Dot-Com Echoes As Rich Stocks Meet Fed Hawks

Constructive views remained constructive Monday and those known for occasionally adopting a cautious cadence did just that amid questions around equities’ capacity to cope with rapidly rising real yields.

“Valuations are likely to come down more before we’re through with this correction,” Morgan Stanely’s Mike Wilson suggested, while JPMorgan’s Mislav Matejka expounded on sentiments expressed here over the weekend.

In “Rates Tantrum Pulls ‘Year-End’ Forward By 51 Weeks,” I wrote that “it seems unlikely the Fed would be willing to stomach the kind of risk asset tumult that would almost surely accompany a trek out of negative territory for 10-year reals.” It’s difficult, I remarked, “to see a scenario where financial conditions become truly restrictive.”

Matejka wrote Monday that “the rise in real rates should not be hurting equity markets, or economic activity, at least until they move into positive territory, or even as long as real rates are below real potential growth.”

While previewing this week’s economic releases, I suggested “an encore from reals would be a decidedly unwelcome development for risk, unless it could plausibly be attributed to the market upgrading its assessment of the economy versus simply pricing in a hawkish Fed.” Matejka wrote that “as long as yields are rising for the right reasons, including better growth, we believe that equities should be able to tolerate the move.”

You get the picture. Everyone knows what the issues are. It’s just a matter of which side of the argument you want to take.

One crucial bit of nuance involves ambiguity around estimating the Fed’s addiction liability, which grows over time. My hypothesis is simple. The longer accommodation remains in place, the further away from real price discovery assets drift and thus the lower the threshold for incremental policy tightening to cause a correction.

The figure (below) is familiar to regular readers, but it’s more germane now than ever for obvious reasons. It seems to me that lower and lower reals are required to keep stocks buoyant.

“Equity valuations are expensive, with the standard justification for these higher multiples being low bond yields, or more recently negative real yields,” SocGen’s Andrew Lapthorne wrote last week, in a sweeping review of 2021.

“There is a logic to this, as you could borrow to invest in equities, but ultimately it boils down to, ‘I’m willing to pay more for equities as everything else is more expensive,'” he continued, adding that “if negative real yields are indeed sustaining higher equity valuations, then improving economic growth, lower inflation and rising rates are all to be feared.”

Obviously, multiples are stretched. The simple figures (below) make the point.

On both counts, the S&P trades at dot-com levels. The quarter-century average for price-to-book is below 3.

The Bank of France on Monday warned about what it called “very high” risks associated with “elevated market valuations.” Those risks are expected to get worse. Officials focused on the French financial system, but the assessment could just as easily have applied globally.

“Some stock market indicators… are signaling persistent exuberance, exposing risk-asset markets to a sudden correction that could potentially destabilize non-bank financial intermediaries that use leverage and spread to other market segments,” the report cautioned.

The figure (below) updates the first figure with last week’s dramatics.

Lost in all of this is Omicron. The Fed has made it abundantly clear that officials believe the risks from the variant and accompanying surge in cases are skewed towards inflationary outcomes, whether from the prolongation of supply chain disruptions or the introduction of still more friction into the labor market.

But for equities, it’s worth asking if, as some have suggested, the sheer ubiquity of the virus brought about by the more transmissible variant means COVID will (finally) transition from pandemic to endemic later this year.

Notwithstanding the fact that the concept of “excess” savings is a cruel joke for the struggling Everyman and Everywoman, there is a lot of dry powder out there. The red line in the figure (below) marks the onset of the pandemic.

If COVID does get “downgraded,” so to speak, the combination of still low risk-free rates, some level of herd immunity, booster regimens and therapeutics could be favorable for risk assets.

That’s especially true considering the mountain of cash still parked in bank deposits and money market funds will still be earning next to nothing even if, by some cosmic miracle, the Fed manages to squeeze in multiple rate hikes.