Secular bull outlook improves as the Fed begins to think again
As the central bank awakens to inflation risks, our policy-error fear fades.
Having spent the weekend digesting last week’s Fed meeting, the market appears to have come around to our view: that the vision laid out by policymakers was long-term bullish, not bearish for stocks.
All along, our primary longer-term concern has been the potential for policy error—that the Fed would keep its collective head in the sand and keep holding policy rates artificially low despite the obvious commodity and wage inflation that is upon us. This almost certainly would promote a major bubble in risk assets that, while potentially profitable near-term for investors, wouldn’t end well. History is rife with the economic detritus of past bubble cycles caused by central bank policy mistakes (think U.S. 1973, Japan 1990, Thailand 1997 and U.S. 2007).
But the message we got last Wednesday—and in subsequent comments since—is that while the Fed is focused for sure on getting the economy back to full employment across all sectors, policymakers also realize that inflation is heating up and will continue to do so, absent any action by them to slow it down. Said differently, last week’s announcement was akin to saying the Fed is thinking about thinking about raising rates.
We think a Fed that is awake and willing to let yields start drifting higher to calm inflationary ripples is the best path to maintaining a solid growth trajectory for an economy that’s currently roaring. If they make this transition smoothly, the 10-year Treasury yield should top out around 2.5-3.0%. This would be very bullish for equities and the economy—and, by the way, the likely best scenario for policymakers to meet their long-term employment goals, as well.
Cyclical value trade remains favored
Such an outcome should, over the next few years, keep the economy going strong (albeit not at this year’s spectacular pace) and earnings accelerating. We in fact have raised our 2023 S&P 500 earnings-per-share forecast to $250, and see the current reflationary trade favoring cyclical value stocks, particularly energy, materials and financial names that also happen to be the cheapest stocks in the market even after their uptrend since last September. We think their recent correction, which ranged from 8% to 20%, is over and are maintaining our tilt toward cyclical value sectors in our model portfolios.
Growth stocks, as last week unfortunately demonstrated, remain closely tied to the direction of the 10-year bond rate. So, absent an even lower discount rate that we don’t see as likely now that the Fed has awakened to inflation, their valuations are very high amid difficult year-over-year earnings comparisons with 2020. We would suggest fading this recent growth rally and waiting until 2022, when forward earnings into 2023 should begin to reaccelerate and Treasury yields should peak for this cycle, to add back to positions.
To be clear, growth should have its day again if the Fed, as we think it will, remembers that longer-term “price stability” is every bit as important to its dual mandate as “maximum employment,’’ however it wishes to define the latter. If the Fed follows this course, this secular bull should have many good years left, meaning sooner or later, we may have to raise our longstanding 5,000 target on the S&P 500.
Of course, actions speak louder than words, so we’ll need to remain vigilant to see if the renewed focus on inflationary pressures begins soon to lead to tapering and then actual rate hikes; we expect the former to come sometime in late August after the Jackson Hole conference, and the latter in the first half of 2022. Digesting this transition could continue to cause some choppiness in markets near term, but it's just what the doctor ordered for the recently weakening long-term secular bull.