“Change makes for a more interesting story, and although we see real evidence for meaningful shifts, low rates, low growth and hyper-accommodative monetary policy lasted longer than expected and could easily extend another year or two”, BofA’s Savita Subramanian and Jill Carey Hall write, in the bank’s official 2020 US equity outlook.
That latter bit (about slow-flation and the persistence of ultra-accommodative policy “lasting longer than expected”) is something of an understatement.
Indeed, 2019’s epochal dovish pivot appears to suggest that the suspension of normal market rules in the wake of the crisis in favor of extreme monetary policy aimed (paradoxically) at ensuring markets could one day return to functioning normally, is now at least semi-permanent. We habitually refer to the following passages from a 2017 note by Deutsche Bank’s Aleksandar Kocic:
In its core, policy response to the crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.
Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.
And so, here we are, more than two years on from when those passages were penned (and a decade on from the crisis), with central banks having cut rates aggressively, tweaked forward guidance and, in the case of the ECB, restarted net asset purchases.
All of that after an experiment with coordinated normalization in 2018 went awry, as Fed tightening conspired with economic outperformance in the US to create unwanted dollar strength, exacerbating the tightening impulse, which then rippled across emerging markets, before finally boomeranging back stateside in Q4 of last year to collide with political tumult (the government shutdown) on the way to precipitating the worst December for US equities since the Great Depression.
As Kocic wrote, “stimulus unwind [is] especially tricky”.
Recent efforts to convey a bias to remain on hold and let already-delivered stimulus work its way through notwithstanding, the bar for more easing from central banks is clearly lower than the bar for a renewed tightening push, something that was underscored earlier this week in the RBA minutes. Wednesday’s Fed minutes could come across as hawkish, but there’s no question that the Fed would sooner cut than they would hike.
The likely persistence of an accommodative lean makes it possible to argue for buoyant risk asset prices on multiple fronts:
- If, on one hand, growth remains sluggish and inflation fails to respond convincingly, the “everything rally” can persist, as bonds are bid on “slow-flation” dynamics, while “TINA” and the promise of abundant liquidity bolsters equities and credit.
- If, on the other hand, stimulus does start to manifest itself in better economic outcomes (e.g., an inflection for the better in manufacturing PMIs), you can argue that although bonds may suffer in a pro-cyclical rotation, equities will rise on risk-on sentiment tied to improving macro, and credit can rally as the cycle is prolonged.
This kind of “heads stock bulls win, tails bears lose” reasoning makes it tempting to stay bullish equities as long as there’s not a clear-cut case for aggressive policy tightening – i.e., for the rapid lifting of the state of exception.
(Incidentally, Deutsche Bank’s Kocic was the only analyst that we’re aware of to nail the S&P in 2018 — although he doesn’t have the official DB equity call, he repeatedly suggested the benchmark would end last year between 2,300 and 2,400, primarily as a result of Fed dynamics.)
Given the above, Subramanian and Jill Carey Hall’s SPX 3,300 target for the S&P in 2020 is hardly far-fetched, although you can certainty quibble with the specifics (i.e., with their sector-level calls and characterization of how the macro regime is likely to evolve).
Looking out a decade, they see the benchmark climbing to 5,300, and they don’t think you need to be a genius (let alone a “very stable” one) to understand the rationale.
“Valuation, while not a powerful predictor in the near term, is a strong predictor of longterm returns”, they write, adding that “the price to normalized earnings ratio of the S&P 500 has explained ~80% of the variability of market returns “.
A simple regression, utilizing today’s price to normalized earnings ratio, spits out an expected annual return of 5% over the next 10 years.
As far as the prospects for an outright bear market materializing, BofA has a checklist of “signposts”. You’ll be comforted to know that only 53% are currently triggered.
Looking back five decades, more than 80% are triggered ahead of historical bear markets.
The figure hit 79% on October 10, 2018, just before the bottom fell out, sending stocks to the brink last year.
Draw your own conclusions.