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Good morning. About 15 years ago, when I was a buy-side stock analyst, a colleague and I had a meeting with the chief financial officer of a Las Vegas-based hotel and gaming company. The roar of a financial crisis was only audible. The first thing the CFO said after we made our launches and sat down was, “Look, we’re not going bankrupt or anything.” I looked at my colleague while we were both thinking: they’re going bankrupt. They did not in the end, but as I recall we did very well with our short position.
That moment came to my mind on Friday, when I received an email explosion from the CIO of a broker, with the caption: “The stock market is not collapsing.” It inevitably made me think that the stock market is in fact collapsing – a thought I have not cherished so far.
I have since recovered from that apocalyptic state of mind and slipped back into my standard attitude of confused ambivalence. But if there has been the occasional smell of fear in recent months, we now have a noseful of the stuff. Terrible moments do not lend themselves to definitive analysis, but we give it a first shot below.
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How scary is that?
Risk assets have been hammering since November, with more volatile, high beta, speculative things taking the worst of it. Because the parts of the markets that have been hit the hardest are also of the highest profile – Cathie Wood’s ARK Innovation ETF, meme stocks, crypto, etc. – it can make the situation feel worse than it is:
On a longer horizon, while stocks are clearly going through an ugly patch, they have been sitting on huge gains since the pandemic began:
The decline so far in January is not a big standout, historically (we looked back at 1973):
The policy, economic and valuation backgrounds are admittedly not particularly reassuring. We are heading for a rate hike cycle and the contraction of the Fed’s balance sheet. The fiscal stimulus of the past few years is disappearing in the rearview mirror. While high inflation is currently accompanied by high growth, the inflationary aspect has control over consumer sentiment, which remains weak. Asset valuations are very high, which means long-term returns are likely to be low over the long term.
There’s clearly making a bear case here, and Bank of America strategists Michael Hartnett and Savita Subramanian are doing it right, in twin notes.
Hartnett sees a one-two-stroke coming for stocks. With the Fed stepping into a richly valued market, a “rate shock” will strike first, followed by a “recession panic” as growth expectations slow. He thinks the slowdown has already begun, pointing to this chart of S&P 500 yields that follows the New York Fed’s survey of manufacturing conditions:
Why a series of two shocks rather than one big push? In Hartnett’s words,
We believe that “rate shock” is just beginning and rate expectations are too low. . . Stock, credit and housing markets are conditioned for indefinite continuation of “Lowest rates in 5000 years” may only take a few interest rate hikes to cause an “event”.
Wall Street leads Main Street, hence our view that “rate shock” causes “recession fear”.
Subramanian argues that with the withdrawal of Fed support, consumers and firms do not have the cash to continue buying stocks at current valuations:
Sound balance sheets are unequivocally positive aspects for consumption, business investment and therefore for the economy. But can consumers and companies act as white knights and support asset prices through continued stock investments and buybacks? We are skeptical. Cash relative to S&P 500 market capitalization is near record lows.
With [Fed] balance sheet reduction of more than $ 600 billion in 2022 (home view), businesses are more likely to see the negative impact through a rising cost of capital and asset deflation than the consumer will see.
Her key card:
Hartnett and Subramanian are calling for a year of decline in equities, not a collapse. Yet we read less in the recent swing in economic data, and in the Fed’s positioning and intentions, than they do. Yes, there was a spate of poor growth data: not just the Empire State Recording, but increase in unemployed claims, and a weak December retail sales report. The resurgence in energy prices makes it all look worse. The Atlanta Fed’s Q4 GDP estimate tells the story – growth forecasts have come in sharp over the past month:
A combination of an inflation-driven tightening cycle and a growth retardation is indeed less than appetizing. But note two things.
First, we are still looking at fairly strong real GDP growth. We are still solid in growth inflation rather than stagflation area. Second, while growth has been slow lately, until we know how much of the slowdown is due to Omicron, it’s probably best not to overreact. The big demand for this year remains the same as it was a month ago: Omicron relaxes its grip on the world economy, moves demand away from goods and back to services, cools inflation a bit, leaving the Fed on a stately edge as a panicked pace? The answer may still be yes.
The best argument against a stock crash also remains the same. It is that bond yields are still far enough below earnings yields that a major stock rush seems unlikely. Oliver Allen of Capital Economics provides this graph of the difference between the S&P 500 earnings returns (i.e. the earnings / price ratio) and 10-year Treasury returns, which shows this benchmark is still far from the danger zone:
It’s a scary moment. Market corrections and shifts in policy regimes are frightening. But it also does not look like the edge of an abyss. (Armstrong and Wu)
A good read
This weekend, Unhedged set aside half an hour to read Dan Wang’s masterful 2021 annual review letter of Shanghai. It’s long, so if you’re just reading one section, let it be “A Summer Storm,” where Wang reflects on last summer’s restraint and what it says about the Chinese approach to dynamics.