In recent years analysts often point to narrowing market breadth, as a small number of mega-cap stocks (Apple, Tesla, etc.) account for most of the benchmark gains. Gavekal’s Tan Kai Xian recently explained how this happens. It is actually part of the business cycle. The US economy looks to be deep into its business cycle, which typically sees market leadership narrow to mega-cap stocks (see the chart below). This is because when the economy runs above potential, higher wage pressure dents profit margins. At such moments, firms operating on thin margins are hurt most, and may turn loss-making. In contrast, fatter-margin firms can keep growing. This trend results in a narrowing rally, causing the market cap-weighted index to outperform
Now a slight quibble: It’s not just profit margins that matter. Amazon isn’t terribly profitable for its size, but can still afford to pay the premium wages now needed to dominate the e-commerce business. This makes its shares more compelling to investors. So looser hiring conditions, whenever they happen, should help competitors catch up and broaden market leadership.
Falling Life Expectancy
American lives are getting shorter. The CDC’s final 2020 report shows life expectancy at birth fell 1.8 years to 77 years. This was the largest drop since 1943, when World War II combat deaths generated a 2.9-year life expectancy decline. This table shows the increased mortality broken down by age group. The horizontal axis is a log scale, which means the absolute size of the difference in each pair of bars indicates the percentage size of the change
Mortality increased at similar rates for every group above age 14. The reasons varied, though. COVID contributed to many older Americans’ deaths in 2020, while drug overdoses and accidents increased in younger generations. We know all those continued in 2021, so we will likely see a similar life expectancy decline when that data is analyzed. This is sad in many ways. Economically speaking, lost years of life mean lost years of consumption and production. Sustained recovery will be hard until this trend changes.
Three Opinions of 2022
“Our positive base case and the prospect of real yields remaining in negative territory leave us particularly bullish on equity markets, especially in the first half. We expect to see some compression of price/earnings ratio multiples for the S&P 500 as rates rise. However, strong earnings growth could still translate into about a 10% total return, in our view.” – BNP Paribas
“While we acknowledge that absolute equity valuations are elevated, this is true for all major asset classes relative to history. We expect global earnings to grow 8% in 2022; this should support a reasonably strong year for equity markets overall and our targets in each region imply about an 11% total return in global equities.” – Goldman Sachs
“The core of our cautious 2022 view on the S&P 500 is our belief that during a mid-cycle transition, price-earnings ratios typically compress. The median S&P 500 stock has corrected 15% from its 52-week high. However, the index is down only 3.5%. What’s keeping the index aloft is that the 15 largest companies now account for 40% of the index’s market capitalization. Consider rebalancing portfolios: U.S. equities versus non-U.S.; growth versus value; cyclicals versus defensives; mega-cap versus small- and mid-cap stocks; and active versus passive management.” – Morgan Stanley
US Economy
- The trade deficit in goods hit a new record in November as imports surged. This is why supply chain bottlenecks have been so extreme.
- The surge in demand for imports has been driven by the US consumer. Retailers boosted inventories by most in decades to get ready for holiday shopping.
- The Chicago PMI ticked higher. This index is sensitive to Boeing’s production, which sent the index lower in November.
- The Dallas Fed manufacturing index was softer than expected.
- Texas-area factory hiring remains robust.
- But the region’s manufacturers are less upbeat about the future, with the expected shipments index declining sharply.
- Price pressures remain extreme but appear to be peaking.
- Home price appreciation slowed further in October. However, we are likely to see faster price gains in November and December.
- Omicron, which is more contagious than the previous coronavirus strains, sent US cases to a new record (some 400,000 new confirmed cases per day).
- But hospitalizations remain well below previous peaks.
- The gap between residential and non-residential construction spending continues to widen.
- Manufacturers haven’t had this much pricing power since the mid-90s.
- The Markit Manufacturing PMI report showed some easing in supply bottlenecks in December
- But factory backlogs should keep production strong this year.
- Job openings ticked down, but demand for workers remains extraordinarily high.
- The ISM Manufacturing PMI declined in December.
- Price gains are slowing as well, which points to some moderation in inflation ahead.
- Factory hiring improved in December.
- The spread between indices of new orders and inventory points to moderation in manufacturing growth this year.
- US automobile sales remained depressed in December, as the semiconductor backlog continues to worsen.
- Mortgage rates climbed to the highest level since early 2020 at 3.4%
- Home price appreciation is expected to slow sharply this year, according to CoreLogic,
- Single-family housing rents continue to surge.
- While service-sector growth slowed somewhat, a good portion of the decline came from moderating supplier delivery delays
- However, inventories remain extraordinarily tight.
- Worker shortages are expected to persist for years to come.
The Fed
This was the worst equity market reaction to FOMC minutes on record.
The FOMC minutes revealed an even more hawkish Federal Reserve than the markets were expecting.
- Inflation concerns:
Participants remarked that inflation readings had been higher and were more persistent and widespread than previously anticipated. Some participants noted that trimmed mean measures of inflation had reached decade-high levels and that the percentage of product categories with substantial price increases continued to climb.
- Faster rate hikes:
Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.
- Balance sheet runoff (not just stopping securities purchases but allowing the central bank’s balance sheet to shrink):
Participants had an initial discussion about the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate from the ELB. They also discussed how this relative timing might differ from the previous experience, in which balance sheet runoff commenced almost two years after policy rate liftoff when the normalization of the federal funds rate was judged to be well under way. Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.
- Starting balance sheet runoff sooner:
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.
- And moving faster:
Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. Many participants also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable, particularly given the shorter weighted average maturity of the Federal Reserve’s Treasury security holdings.
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- Bonds around the world sold off in response to the hawkish FOMC minutes.
The probability of liftoff in March breached 75%.
And the odds of a 100 bps rate increase over the course of this year is now above 80%.
Shares sold off sharply, especially companies trading with high multiples (or what some refer to as high-duration stocks).
Speculative assets were hit particularly hard.
– ARK Innovation ETF:
Bitcoin:
Next, we have some updates on the housing market.
- Mortgage-backed bonds were under pressure amid talk of faster Fed balance sheet runoff.
As a result, we should see higher mortgage rates. Housing stocks underperformed on Wednesday.
The FOMC latest minutes indicate the QE purchases will end in March and a rate hike could come that same month. They also dropped a hint about actually reducing the balance sheet. I applaud their desire to move faster but color me skeptical on the last part. The only reason to reduce the balance sheet, which unless done in real size is meaningless, would be to give them cover for not raising rates, which would be a serious mistake. If the US economy can’t handle 0.75% interest rates, we are in deep kimchee.
As of now, the Fed is simply becoming a little less loose. They are still expanding the balance sheet. Real interest rates are still negative, and will remain so unless the Fed hikes far more than anyone expects, or inflation drops faster than anyone expects.
But let’s come back to the main thrust. First, we must realize quantitative easing was intentionally designed to push up stock prices. It was not a surprise to policymakers.
Market Data
- The market is now fully pricing in three rate hikes this year.
- The S&P 500 held support at the 50-day moving average.
- The Nasdaq 100 is also at support.
- Despite the Nasdaq Composite hovering relatively close to its recent peak, nearly 40% of stocks on that exchange have been cut in half. Nearly two-thirds of them are in bear markets. This kind of behavior hasn’t been seen since at least 1999. That is called poor breadth. For example, during the last six months, Zoom, Lemonade, Beyond Meat, AMC, and Peloton have dropped over 50%.
Thought of the Week
“The present is the present”
Picture of the Week
All content is the opinion of Brian J. Decker
