While rock-bottom yields and low rates support higher valuations, a forward P/E ratio of 23 for the S&P 500 (Refinitiv) is well above the historical norm. We recognize a pullback is inevitable. Timing and estimating the magnitude of any correction, however, becomes much more problematic.
Against the backdrop of renewed volatility and the scars left by the Covid-induced recession, the Federal Reserve announced a shift in how it will conduct monetary policy. Bottom line, rates are likely to remain low for a long period. The impact on investors, savers and borrowers could be significant.
1. A kinder, gentler Fed
- As the Fed’s view of the economy evolves, changes in how it implements policy and targets its dual mandates, full employment and price stability, would be expected to evolve, too.
- Fed Chief Jerome Powell previewed the Fed’s “Statement on Longer-Run Goals and Monetary Policy Strategy” in a late August speech.
- The new tone will have long-term ramifications, as it could keep rates low for a longer period.
- It’s the first update since 2012.
- What’s behind the change? Four key economic developments motivated the review.
- The Fed believes the long-run potential for growth has slowed, falling from 2.5% in 2012 to 1.8% today.
- The general level of rates has fallen at home and around the world. Estimates of the neutral federal funds rate have fallen substantially.
- The record expansion led to a strong labor market, with added benefits to those at the lowest income levels.
- The low jobless rate didn’t trigger higher inflation.
- The Philips Curve (the tradeoff between inflation and unemployment) broke down. Muted inflation was consistent with a 3.5% jobless rate.
- The persistent undershoot in inflation is a cause for concern per Powell.
Figure 1: Muted Inflation
Source: St. Louis Federal Reserve July 2020
‘Statement on Longer-Run Goals and Monetary Policy Strategy’—a shift
- There is no numerical goal for the unemployment rate.
- The 2% inflation rate will be maintained.
- Monetary policy must be forward-looking, as policy works with a lag.
- A big shift: The Fed will seek to achieve inflation that averages 2% over time.
- If inflation runs below 2% for a while, the Fed will allow it to run “moderately above 2% for some time.”
- “Moderately” or “some time” was not defined.
- Powell defined this as a “flexible form of average inflation targeting.”
- Without an unwanted rise in inflation or the emergence of other risks, the Fed is signaling it won’t preemptively raise rates as it has done in the past.
- Might we see a jobless rate below 4% and a fed funds rate near zero? Possibly.
- Policy actions continue to depend on the economic outlook and any risks to the outlook, including potential risks to the financial system that could impede the attainment of its goals.
- The Fed is trying to embed a modest degree of inflation back into the system without sparking financial imbalances, a tricky task.
September Fed meeting
- In its September 16 statement, the Fed said it will “aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%.”
- The Fed plans to hold the fed funds rate at near zero until it believes this three-point test is met:
- Maximum employment has been achieved.
- Inflation has risen to two percent.
- Inflation is on track to moderately exceed two percent for some time (my emphasis).
- When asked at the press conference, Powell broadly defined ‘moderate’ as, “It means not large. It means not very high above two percent. It means, moderate.”
- Regarding ‘some time,’ Powell said, “What it means is not permanently and not for a sustained period.”
- It’s not rigid. There are no numeric triggers. It gives the Fed discretion.
- Powell indicated he’s not particularly worried about stock market bubbles.
The Fed’s projections include:
- No rate hikes are projected through 2023.
- GDP is projected to fall 3.7% this year versus -6.5% in June.
- The year-end unemployment rate is expected to be 7.6%, versus a 9.3% projection in June.
- Estimating actual numbers is difficult in today’s environment. The wide range of projections encompassed in the quarterly update reflects the uncertainty.
- What’s encouraging? The upgraded outlook reflects better-than-expected progress.
Bottom line for investors
- The Fed has already pledged to keep rates low for a long time.
- A flexible inflation target gives the Fed more wiggle room to hold rates lower for a longer period, i.e., it is signaling it will tolerate higher inflation, at least for a little while.
- Very low rates, coupled with economic growth, have been a strong tailwind for stocks.
- The Fed believes that global disinflationary forces will outweigh any inflationary ripples that may occur from its accommodative policy, as we saw in the last expansion.
- The Fed’s guidance, coupled with well-anchored, market-based inflation expectations, could keep long-term bond yields low for an extended period.
- But there are risks. Some fret that a very accommodative monetary policy and massive fiscal stimulus could lift inflation faster than the Fed expects.
- Unwanted imbalances could materialize.
- Might we begin to see too much complacency regarding low yields? Maybe, but odds favor a low fed funds rate for a long time.
2. Economic progress report
- Table 1 indicates the economy hit bottom in April.
|Table 1: Monthly Changes in Key Metrics
|Ex-autos, ex gas stations
|Nonfarm payrolls (millions)
Sources: St. Louis Federal Reserve, U.S. Census Manufacturing production excludes utilities and mining. It accounts for 75% of industrial production.
Consumer spending is a more broad-based category that encompasses spending on services not accounted for in retail sales.
- We experienced a much sharper bounce than most analysts had anticipated in May and June.
- In my view, the sharp stock market rally suggests investors were more optimistic.
- Despite the uptick in Covid cases in June and July, the economy continued to rebound. However, the pace has moderated.
- Still solid by historical standards but nonetheless, a moderation.
- Table 2 highlights key economic data points and how much each has recovered from April’s low.
|Table 2: Road to Recovery—Getting Back to Even
|Ex-autos, ex gas stations
Sources: St. Louis Federal Reserve, U.S. Census
All data points August 2020 except for consumer spending: July 2020
- Manufacturing production has clawed back two-thirds of its loss.
- Industrial production lags amid weakness in oil and gas.
- Retail sales have shined.
- It’s a V-shaped recovery thanks to pent-up demand, and fiscal support via $1,200 checks and generous jobless benefits.
- Let’s not discount job growth and the inability to spend on canceled events, vacations, restaurants and more, which appears to be funneling some cash into other sectors.
- Consumer spending has lagged, as it includes spending on services and other categories that require person-to-person interaction.
- The swift decline in the unemployment rate to 8.4% is encouraging, though it remains elevated. Few thought we’d see a jobless rate below 9% this quickly.
- Notably, Fed’s September economic projections reflected a sharp reduction in the expected year-end jobless rate versus June.
- The rebound in nonfarm payrolls has lagged economic activity.
- Many analysts believe we still need fiscal stimulus, which may or not be forthcoming.
- Powell said the economy has proved to be resilient in the lapse of jobless benefits.
- A savings rate of 17.8% suggests there is still fuel in the tank to support activity.
Figure 2: Fuel in the Tank
Source: St. Louis Federal Reserve, July 2020
- But uncertainty reigns.
- Weekly jobless claims have been in a narrow range of 790,000–890,000 over the last six weeks (nonseasonally adjusted; claims fell 76,000 in the latest week to 790,000).
- The still high level of layoffs suggests deep wounds won’t heal quickly.
- A resumption of the downward trend would signal a higher degree of confidence in the recovery.
- The DOL recently changed its methodology for seasonally adjusting claims to better reflect the impact of the virus on layoffs.
- Separately, the recovery in housing, traditionally a leading indicator, has been strong.
A peek ahead
I. A Q3 rebound
- The Atlanta Fed’s Q3 GDPNow model puts GDP at an annualized increase of 31.7% as of September 16.
- September’s data could chip away at today’s estimate.
- Yet, despite Q3’s rebound, layoffs remain high, signaling underlying problems haven’t dissipated.
- Q2 S&P 500 earnings fell 30.2% versus the July 1 estimate -43% (Refinitiv).
- Covid’s effect has been considerable, but it has also created distortions that have benefitted some firms.
- Q3 is forecast to fall 22% versus a forecast of -25% on July 1.
- While year-over-year growth is not expected to turn positive until Q1 2021, Q2 S&P 500 operating earnings of $28/share is likely the bottom.
- Q3 is currently projected to tick up to $32.55/share.