With today’s Federal Reserve rate-hike as baked into the cake as it can be, all eyes will be on the expectations for the future and the word “accommodative” and, no doubt, stocks will charge on ahead aimlessly flouting the fact that “well The Fed wouldn’t be hiking if they were worried” and/or “The Fed will immediately switch to easing if stocks take a dip.”
However, while investors will pore over the Federal Reserve’s dot-plot projections today, looking for any and every silver lining, Bloomberg’s Ye Xie warns that it would be wise not to lose sight of the bigger picture. Regardless what the Fed does and says today, equity investors should expect lower returns and higher volatility in the coming months and years.
Two more hikes by year-end shouldn’t spell the death-knell for stocks, on the face of it. After all, estimates of the Fed’s real neutral policy rate are on the rise — using market-based measures — and the Fed itself has suggested the short-run neutral level could be higher.
Nevertheless, as policy becomes less accommodative, the Fed no longer suppresses risk premiums.
Note that Fed tightening typically leads equity volatility by two years or so. Remember the January-February volatility shock? It came 25 months after the first Fed hike. So expect more such episodes, even if they’re not of the same magnitude.
A higher risk-free rate suggests that P/E expansion, which has contributed a large portion of the equity gains since 2009, is coming to an end. That means the market has to rely entirely on earnings growth for gains.
Alas, earnings estimates look too optimistic. Sure, tax cuts are offering a boost, but there seems to be little discount for the trade war or wage pressures. A simple regression analysis suggests earnings estimates should be growing about 6%, given trade growth around 4%. Instead, EPS is seen rising 23% over 12 months — the outlier red star in the chart below.
Trading can be categorized into four phases.
“Reflation” is characterized with high readings on manufacturing PMIs and wages,
“Goldilocks” is when PMIs are high but wage gains are restrained,
“Stagnation” is the reverse of Goldilocks and
“Slowdowns” see both low PMIs and weak wages.
See the median monthly equity returns and 30-day volatility for each, since 1990:
Stocks perform best during Reflation periods, which often come after a recession. Goldilocks — where we’ve been the past year — comes second, with Stagnation and Slowdown episodes the worst.
Currently, the PMI is above 90% of its historical experience, and unemployment is drifting ever lower. That suggests a transition toward Stagnation is looming.
It doesn’t necessarily mean the bull market’s demise — that would probably take a recession on the horizon, and/or wage gains accelerating towards 3.5%. What it does means is the easy part of the bull market is over…
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