'Ben'-edictions On The Economic And Profit Cycle
Via JPMorgan's Michael Cembalest,
1:1 In the beginning, Ben Bernanke hath said, let there be liquidity.
1:2 And so didst the Federal Reserve reduce the cost of money to zero, and increase its balance sheet four-fold, buying one third of the US Treasury market.
1:3 And for one thousand days and seven hundred, so didst the Federal Reserve keep short term interest rates at zero, depriving the moneylenders of their profit.
1:4 The cheapness of money made all the stocks in the land, whether beast or fowl, look attractive to the people. And so didst the equity markets rise by 100% since December 2008, bringing joy to all investors who hath owned them.
1:5 And when the people studied prior recessions and recoveries, they discovered that the stock market’s current rise could not be fully explained by improvements in corporate profits, manufacturing surveys, interest rates and inflation, as in the past. They believed that a higher power hath watched over them.
1:6 And so each among them sayeth the following benediction: “May the Fed bless you and keep you; may the Fed extend its balance sheet to shine upon you; and may the Fed lift up asset prices and protect you from harm”.
Predicting equity market rallies during a recovery
Rising equity markets are usually a consequence of improved profit and economic conditions. We estimate the market’s rise based on improving profits, GDP growth and manufacturing surveys, and changes in the yield curve, inflation and the dollar.
As shown, the model does a good job estimating prior postrecession stock market rallies, but this time, there’s a large gap that our selection of market and economic variables cannot explain. The Fed’s Quantitative Easing program, which represses the value of cash and other low-risk forms of savings, is a likely explanatory factor. The unusual outperformance of defensive, higher-dividend stocks vs. the market since December 2008 is one example of QE’s impact on equity markets.
2:1 And it came to pass, that the stock market rally outpaced the growth in corporate profits. Profits growth in H1 2013 was only 4.5% in 2013 compared to H1 20121, and close to 0% ex-financials. And so for four hundred days, P/E multiples rose.
2:2 When the shepherds hath separated the wheat from the chaff, they found that after stripping out stock repurchases and loan loss reserves released by financial institutions, there was only 0.8% profits growth left to feed the hungry shareholders.
2:4 The elders asked to see some history on stock market valuations, to see if the people had lost their way.
2:5 And so the scribes showed the trailing price to earnings ratio of the S&P 500 since the year one thousand nine hundred and twenty six, and found that while multiples had risen, they were roughly average on a long term basis.
2:6 Yet while P/Es are median and profit margins are high, profits growth hath risen on the back of the laborer, whose compensation as a share of revenues and GDP is at a post-war low. Top-line revenue growth during this cycle is weaker than
the prior five.
2:7 So the scribes surveyed the world to see what layeth on the horizon that could drive earnings higher. They found that the four pillars of the US economic temple were improving (housing, consumption, production and employment), as the US survived the de-leveraging of household balance sheets, higher income and payroll tax rates, rising oil prices and one of the largest budget deficit adjustments in the last 50 years.
2:8 And the scribes found that in the land of the Romans, the Iberians, the Saxons and the Franks (but not the Gauls), manufacturing conditions were finally improving,
... and that in the Eastern lands, conditions were stabilizing as well.
2:9 And they found that a measure of global manufacturing orders relative to inventories is rising, heralding a period of higher growth in industrial production.
2:10 Should these positive trends continue into 2014, ye may see revenue and profits growth rise from their current stagnation, justifying the faith of the believers.
3:1 And it came to pass that the Fed looked at prior cycles, and saw that conditions were still too weak to raise policy rates.
3:2 And so shall the Fed keep the cost of money low, probably below 1%, for another couple of years.
3:3 But what the Fed giveth, the Fed also taketh away. The Fed shall soon commence its tapering of fixed income securities purchases, which hath numbered in the tens of billions each month.
3:4 Thus will the people see what happens to an economy whose modest improvements have rested heavily on interest rate-sensitive sectors and the low cost of money.
3:5 The rise in the yield curve may result in bitter fruit for the Risk Parity investor, whose portfolio hath consumed many Treasury, Agency and credit positions financed with substantial leverage. If so, the Risk Parity investor may end up disrupting the bond markets in return, as he hath done in June of this year.
Will housing hold up in the face of higher interest rates?
Modestly higher interest rates and higher home prices have made housing slightly less affordable than at its peak last year, but affordability is still high. There has been a dip in pending home sales and new homes sales, while existing home sales, buyer traffic, building permits and buyer intentions are stable. Goldman Sachs estimates that ~60% of 2012-13 home sales were all-cash, compared to 20% pre-2008. Such buyers (often funds buying to rent) are presumably less sensitive to higher rates. We will know more in a few months, but our base case is that housing momentum in 2014 will slow vs. 2012-2013.
4:1 And the people asked, hath not prior periods of rising interest rates yielded bountiful returns for equity investors?
4:2 And the scribes said, yes: rising and steepening yield curves have usually been associated with improving economic conditions for households and for companies, and strongly positive returns on equities.
4:3 But the scribes cautioned, they had never seen the hand of the Federal Reserve laid so heavily before, and knew not the consequence of its withdrawal. Based on historical measures of where 10-year interest rates settle in a recovery relative to inflation, the 10-year Treasury could rise to 4% - 5%, compared to its current level of 2.8%.
4:4 And the people asked, why must the emerging economies suffer so from the exodus of Federal Reserve liquidity?
4:5 And the scribes answered, “because EM growth hath slowed sharply, which hath concerned foreign investors who did not expect this to be so”. The latest reading of EM household demand growth is now roughly the same as in the developed world.
4:6 And so net capital inflows into debtor nations such as Turkey, Indonesia, Brazil and India hath reportedly fallen to zero, causing painful interest rate hikes and currency declines. And so shall they suffer from the end of the “carry trade”.
5:1 Ye hath been told that this would be another year of feast for investors, and famine for laborers. From the introduction to the 2013 Eye on the Market Outlook: “In all, 2013 looks to be another year of markets outperforming what economic growth conditions alone would imply”. Rising multiples, rather than rising profits, is the reason why.
5:2 The people rejoiced in their 10% YTD returns on global equities and prepared to wander, waiting to see the contours of a world in which the Fed will have in part forsaken them. Yet the greatest monetary story ever told is coming not to an abrupt end but a gradual one. The Fed’s balance sheet started at $900 billion, is now at $3.6 trillion, and will peak at over $4 trillion and remain there as the Fed reinvests interest and maturing principal (even though new purchases will have ended).
5:3 Retain some risk in thy portfolios, but prepare for lower returns than those seen since the end of 2008.
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