Will QE2 Impact Equity Market Fundamentals: Consensus And Fringe Views
In his weekly "kickstart" piece, Goldman's David Kostin shares a glimpse of how portfolio strategists view the impact of QE2 on UW equity market fundamentals. In a nutshell, per Goldman bulls cite 20% upside to Fed model and a lower equity risk premium. Goldman is far less optimistic: "We believe QE2 is unlikely to change our sales or margin forecasts, so return prospects become a valuation debate. Our targets imply less upside, given 13.5x P/E is consistent with prior 1-2% real rate regimes." Furthermore, Goldman's economic team has already priced in $1 trillion of QE2 in its 2011 GDP forecast of 1.8% (below consensus of 2.5%), meaning at worst the overall economy will continue to operate at negative growth rates, once Q3 GDP is revised lower and Q4 GDP found to be negative following the inventory crunch. As Kostin puts it: "The US has a demand, not a supply, problem." Alas, the Fed is completely unable to grasp this. And the more it tinkers with the market, and the more fundamentals are disconnected from reality, the less Americans will trust the economic situation and retrench even more, leading to an even more pronounced demand "problem." As for markets, AJ Cohen's successor hits it right on the head: "We believe the forward path of stocks will be determined by potential asset allocation shifts by owners of 70% of the US equity market. Individuals own in aggregate 53% and pension funds own 17%. Shares will trade sustainably higher if these investor groups decide to re-risk from bonds to stocks. Any shifts most likely will be gradual." In other words, unless investors regain their faith and confidence in stocks, the market will merely trade on Fed liquidity and not on anything resembling fundamentals... or reality.
More insights from Kostin:
The consensus view is the Fed will announce next Wednesday, Nov 3rd that it intends to start buying US Treasury securities. Clients have coalesced around the belief the initial announcement will be $500 billion in size, with an indication of willingness to purchase up to $1 trillion. Another possibility is the Fed might announce an initial purchase of $100 billion of securities and a commitment to buy a similar amount per month for an extended, but undefined, time period.
The bullish argument for equities goes as follows: (1) The Fed buys longdated Treasuries to reduce term premium and lower interest rates across the maturity spectrum; (2) The low yields penalize individuals and corporations who hold cash; (3) individuals and institutional investors re-allocate their savings into higher risk instruments such as equities, high yield bonds, emerging market debt and equity, and commodities; (4) firms pursue new capital spending initiatives and boost employment; (5) asset price inflation has a wealth effect and spurs retail spending; (6) a consequence of lower US interest rates is a weaker US Dollar which benefits US exporters and also stimulates some incremental domestic job growth.
Our year-end 2010 price target for the S&P 500 remains 1200 or 1% above the current level of 1183. We expect the S&P 500 will trade sideways during 1Q before rising during the subsequent six months. Our 12-month forecast of 1275 reflects a price return of 8% and a total return including dividends of 10%. For details, see our report US Equity Views: Updating our price targets as investors focus on 2011 (October 15, 2010).
We expect the level of the S&P 500 will track the path of EPS growth. We forecast 10% EPS growth between 2010 and 2011. Bottom-up consensus EPS growth equals 14%. Our DDM-based 12-month price target of 1275 implicitly assumes the current NTM P/E multiple remains unchanged at 13.5X. Note that the current multiple equals the average P/E multiple of the S&P 500 during prior periods when real interest rates ranged between 1% and 2% which matches our forecast interest rate environment for 2011.
Three topics drive our view of the trajectory of the US equity market. (1) Sales; (2) profit margins; and (3) money flow. Below we briefly outline how each of these items will be affected by the pending QE2.
1. QE2 is unlikely to change our sales forecasts. Goldman Sachs Economics 2011 US GDP growth forecast already incorporates at least $1 trillion of Treasury purchases by the Fed. Despite the hefty forecast of Fed purchases, our 1.8% GDP growth forecast remains below the consensus expectation of 2.5%. The buy-side seems to be in the 2.0%-2 ¼% range. Our current index and sector-level sales forecasts incorporate our GDP growth assumptions and therefore already capture QE2. Capacity utilization hovers at 74%, up from the March 2009 low of 68% but below the 81% long-term average, so firms are not compelled to fast-track new projects despite the availability of cheap financing. The US has a demand, not a supply, problem. The US Dollar has weakened in the 12 weeks since QE2 entered public debate and it will benefit revenues of US companies, although by less than many investors believe. S&P 500 generates just 30% of sales outside the US.
2. QE2 is unlikely to change our margin forecasts. Our index and sector level net margin estimates incorporate our US and world GDP, interest rate, inflation, oil and US Dollar forecasts and the firm’s macroeconomic view assumes $1 trillion of QE2. If the Fed successfully spurs higher inflation than we currently assume (1.1% in 2011), it will have a negative impact on profit margins because rising input costs will not be fully-passed through to the consumer. Passing inflation along to the end customer will be particularly difficult in an environment with nearly 10% unemployment. Our 8.4% net margin forecast stands below bottom-up consensus of 9.0%. The Fed’s desire to re-inflate the economy tilts margin risk lower rather than higher. Firms reporting negative margin surprises in 3Q span the value chain from raw (X, AKS, NUE, MEE) to intermediate (GENZ, LLTC, BMS) to end-demand (AN, AVP, KMB, SLB, EFX, AVY, T) to cite just a few examples.
3. Therefore, QE2’s potential impact on the US equity market reduces to a debate over valuation. Bulls argue stocks are dramatically undervalued relative to bonds. It is true that using Treasuries, BBB corporate bonds, or TIPs in the Fed model leads to a conclusion the S&P 500 is 20% undervalued. Bulls similarly argue that QE2 will drive both yields and risk lower, reduce the cost of equity, and support a DDM valuation above our 12-month target. Bulls implicitly argue stocks should trade at a higher P/E multiple. Our more modest return projection incorporates a current starting point valuation that shows stocks trade at a 13.5x NTM P/E multiple consistent with past real interest rate regimes of 1-2%. However, the current P/E multiple is calculated when margins stand at all-time highs. A P/E assuming normalized margins would be 14.6x closer to the long-term average. We believe the forward path of stocks will be determined by potential asset allocation shifts by owners of 70% of the US equity market. Individuals own in aggregate 53% and pension funds own 17%. Shares will trade sustainably higher if these investor groups decide to re-risk from bonds to stocks. Any shifts most likely will be gradual.
And here are the key charts from Kostin:
A look at sales, earnings, and most importantly, margins:
And Correlation and Risk: