By Justin Pawl, CFA, CAIA, CFP®
Last Week Today.
- Norges Bank raised rates by 0.25% from 0% and intends to raise rates by another quarter-point in December. Norway is now the first developed country to raise rates since Covid brought the global economy to a near standstill.
- China outlawed cryptocurrency transactions on decentralized blockchains (e.g., Bitcoin). It’s a heavy-handed decree to stifle competition in advance of China’s central bank rolling out its digital currency next year. Transactions with China’s digital Yuan will be fully traceable, intensifying Beijing’s surveillance abilities and control over its citizens. Prices of Bitcoin, Ether, and other digital currencies fell 4% or more on the news.
- Global equity markets got off to a rough start last week as concerns about global contagion from China’s over-leveraged property market, epitomized by Evergrande, came into focus. After a two-day slide of ~4%, buyers overcame sellers, and the S&P 500 rallied to close the week higher by 0.5% and just 2% below its all-time high. Perhaps more importantly, the S&P 500 moved above its 50-day moving average (the purple line in the chart), a key technical level that has supported the index since May 2020. Speaking of trends, it’s been 224 days and counting since the last 5% correction, representing the 8th longest such streak since 1930.
Sources: Bloomberg L.P. and Covenant Investment Research
- The S&P 500 is up 20% for the year. While historically expensive by many valuation measures, earnings growth expectations have driven market gains this year. Based on the Forward Price/Earnings valuation metric, the market is cheaper now with a 21x Forward P/E multiple than at the start of the year when the multiple was 23x. Although less expensive than earlier in the year, it’s worth noting that the S&P 500 Forward P/E ratio remains more than one standard deviation above its 25-year average of 16.8x, buoyed by ultra-low interest rates and residual fiscal stimulus.
Source: J.P. Morgan
- International equities lagged behind their U.S. counterparts last week. The Developed Markets Index declined by -0.3%, and Emerging Markets fell -1%. EM was dragged down by the Evergrande-epicenter China, which saw the MSCI China Index fall by -2.8% to -16.8% for the year.
- Yields on US Treasury yields rose as the Fed moved closer to announcing the beginning of QE-tapering and Congress remains embroiled in a battle over the debt ceiling. After spending a month-and-a-half trading in a yield range of 1.2% – 1.35%, the benchmark 10-year US Treasury Yield broke higher to end the week at 1.45%. Meanwhile, the 30-year bond yield rose 0.08% to 1.98%, towards the upper end of its trading range established at the beginning of August.
- For more detail on weekly, monthly, and year-to-date asset class performance, click here.
Tapering: Monetary and Fiscal. The Fed will begin reducing US Treasury and mortgage bond purchases by the end of the year. That’s the conclusion of most economists and professional investors following the Federal Open Market Committee’s meeting last week. Even before last week’s meeting, many believed tapering would begin in Q4, but comments last week solidified the forecast. Unlike the Taper Tantrum of 2014, the Fed’s communications regarding the prerequisite conditions to begin tapering this time have been good enough that financial markets barely reacted.
Unless there’s a major economic setback, Chair Powell will announce the start of tapering at their next FOMC meeting on November 6th. The Fed intends to use the 2014 reduction of bond purchases as the template for the 2020/2021 reduction when tapering begins. In 2014, the Fed reduced bond purchases by approximately 12% per month until their balance sheet stopped growing. At Powell’s press conference following last week’s FOMC meeting, Powell remarked that the economy’s strength justifies a slightly faster reduction, and the committee is targeting balance sheet stability by mid-2022. As a reminder, the Fed is currently purchasing bonds at a pace of $120 billion per month: $80 billion US Treasuries and $40 billion mortgage-backed securities. To meet their “zero balance sheet growth” by mid-2022 goal, economists at FHN Financial estimate the Fed will reduce US Treasury purchases by $15 billion per month and mortgage-backed security purchases by $10 billion per month, beginning in November and ending in May 2022. The chart below illustrates how reduced bond-buying will impact the Fed’s balance sheet size through the tapering process. At the conclusion of tapering, the Fed’s balance sheet will reach approximately $8.4 trillion, close to twice the size before the pandemic.
As this chart depicts, tapering is merely slowing the pace of the Fed’s balance sheet expansion. Tapering is not reducing the size of the balance sheet, nor is tapering the same thing as monetary policy tightening. The Fed’s balance sheet will continue to expand through the end of tapering, and the Fed has not indicated when (or if) it will shrink its balance sheet. Indeed, the Fed may delay reducing the size of the balance sheet until after it begins raising interest rates which could be late in 2022 or 2023. While many fear tapering will put upward pressure on yields, history doesn’t support that view, and hence the economic impact of tapering will be muted.
However, while the Fed’s imminent shift in monetary policy is not expected to impact economic growth, the decline in the Federal government’s fiscal stimulus spending could have a pronounced impact. Estimates vary, but the government has spent at least $6 trillion propping up the economy since the pandemic began. Stimulus in the form of no-cost financing for businesses, checks to households, and generous unemployment benefits have either ended or are set to phase out soon. As a result, government spending will decline significantly, creating an unusually large “fiscal cliff.” Indeed, the year-over-year change in spending will be the second largest in history, surpassed only by the change in government expenditures following the end of World War II. Even with the sharp spending decline in 2022, fiscal stimulus will fall further the following year such that 2023 is expected to register as the 12th largest change in the budget balance. In sum, the magnitude of pandemic spending, and subsequent reduction, will create a multi-year headwind for economic growth.
Source: Bloomberg L.P.
As fiscal stimulus fades, economic growth will decline from the unsustainable pace of the pandemic recovery. We expect real (inflation-adjusted) annualized GDP will fall from 5% – 6% this year towards the long-term potential output of the economy, which is closer to 2% – 2.5% by the end of 2022. There’s downside risk to our forecast as the economy adjusts to supply chain disruptions and the potential for additional pandemic variants.
A return to the “Good, but not great” growth theme that preceded the pandemic doesn’t imply equity markets will implode. Household savings grew by ~$2 trillion during the pandemic, providing dry powder to support future consumption. Moreover, the rapid economic recovery following the lockdown meant tax receipts were higher than anticipated, and state and local governments have not been forced to spend much of the federal government’s direct fiscal support. However, slower growth and high starting valuations should temper investors’ expectations that equities can continue to provide the same 20% annual returns of the last two years.