Stock markets have started the week in green colors, although the decline of the last month has eaten up half of this year's juicy rally.
In this post, we discuss how liquidity is improving globally. However, I’m bringing a new perspective to this familiar topic. Then we will look at the latest inflation data, which throws more ice on the disinflation camp. Finally, we will take a look at the valuation of the S&P 500, and how it’s hard to get a flattering picture of the index.
Liquidity is improving globally
I read a good article in the Financial Times about the development of global central bank liquidity, and I would like to share a few thoughts with you. By the way, if you get bored with the constant talk of liquidity, please let me know. I think it's worth talking about the forces that drive the market.
Investors' attention is often focused on the US Federal Reserve, which is the most important financial institution in the world, but by no means the only one. Although officially the Fed is shrinking its balance sheet by almost $100 billion a month in the name of the QT program, in practice the market-relevant net liquidity has been stagnating since last summer, as my active readers know.
The Fed is not the only one. This graph shows the development of the balance sheets of the four major central banks, the Fed, the ECB, the People's Bank of China, and the Bank of Japan. As you know, China's central bank is nursing its festering financial system. On top of that, the Bank of Japan's balance sheet has started to swell for a change as it continues its yield curve control. In effect, it tries to lock the interest rates on bonds in the market at a certain desired level, and if interest rates threaten to rise, it buys as many bonds as it can until the interest rate goes back down. Long-term interest rates are currently pegged at 0.5%. (It remains to be seen when similar policies will become commonplace here in the West.)
This shows the combined balance sheets of the four biggest central banks in US dollars. Citi estimates that a one trillion increase in central bank liquidity will lift key equity indices, such as the S&P 500, by 10%. Coincidentally, that's about how much it has risen since last fall.
The key question for investors is how the different central banks will operate in the future. I have previously brought up the arguments of Michael Howell, who keep a close eye on liquidity. He argues that the liquidity cycle has already turned for the better. This would mean that it is OK to sit in equities even in an uncertain environment.
On the other hand, a Citi strategist points out that Japan may give up interest rate controls when the central bank governor takes over in the spring, but nobody really knows. China's central bank is probably being careful not to inadvertently fuel another property bubble, but Xi Jingping is increasing his influence in China's financial system and dictators are usually quite generous injectors of money for their own needs. If most central banks really do take a tight stance, there will be buying opportunities for those with cash in risky asset classes later on. Let’s keep on following the situation.
Inflation is not abating
Inflation has been a recurring theme in What’s Up with Stonks. Sometimes accelerating, sometimes cooling, but always uncomfortably high. I will try to keep this inflation section short, but inflation drives interest rates and interest rates in turn drive equity valuations, which makes the topic relevant for now.
Inflation data from the US on Friday showed continued upward pressure on prices, rather than disinflation. The consumption-derived inflation gauge PCE, which is favored by the Fed, showed core inflation accelerating to 4.7% year-on-year. Despite weaker household incomes, there is no stopping the generous American consumer in restaurants and shops.
Unlike the CPI, where shelter is known to account for a third of the weight, in the PCE its only half of that. Thus, the high figure cannot be explained away by shelter inflation, which is slow to update due to its methodology. On Bloomberg, several market commentators threw in the towel on disinflation.
After such a dumpster data release, market expectations about the future level of the policy rate bounced in the usual way. The policy rate is now expected to peak at 5.4% and remain above 5% at least until early next year.
Similarly, market interest rates are hitting post-pandemic highs. The US 2-year bond rate is approaching 5%. The 10-year bond, which acts as a gravitational force for risky investments such as stocks, is hovering at almost 4%.
Rising interest rates are awkward for equities. As a small relief, on the other side, the economy shows no signs of slowing down. In the real economy, you grind out the cash flows whose present value should be reflected in stock prices. With recent data, the Atlanta Fed's GDP Now gauge shows economic growth of almost 3% in the first quarter.
As I have often underlined, a strong economy and strong inflation cast a shadow over equities.
This graph shows weekly claims for unemployment benefits. So far, there is no sign of an economic slowdown in this area. Although, by the time this goes up, the stock market is already buzzing. The labor market is tight, feeding sustainable inflation. Over time, it will be interesting to see how structural this change in the labor market is. If, as some expect, the labor shortage is a decades-long phenomenon, you can forget about low interest rates for a while. This would of course be good news for young people entering the workforce, but not so much for capital.
The S&P500 valuation is not attractive
For equities, the questions include how high interest rates need to go to break employment and cool inflation. And, since raising them this high is not yet working, will the increases eventually go too far and the economy plunge into a deep recession, destroying results in the process?
Even the current pricing of equities is difficult to justify unless earnings increase, and interest rates fall at the same time. If this Goldilocks scenario materializes things will be fine but it doesn't look so likely now.
This is a gross simplification, but let's assume that the S&P 500's earnings grow by 4.5% per annum in nominal terms from now until forever and that its return on equity remains at the excellent 18% level where it has been averaging lately.
Let’s assume a WACC of 9%, where the long-term risk-free rate is 4%. The risk-free rate should reflect long-term real economic growth and inflation. For example, 2% real economic growth and 2% inflation doesn’t seem an impossible combination in the big picture. On top of that, there is a historical 5% risk premium. You can argue about the risk premium, because in uncertain times it tends to widen, but let's go with that for now.
This would give the index a current value of 3,700 points, 8% below the current figure. NB: in general, the long-term earnings growth expectation for an individual company should be below the risk-free rate, because an individual company can hardly grow indefinitely with the economy and inflation, keeping competitors on the other side of the fence. However, at the index level, I believe earnings have grown slightly faster than the risk-free rate.
If, on the other hand, the historically strong profitability of companies doesn’t hold up (which is very possible) or the risk-free rate rises even further in the long run, it’s difficult to see even the 3,700 level as attractive.
Of course, that formula is clumsy in that it assumes the same things will go on forever, but as such it works satisfactorily as a support for fluffy ballpark scenarios.
I compared this reading with various scenarios published by DCF wizard Damodaran in January, where I modified the current consensus forecasts, and the most optimistic reading was 4,100 points for the index. Here’s a link to the blog post, if you want to download the excel files yourself and play with your own assumptions for the index.
Thank you for reading the post! Read analysis and make good stock picks!