Preaching To A Choir Of Bears

It almost feels gratuitous to keep making the case against US equities. It’s preaching to a choir that increasingly includes most investors, from retail to institutional and everyone in-between.

I’d expect the bearish drumbeat to continue alongside hawkish Fed banter. “Whether the Committee would want to pull some proposed or thought-of policy-rate increases from 2023 into the December meeting, I think that’s a judgment that’s premature to make,” Jim Bullard said over the weekend, on the sidelines of the IMF meetings in Washington.

Obviously, Bullard’s remarks suggested the Fed will in fact ponder another 75bps rate hike at the December gathering following another assumed three-quarter point move next month.

Bullard also reinforced the notion that once the Fed gets to terminal, they intend to sit there for as long as possible. “We’ll be able to basically stay where we are and watch inflation come down,” he mused. As the figure (below, from BofA) shows, core CPI would need to be 0.2% MoM going forward in order for the Fed to see 3% by next summer.

Core prices have risen at least 0.6% in five of the last six months. If that trend were to continue into 2023, core CPI could loiter near 6.5%. Bullard acknowledged as much. “There’s a lot of risk that inflation goes higher still, and then we have to react to that,” he added.

And then there’s the rest of the economy. Virtually nothing argues for a Fed pivot in the very near-term. The table (below, from BofA) is a somewhat useful checklist.

“The only market and macro metrics at levels normally seen when the Fed panics, pivots or eases after market or macro pain is rates volatility and maybe stocks too,” the bank’s Michael Hartnett remarked.

Everyone knows the labor market is still strong, but as Hartnett went on to say, “ISM isn’t weak enough and credit spreads aren’t telling the Fed to fold yet” either.

Of course, this discussion is incomplete without a nod to the possibility that uncomfortably high rates vol and the attendant dearth of liquidity in the Treasury market could override all other concerns for the Fed. But any intervention wouldn’t be framed as a pivot. It’d be explained by reference to market functioning and financial stability, much as the Bank of England attempted to emphasize that their own emergency bond-buying (which ended Friday) wasn’t QE, but rather a temporary emergency backstop to prevent a systemic meltdown.

For investors, such an explanation for a Fed relent on balance sheet policy would be a distinction without a difference initially. That is, risk assets would rally, but until the Fed concedes that QT simply isn’t tenable (even if tighter policy through rate hikes is), markets will struggle to sustain a bid. On Saturday, Bullard said it’s “way too early to say that we would change [balance sheet policy] any time soon.”

US equities simply aren’t appealing in this environment. Not at the index level anyway. The table (below, from Goldman) gives you a snapshot of relative and absolute valuation metrics.

Although Goldman was able to find some things ostensibly worth buying by sifting through the Russell 1000 for cyclicals that trade cheap to recessionary earnings and profitable growth stocks trading at discounts to their 10-year median valuation, the bank’s David Kostin delivered what I think it’s fair to call a dispirited view of the index, which still trades on a 16x multiple.

“Most absolute valuation metrics show that US stocks remain expensive versus history,” Kostin said, noting that although the P/E looks “less stretched than other absolute metrics,” it’s still 66%ile, and besides, “investors are skeptical about the EPS forecasts that underlie that metric.”

On a relative basis, stocks don’t look much better. “Despite elevated recession risk, geopolitical tension and a generally murky macro outlook, the earnings yield gap trades close to the tightest levels in 15 years,” Kostin went on to say. Relative to 10-year reals and IG credit, US equity valuations are 75%ile (or more) looking back four decades.

At the end of the day, it all comes back to the Fed. As BofA’s Hartnett put it, a “Fed panic is always a necessary and often sufficient condition for ‘The Big Low.'” A panic is coming, he said, but there’s “not enough macro or market pain yet.”