Last week, gasps of shock were heard around Wall Street trading desks when Bank of America decided to outdo every other economist with its either idiotic or brilliant forecast for seven 25bp rate hikes this year. All else equal, we would say "idiotic" as 7 rates hikes would almost certainly send the market crashing as real yields explode, long before the 7th hike is implemented, and to our surprise, BofA does not completely disagree. Yet as the bank correctly notes, the Fed is caught in a trap, and while markets will certainly crack long before the tightening process is completed, the economy is in desperate need to cooling off after Biden's ridiculous trillions in stimmies have unleashed a historic inflationary tsunami.
Admitting the forecasts from her own bank's economists "may sound extreme"...
... BofA chief equity strategist Savita Subramanian - who maintains her 4,600 year-end S&P price target for reasons she explains below - writes that "the pivot from super dovish to more hawkish policy underscores that we are at the point of peak liquidity" as the Fed is now more focused on containing the inflationary conflagration that has been sparked by Biden's out of control spending.
What is remarkable, and summarizing the findings from Matt King's seminal note from last month, Savita notes that seven hikes doesn’t even get us to a “neutral” rate, "which is why a move to 1.75% on the Fed Funds rate this year is, in our economists’ view, entirely warranted." She is, of course, right when discussing the economy. The far bigger question is how many hikes can the market sustain without breaking. That is the $64 trillion question.
But beyond mere balance sheet reduction, Subramanian notes that other factors are more concerning: according to BofA, the key risk to stocks from a Fed hiking cycle remains that the Fed is embarking on a hiking cycle into an overvalued market, in fact as Michael Hartnett showed last Friday, the only time stocks were more overvalued entering a rate hike cycle was 1999.
As BofA reminds us - tongue in cheek - "this ended poorly last time (1999)."
Of course, it's not just risk that overly aggressive rate hikes send stocks tumbling: QT itself will have a far bigger impact on risk assets than mere rate hikes; as Savita explains, Fed Fund rates alone have no significant relationship to US equity returns (we disagree but here is her evidence)...
Despite our economists forecasting a faster pace of hiking than the market is pricing in (with their call for seven hikes this year and four next year), this would still be one of the slowest tightening cycles in history (implying a 1.5ppt annualized rise in the Fed Funds rate vs. a 2.1ppt average annualized rise in prior tightening cycles), with the total increase in the Fed Funds rate in-line with the average for prior tightening cycles.We find no consistent relationship between the pace of hiking and the absolute or relative performance of large and small caps (charts below)
... and "what matters more is quantitative tightening, its effect on 10-yr yields and, of course, earnings." But QT is likely to take center stage in 2022 given that as BofA shows below, Fed balance sheet increases have explained more of S&P 500 returns than earnings post-GFC.
So in light of all this why isn't Savita predicting a far lower year-end price target for the S&P? After all, her BofA colleague Michael Hartnett will not rest until the S&P tumbled well below 4,000 (which he believes is the strike price on the Fed put).
The reason, according to the BofA strategist, is that she views her 4,600 price target as conservative - at least in the context of far more bullish Wall Street peers - and notes that her liquidity framework "suggests muted returns from here – 4600 on the S&P 500 by year end, and just +1.5%/yr over the next three years based on YoY Fed balance sheet change and +2.8%/yr based on rate of change."
Additionally, she expects EPS growth to slow to 6.5% this year from 48% in 2021; as a reminder, Hartnett is far more bearish, and in his latest Flow Show noted that the probability of global EPS turning negative in H2 is 40% and rising.
Addressing this question directly, Savita writes that she maintains her "year-end target of 4600 based on our five-factor target outlook incorporating valuation, sentiment, fundamentals and technical factors, and we believe that risks to equities would be greater if the Fed did nothing."
Still, since her job in this particular case is to explain to the bank's client why 7 rate hikes does not translate to a market crash, one specific reason why the BofA strategist remains relatively bullish (if only because she was told to be), is that according to her, the public to private sector liquidity hand-off pushed combined consumer/corporate cash to >$19T+, which would shift from generating no return to a healthier ~2ppt returns. She explains:
Following a ~$11T increase in the Fed balance sheet and money supply (M2), the Fed and US government successfully injected much needed liquidity into the system and saved the world. Now, the consumer and corporates are sitting with a record $19T in cash, a 35% increase from 2019.
Naturally more cash is better than less cash, and as Savita extrapolates, "balance sheet strength is bullish for the real economy. The financial crisis taught corporates and consumers about the risks of leverage and the unsustainable leverage that we saw during the financial crisis is nonexistent today and bloated leverage ratios post-recessions are non-existent today." While we disagree here because the big variable is the trillions in excess reserves that have been injected into banks and thus any sharp decline in reserves will act to dramatically destabilize banks (as we saw in Sept 2019), BofA claims that banks, as a proxy, "are better capitalized than ever, and are expecting to see loan growth in 2022." Meanwhile, corporates locked in long-dated debt obligations at low fixed rates, with the mix of long-term fixed debt now 80% vs. 58% pre-GFC. The upshot from all this - and we agree with this - rising rates may not hurt for a while.
What will companies do with the excess cash? BofA expects more capex, R&D spend and dividend raises than buybacks, while consumers are likely to ramp up spending in services in 2022 given that durable goods spending accelerated post-COVID leaving more pent-up demand for services.
Clearly showing just how much she stretched the goalseek function in excel to come up with some more favorable "benefits" from higher rates, Savita goes so far as to praise the generous benefits that higher rates will confer on - wait for it - interest income!
A higher cash yield translates in additional interest income, and we estimate a 0.8% tailwind to S&P 500 EPS from a 90bp YoY increase in the Fed funds rate (house forecast for average 2022), all else equal. And we see a smaller headwind from higher interest expense, as 80% of corporate debt has long-term fixed rates today, compared to just over 50% prior to the GFC.
Right... just ignore interest expense.
There is one more argument brought up by Savita as to why higher rates will boost risk assets, and it has to do with the strong, significant relationship between S&P 500 Price to Earnings ratios and CPI, where higher inflation usually translates into lower multiples...
... which is hardly a surprise, but what is amazing is how the BofA chief equity strategist actually manages to spin this as a positive.
As she says, one reason is that S&P 500 earnings are positively correlated with CPI. But S&P 500 EPS are negatively correlated with wage inflation (Exhibit 7). Moreover, the bank's Corporate Misery Indicator, a macro model that has led the profits cycle, remained positive during the early and mid-stages of Fed tightening cycles indicating that the Fed’s attempt to control inflationary pressures was either (a) positive for margins, (b) not enough to derail demand, or (c) some combination of the two (Exhibit 8)
In other words, and this is some truly remarkable logical gymnastics, she concludes that "if the Fed is hiking rates to control inflation, that’s positive for equities" as runaway inflation would likely compress S&P 500 multiples and cut into earnings; and if inflation moderates significantly, the Fed has signaled it will adapt its policy on a real-time basis.
And that's how you just take your first step toward "validating" Erdoganomics, or in this case that rate hikes are actually positive for stocks.
Yet while we commiserate with Savita for having been told to somehow spin the bank's forecast of 7 rate hikes into a non-apocalyptic outcome, not even she can avoid the reality that what comes next will be painful, and while one can ignore rate hikes (we wouldn't), just focusing on the bank's "QT model" suggests far more muted returns from here, which according to Savita translates to 4600 on the S&P 500 by year end (a far more bearish Morgan Stanley is at 4,400 just so readers get a sense of what Wall Street's bears have to work with; the bulls are all 5,000 and higher), and low single digit returns over the next two years.
That said, even Savita admits that if inflation continues to surprise to the upside, "the strong negative relationship to PE multiples is worrisome. Moreover, EPS growth for the S&P 500 and most sectors has been inversely correlated with changes in wage inflation." Finally, the bank forecasts a demonstrable slowdown in EPS growth from 48% in 2021 to 6.5% in 2022, a number which Subramanian's colleague Michael Hartnett believes will turn negative in the second half.
And while other notable Wall Street voices, including Morgan Stanley’s Michael Wilson, (see "Wall Street's Most Bearish Analyst Warns Of "Calamitous" Collapse In First-Half Earnings") share BofA's modest pessimism, the assessment is by no means the consensus view. JPMorgan Chase & Co.’s team reiterated on Monday that growth will remain solid this year and with still more upside for equities, following the ferocious rally of 2021. Then again, since it is JPM's mandate to remain the fluffer of the Biden/Powell regime until the bitter end, we would urge all to discount what Jamie "Bitcoin is a worthless fraud" Dimon's bank has to say about the future.