitimate one out there, and readers of this space know that Federated Hermes in general is concerned that the Fed is committing a major policy error. In our view, its monetary policy is far too stimulative at present, ginning up demand against an economy that is booming and where labor is tighter than the Fed thinks. The risk we worry most about, frankly, is that at some point next year, with growth and inflation still roaring ahead, and average American citizens increasingly upset about high prices, the Fed could panic, and begin trying to play catch-up ball. If policymakers panic too much, they could induce the very recession that the “peak everything” people have been forecasting to be around the corner anyway. Because of this risk, we are monitoring very closely all the indicators we believe are on the Fed’s own dashboard to prepare our portfolios for a more aggressive shift in policy beyond November’s likely tapering start. For now, however, our read is that the Fed’s very strong predilection is to not panic at all, to err on the side of stimulating, and to move slowly and in well-flagged shifts. This makes us reluctant, frankly, to worry excessively right now about a sharp policy tightening that may never come.
When we add all this up, we think the outlook for stocks remains quite constructive, and have kept in place our recently upwardly revised S&P price targets of 4,800 and 5,300 for this year and next. And given our ongoing worries that inflation will be stronger for longer than most think it will, we are keeping our portfolios tilted toward more cyclical names with the pricing power to hang onto much of the revenue gains they are and will be seeing from nominal GDP growth in the high single digits. More broadly, we have focused all our active portfolios toward companies with pricing power built into their economic models, which by the way includes many of the names we own in our more growth-oriented portfolios. The reason we are only neutral weighted in growth stocks is that in the environment ahead, we see further rises in bond yields as inevitable. So, though the long-duration growth names should do fine fundamentally, rising discount rates in the form of the 10-year Treasury yield could continue to pressure their valuations. This could cause them to lag the market, but hardly to crash it.
So, plenty to worry about out there. Good news for the bull.