Bullish Opinion

 

Goldman Sachs – S&P To Hit 5100

There is one thing about Goldman Sachs that is always consistent; they are “bullish.” Of course, given that the market is positive more often than negative, it “pays” to be bullish when your company sells products to hungry investors.

It is important to remember that Goldman Sachs was wrong when it was most important, particularly in 2000 and 2008.

However, in keeping with its traditional bullishness, Goldman’s chief equity strategist David Kostin forecasted the S&P 500 will climb by 9% to 5100 at year-end 2022. As he notes, such will be “reflecting a prospective total return of 10% including dividends.”

The assumptions for his market prediction are exceptionally bullish:

He starts by stating that while he expects the market S&P 500 index will climb by 9% to 5100, such will occur in the face of: “Decelerating economic growth, a tightening Fed, and rising real yields suggest investors should expect modestly below-average returns next year.”

Notably, he also estimates that despite a slowing economy, rising yields, and tightening monetary supply that: “Earnings growth, which accounted for the entire S&P 500 return in 2021, will continue to drive gains in 2022. S&P 500 EPS will grow by 8% in 2022 to $226 and by 4% in 2023 to $236. Aggregate sales for S&P 500 index will rise by 9% in 2022 and 5% in 2023.”

As noted, David Kostin is quite “bullish” heading into 2022.

 

Bearish Opinion

 

Morgan Stanley – S&P Closing Lower At 4400

There are two sides to every coin, even on Wall Street. In this case, the other side of Goldman’s bullish call is Morgan Stanley’s chief equity strategist Mike Wilson.

Mike Wilson’s market prediction for 2022 is for a more marked pickup in volatility.

“We think there are a number of reasons to suggest that global equities’ serene progress will become more volatile as earnings growth slows, bond yields rise, and corporates continue to juggle the challenges of disrupted supply chains and elevated input costs. We think these issues weigh most heavily on the US equity market.”

Here are his three main market predictions:

  1. Earnings Uncertainty: As opposed to Goldman Sachs, Wilson expects that much of the persistent price outperformance of the US versus world markets over the last decade was driven by superior and durable earnings trends. While they expect earnings growth in 2022, expectations weaken materially given cost pressures, supply issues, and tax/policy uncertainty.
  2. Premium Valuations: The S&P valuation multiples remain at a premium with current trailing P/E’s of 21 still close to a 20-year high. Consequently, US equities currently trade at a record valuation premium to global peers.
  3. Higher real bond yields: The record valuation premium also exists at a time when the US’s high exposure to growth stocks means its relative performance remains inversely correlated to real bond yields in recent years. Our bond strategists expect the latter to increase materially through 2022

While US equity underperformance has been rare post-GFC, the secular backdrop is likely shifting. Wilson suggests the decade of outperformance of US stocks may shift to underperformance versus global peers.

The question is, who will be correct?

Both Goldman and Morgan make some critical assumptions to justify their outlook for 2022. If those outcomes fail to come to fruition, so will their forecast.

While we don’t make market predictions, we analyze the “risk” of what could reverse the current bullish bias.

So, as we head into 2022, here is a shortlist of the things we are either currently hedging portfolios against or will potentially need to in the future.

  • Economic growth slows as year-over-year comparisons become far more challenging.
  • Inflationary pressures remain far more persistent than anticipated which impedes consumption and compresses profit margins.
  • Rising wage and input costs reduce corporate earnings disappointing earnings growth expectations.
  • Valuations begin to weigh on investor confidence.

 

What Caused Inflation?

 

The Fed’s decisions in 2008–2009 to drop short-term rates to near zero and then launch quantitative easing bond buying programs were unprecedented at the time. But they “worked” well enough to keep the wheels on. The economy survived. That being said, correlation is not causation. I maintained then and I believe now that the recovery was due to businesses, both small and large, adapting to the new climate. Federal Reserve policy was a distant second.

But the problem is, Fed officials thought their policies were responsible for the recovery.

But those 2008–2009 decisions also didn’t come from nowhere. In the early 1990s and again in the early 2000s, Alan Greenspan’s Fed had responded to recessions with sharp, aggressive rate cuts. Those “worked” too, and Greenspan even managed to tighten again afterward. Fed officials in 2008 no doubt looked back at those years and figured they could get away with it, too.

Previous Fed leaders raised rates because their rate cuts had the desired effect of spurring growth and sparking inflation fears. But post-2009 GDP growth, while positive, was nothing like previous recoveries. Inflation (at least as the Fed measures it) also failed to show up on schedule. Bernanke and then Yellen, looking at the playbook, thought as early as 2013 they were “supposed” to tighten policy, but the data at the time didn’t support it. Perhaps more important, Wall Street didn’t support it, either. Remember the multiple taper tantrums?

So the Fed waited and waited, finally taking a tentative first step in 2016 and then a series of rate hikes and asset purchase reductions in 2016–2019. It didn’t have the desired effect and seemed to cause other problems. So, in a move we now forget amid the other noise, the Fed began easing in late 2019—months before COVID was known.

Imagine, then, you are Jerome Powell in early 2020. You’re already struggling to deal with massive debt, bond market liquidity issues, and stagnant growth. Then you get hit with simultaneous global supply and demand shocks.

But that’s not all. To keep the wheels on, you need Wall Street banks to cooperate and help you finance the government’s large and growing debt. Otherwise, rates will spiral higher. Even worse will follow. In theory, you are their regulator, but it’s not entirely clear who has more power. The Fed can force money into the system. It can’t force banks to buy Treasury debt or lend to consumers and businesses.

One consequence of inflation is that it pushes “real” interest rates lower. Depending on your benchmark, short-term USD rates are now around -6%.

If the Fed follows recent practice and raises rates a quarter point at each meeting starting in mid-2022, it might add up to a 1.25% hike by the end of next year. If inflation does what I think it will do, that will still leave negative real interest rates of -3%, still extraordinarily accommodative. But would markets tolerate anything tougher? Probably not.

This is the corner the Fed is painted into. They would have to stop their asset purchases and raise the Fed Funds rate 300 basis points or more just to get real rates to 0%. Doing so would generate a taper tantrum on steroids. Does Jerome Powell have the stomach for it? Color me skeptical.

It would have real-world consequences. Most obviously, higher rates would raise borrowing costs for the biggest borrower of all, the US Treasury. The debt has reached a size at which even tiny rate increases add big bucks to the government’s bill.

If the Fed hikes short-term rates and money moves from stocks into longer-term Treasury bonds, we could be looking at an inverted yield curve soon thereafter. Banks would then stop what little lending they are doing now, which wouldn’t be good for debt-dependent consumers, businesses, and others who rely on the first group. That’s a really good way to trigger a recession.

Jerome Powell knows all this. The last thing he wants is to have shepherded the economy through COVID only to send it into a deep recession. I’m sure he will try to thread the needle somehow, but the odds are against him.

So where does it lead? I think Powell will keep trying to jawbone inflation down without doing anything to upset the market applecart. It will work for a while, too. But if the supply chain snarls continue and energy prices stay elevated (neither of which Powell can do much to change), inflation won’t come down much.

I think Powell believes the disinflationary era is over, at least for a few years. The China-led globalization that kept goods prices low for the last 20 years has mostly run its course. Add in demographic-driven labor shortages and we seem set for a meaningful trend change.

That’s not to say hyperinflation is coming. A world of 5% inflation isn’t necessarily a catastrophe. It was that high or higher for most of my early career. But after decades of 2% or lower CPI, and the correspondingly low interest rates, 5% will be a major adjustment.

Here’s the problem. The inflation that the Fed is supposedly fighting was not caused by them and their tools are insufficient to fight it. Admittedly, zero-level interest rates caused high prices in car loans, used cars, and homes. Raising rates will take care of those problems, but given how the Fed measures inflation, the prices in those markets coming down will not significantly impact inflation.

Quantitative easing? It has an effect on housing but it is more of an impact on asset price inflation especially the stock market and the entire financial system. Quantitative Easing is a massive stimulus program for Wall Street and the stock market, etc. It does nothing for the bottom 60–70% of Americans.

Quantitative easing changed almost nothing but asset prices in the financial markets. Low interest rates affected, again, car loans and mortgages. That is all on the Fed.

But actual inflation? That’s all on fiscal policy and Congress. The Federal Reserve can accommodate Congress with buying government debt, but that shows back up on their balance sheet. It is not “hot money.”

The multiple stimulus packages Congress passed were hot money squared. It went into the hands of people who actually spent it. And since they couldn’t buy services like restaurants, hotels, and travel they bought “stuff.” So we had a “demand shock.” Consumers wanted more than businesses could produce.

But wait, there’s more. COVID seriously impacted supply, too. When your employees can’t come to work shortages start to build up rather quickly (think lumber, chips, etc.). Further, businesses were facing wage inflation and higher costs for their component products. They raised prices, sometimes because it was justified and sometimes simply because they could. Note that profit margins for the largest companies in the US are at all-time highs. It’s not any different than smaller companies. $10–$12 per pound for bacon? A $23 pastrami sandwich in Boston? There are literally thousands of such anecdotal stories.

Cummins Diesel says that they will be dealing with chip shortages for another two years. They’re buying run-of-the-mill, low-end chips. Chip fabricators do not want to build a factory to manufacture low-end chips when the demand will not be there two to three years from now. They need to see 10-year horizons. That is the same for multiple businesses all across the spectrum. Businesses can see an initial demand created by massive stimulus from Congress, supply chain disruptions caused by COVID, and realize that things will settle out and building another production line today will not be useful when demand evens out two years from now. It’s just going to take time to sort through the demand and supply shocks.

And there is nothing the Federal Reserve can do with their policy tools that can fix the cause of inflation created by Congress.

I am not certain what the Fed will do, but what they should do is draw down quantitative easing much quicker than any of us anticipate—in 4–5 months max. Then they need to start raising rates. And they need to keep raising rates until inflation is under 2.5%. They cannot repeat the mistake that Arthur Burns made in the ‘60s and ‘70s by letting inflation run hot because he thought it was transitory. Ultimately, the cure for high prices is high prices. Inflation will, if not accommodated by the Fed and Congress, recede and we will be back to a disinflationary/deflationary environment.

Jerome Powell’s problem is that Wall Street won’t like a reduction, much less a cessation of quantitative easing. Higher interest rates are not conducive to the ongoing financialization of everything.

There is a very real possibility, if not probability, that the stock market enters a bear market in 2022 while inflation remains high. It could happen before the Fed raises rates. What does Powell do then? Does he fight inflation, as the Fed’s mandate says he should, or follow recent precedent and accommodate the markets?

By continuing to fight inflation he risks a mild recession. We’re not talking 1982 and Volcker. More like 1991, which the markets shrugged off after a year and continued on into a bull market. A mild recession will solve the inflation problem then Powell can come riding to the rescue.

Powell’s mistake was not ending QE and raising rates in late 2020 when the economy was clearly getting stronger. The Fed has already made its policy error. Congress also made a massive bipartisan fiscal policy error, even if well-intentioned.

To compound the problem, COVID has changed the employment market significantly. Many people have simply decided to not be part of the labor force, because of retirement or for personal reasons. We have spiraling wage inflation, which is real and sticky and is not going away soon.

It will be a massive policy error, much more extreme than the last one, if the Fed doesn’t lean into inflation even if the stock market suffers a short-term retreat. What have we learned over our last 50 years? The market comes back and will be stronger and higher. Valuation will matter.

But not if the Fed lets inflation really take hold. Jerome Powell clearly knows the history of Arthur Burns and his successor, William Miller, screwing up. Here’s hoping that Powell is made of sterner stuff.

  • Corporate profits weaken due to slower economic growth, reduced monetary interventions, and rising costs.
  • Consumer confidence continues to weaken as consumption is crimped by rising costs and slowing economic growth.
  • Interest rates rise which trips up heavily leveraged consumers and corporations.
  • A credit-related event causes a market liquidity crunch.
  • The Fed makes a “policy error” by tightening monetary accommodation as the economy slows suddenly.
  • A mid-term election resulting in a broad sweep by Republicans in both houses further reducing monetary accommodation and spending.
  • The “housing bubble 2.0” implodes.
  • Corporate stock buybacks, which accounted for 40% of the market’s appreciation since 2011, slow as companies begin to hoard cash as the economy slows.
  • The massive inflows into US equity markets over the last year slows.
  • The avalanche of M&A activity, IPO’s, and SPAC’s of poor quality companies results in negative outcomes.

I could go on, but you get the idea.

 

Did People Really Do That?

 

In December 2019 someone paid the $120,000 banana duct-taped to a wall. Then, in March of this year, an artist known as “Beeple” made $69 million at auction for a digital-only collage of 5,000 images – thanks to the non-fungible token (“NFT”) craze.

In June, an Italian artist got paid $18,000 for a 25-square-foot box of nothingness. A month ago a Danish artist took $84,000 in cash and ran in exchange for a piece called, well… “Take the Money and Run.”

A 2,000-pound, 14.5-inch Tungsten cube that was minted solely to create a NFT that included the right to visit and touch the cube once a year. The NFT sold that week for about $247,000 worth of Ethereum cryptocurrency tokens.

How about this next one…. Real estate that doesn’t exist.

Yes, I’m serious… Folks are shelling out real money – millions of dollars, in fact – for property that they can’t live on, rent to someone else, or even visit. Here’s how the Wall Street Journal reported the latest big transaction in non-existent real estate last week…

“Republic Realm, a firm that develops real estate in the metaverse, said it paid $4.3 million for land in the world Sandbox, the biggest virtual real-estate sale publicized to date, according to the company and to data from the website NonFungible.com, which tracks digital land sales.”

“Republic Realm bought the digital land from video-game company Atari SA and the two firms said they plan to partner on the development of some of the properties.”

That deal broke the record from just one week earlier. A subsidiary of Canadian investment firm Tokens.com paid about $2.5 million for digital land in Decentraland’s Fashion District.

Paying millions of dollars for the equivalent of a piece of land in a video game is ….INSANE?

 

US Economy

 

  • The November payrolls report was disappointing.
  • However, the unemployment rate declined more than expected. One interpretation is that the labor market has tightened further, with employers increasingly struggling to hire workers.
  • Biggest employment gains and losses by sector:

 

 

  • The pace of hiring has been lagging business expansion.
  • The ISM index has been distorted to the upside by supplier delays.
  • For now, there are no signs in the report that supply-chain issues are easing.

 

 

 

  • Factory orders continued to surge in October.
  • The updated capital goods orders were even stronger than the earlier report. Business investment remains healthy.
  • COVID cases are on the rise again.
  • Payrolls are not a good measure of labor market tightness. The quits rate is a better indicator and it suggests that the US is near “full employment.”
  • Real wages are starting to catch up with productivity growth, potentially pressuring corporate margins.
  • The real fed funds rate is at extremes no matter which index is used to measure inflation. It points to extraordinary levels of monetary accommodation.
  • The market is now assigning a decent probability that the Fed will hike rates by May.
  • High-frequency indicators point to an acceleration in residential construction activity.
  • Separately, Fannie Mae and Freddie Mac increasingly waive home appraisals in mortgage financing transactions.
  • The trade deficit declined sharply in October, as US exports hit a record high. Maintaining this trend may be challenging if the US dollar strengthens further.
  • Unit labor costs surged since the start of the pandemic.
  • Labor productivity declined sharply in Q3 as more Americans returned to work.
  • Longer-term inflation expectations remain stable.
  • Deutsche Bank expects the GDP deflatorto rise by 6% this year.
  • The ISM Services PMI price index points to CPI remaining elevated over the next few months.
  • The Fed’s Beige Book survey points to easing concerns about supply chain issues.
  • We continue to see lower numbers of container vessels waiting to unload at US West Coast ports.
  • However, it’s all about how ships are counted. A broader count suggests that the logjam remains acute.
  • The Evercore ISI auto dealers sales index appears to have bottomed.
  • The Oxford Economics supply chain stress tracker remains near the highs.
  • Student debt as a share of total consumer credit seems to have peaked.

 

 

  • The October job openings report topped forecasts, pointing to persistently tight labor markets.
  • Private-sector job openings hit a record high.
  • Job vacancies in manufacturing are surging.
  • The number of unemployed workers per job opening hit a record low.
    *  Stalled labor force growth will cap US economic expansion.
  • Loan applications to purchase a home remained strong after the Thanksgiving-week lull.
  • Wholesale used car prices climbed another 5% in November.

 

 

  • Port of LA container ships’ waiting time:

 

 

  • Lead times to deliver semiconductors:

 

 

  • When do economists see supply-chain disruptions easing?

 

 

  • The Build Back Better(BBB) plan could push tax hikes off until after the 2024 election.

 

 

  • Still, BBB tax hikes could be the largest in both absolute terms and relative to GDP.

 

 

  • Household net worth is at record highs as a share of US GDP as house prices and stocks surge.
  • The Nasdaq Composite breadth has been deteriorating all year.

 

 

  • US equities have outperformed global stocks as new COVID variants emerged (foreign investors move capital into the US).

 

Market Data

 

  • US refined energy products inventory is much too low for this time of the year.

 

 

  • The Nasdaq 100/Dow Jones ratio held resistance at the dot-com peak.

 

 

 

  • In a year with such high index returns, a substantial percentage of stocks dropped more than 35%.
  • The 2-year Treasury yield climbed above 0.7% as traders bet on a more hawkish Fed policy.

 

 

Thought of the Week

 

“(Market) Predictions Are Difficult…Especially When They Are About The Future”

– Niels Bohr

 

Picture of the Week

 

An Iceberg Flipped Upside Down

 

 

Albino Peacock In Malaysia

 

 

 

 

All content is the opinion of Brian J. Decker