Why equities could fall sharply

In the AFR on Friday I wrote that, for the first time in a long time, we agree with Jeremy Grantham: equities likely need to correct quite significantly. Here are some simple mental models. The cyclically-adjusted Shiller price-earnings (p/e) ratio is currently sitting at 37 times compared to its long-run mean of 17 times and median of 16 times. The only time in the last 150 years it has been higher was just prior to the 50% drop in US equities during the “tech wreck”, which resulted in the Shiller p/e falling from 44 to 21 times.

If we suppose that it is reasonable for US shares to normalise back to their pre-pandemic peak on the basis that investors incorrectly extrapolated ultra-low inflation and 10-year bond yields in perpetuity, stocks would need to adjust downwards by 28 per cent from current levels.

If we consider a more serious downside scenario whereby equities mean-revert to their December 2018 level, which is when the Fed last had its cash rate at a “neutral” level of 2.5%, shares would have to drop 48%. There are many shortcomings with this analysis. One of the biggest is that this time is different to the recent past in so many ways. Unfortunately, that point of difference implies an even greater downside risk.

When was the last time you can remember a US President egging on the Fed to crush inflation and raise interest rates? When do you last recall inflation being a major US political issue? The post-GFC period has been defined by politicians trying to strong-arm central banks into easier, not tighter, policy settings.

Of course, President Xi is begging the Fed not to hike interest rates given his currency is pegged to the US dollar. Furthermore, China is, like the US, home to hordes of “zombie” companies. In the US, zombies represent roughly 15-20% of all listed firms. These are entities that do not have enough money to service the interest repayments on their debt using their existing earnings. Heaven help them if rates rise sharply, as they are now doing. In China, the state has been the primary backer of many of these entities, which can only survive with access to this artificially cheap public sector funding.

Since we started warning about the spectre of a savage fall in global equities (and correlated crypto) on 23 December, the S&P500 has corrected 5.1 per cent. The tech-focused Nasdaq index has slumped 10%. And Bitcoin has dropped 19%.

The key driver has been rates. Since 23 December, the US 10-year government bond yield has jumped from 1.49% to as high as 1.90%. In Australia, 10-year government bond yields have leapt from 1.65% to over 2.0%.

The catalyst for the move has been a raft of data confirming the US likely has a persistent, rather than transitory, inflation problem. Core inflation is running at 4.7%, miles above the Fed’s 2% target. This might be okay if it was all explained by temporary supply-side factors.

But US wages growth is also expanding at a very high 4.7% annual rate, which is feeding into a nascent wage/price spiral. This is being powered by an exceptionally tight US labour market where the jobless rate is just 3.9%, in line with the Fed’s estimate of full employment.

To make matters worse, inflation expectations are decoupling from the Fed’s 2% target, with US households now forecasting inflation of 6% in the next 12 months and 4% over the following three years.

Turning back to the supply-side, many of the cost-push pressures could be somewhat persistent. Reshoring of supply chains away from China is likely to be an inflationary process for years to come. Starving fossil fuel industries of cheap money means they underinvest in capacity, which makes it harder for supply to sate rising demand. The "greenification" of energy industries could also become a prolonged inflationary pulse.

We have not seen this combination of high core inflation, strong wages growth, super-low unemployment, and soaring consumer inflation expectations in decades. The concern is this is becoming secular: similar conditions are evident in many developed economies. And Australia may be heading down a comparable, if not identical, road.

This week the official statistician reported that Australia’s unemployment rate declined to just 4.2%. In November my colleague Kieran Davies presented an analysis showing that “underlying inflation in Australia would have been around the mid-point of the Reserve Bank of Australia’s target 2-3% band had it not been for the government’s housing subsidies”.

“Constructing a version of the trimmed-mean CPI that uses home prices excluding subsidies and reweighting the CPI basket accordingly, annual underlying inflation was 1.3% in the fourth quarter of 2020, increasing to 1.8% in the second quarter of 2021 and to 2.6% in the third quarter,” Davies says. “This is much higher than the published—including subsidies—series, which showed annual inflation of 1.1%, 1.6% and 2.1%, respectively.”

Assuming core inflation does push-into the mid-point of the RBA’s target band in January, and the wages data in February similarly portends a normalising trend, Australia’s very dovish central bank could be on track for its first cash rate increase in the second half of this year.

Martin Place will, however, want emphatic empirical proof that it is converging on what we call the “magic triumvirate”: 3-point-something per cent unemployment; 3% plus wages growth; and sustainable underlying inflation heading towards the 3% end of its target band.

And the RBA’s hikes are likely to be slower and steadier than its overseas counterparts because there are many important differences in the Australian economic story, including much higher-skilled migration, which has offered a more elastic pool of labour supply that has kept a lid on wages growth.

Coming back to equities, rates and the Fed, which are the tails that wag the global financial market dog, we have been looking for a key regime change revolving around the speed with which the Fed hikes in 2022.

Market pricing for only three Fed hikes in 2022 late last year seemed extremely optimistic. The truth is that the Fed should be at a 2.5% cash rate right now, and looking to shift into more restrictive settings, implying a cash rate at or above 3%.

Some of this depends on where the neutral rate is in the US, and there are credible reasons to believe it might be lower than the Fed’s estimate of 2.5%. But the Fed is ultimately in the driver’s seat, and taking its neutral estimate at face value, that is where we should be.

Another tell that policy in the US needs to tighten materially is that the financial conditions index (FCI) the Fed relies on has been signalling that monetary settings are currently near the most stimulatory levels in history.

An FCI index is an overall measure of how restrictive or loose policy is and captures a range of variables, including the Fed’s cash rate, 10-year government bond yields, credit spreads, equity valuations, and the trade-weighted exchange rate.

On 14 January, Goldman Sachs wrote that its widely watched FCI is “about 2¼ standard deviations easier than its historical average and 153 basis points easier than at the start of 2020”. While the Fed declaring that it is ready to lift rates in 2022 had increased 10-year bond yields, this effect was being more than overwhelmed by rising equity valuations. Having said that, the recent equity correction combined with even higher bond yields and wider credit spreads should have tightened the FCI somewhat.

Surprisingly, markets are still only pricing in four Fed hikes in 2022, which would put its cash rate around 1%, or less than half the neutral estimate of 2.5%. It seems that a more prudent policymaking path would involve the Fed lifting its cash rate to between 1.5-2.0% this year, especially if future wages and inflation data validate the presence of a persistent wage/price spiral.

This change in the expected Fed funds rate profile could be one catalyst for a material equities correction in the order of 10-15 per cent, or more, in the short term. A much larger correction would loom once the Fed pushed its cash rate into genuinely restrictive territory north of 2.5%. 

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