Markets have rallied on stimulus hopes and Q3 earnings season may bring good news.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
- The rally in stocks has become broad-based again. Small caps and even the lagging energy and financials sectors are showing signs of improvement, and most stocks have resumed their uptrend. All eyes are on the prospect for more fiscal relief.
- A potent combination of fiscal and monetary policy has, so far, succeeded in rescuing the economy and markets. Could this lead to a prolonged era of deficit spending “absorbed” by the Fed?
- If so, an ongoing expansion in the money supply could lead to inflation and a rotation from growth to value.
- Earnings season for Q3 is starting and there is evidence that it may be better than expected—like Q2 earnings season was.
- If the recovery timeline follows the analog of the global financial crisis, earnings should be bottoming now. That means the market can start to grow into its lofty valuation.
The stock market put in a robust performance last week despite questions about whether and when there will be a next tranche of fiscal relief. The markets are very focused on the prospects for fiscal relief, given that the COVID-induced liquidity impulse is waning.
As the chart shows below, the tape was red hot last week with 89% of stocks now above their 20-day moving average. It was just a few short weeks ago that the market was quite oversold at 8%. All of a sudden this has become a broad-based rally again.
MA means moving average. Daily data as of 10/11/2020. Source: FMRCo, Bloomberg, Haver
The Russell 2000 index has risen from the depths and is now making a new recovery high and is not far from its February all-time high. Even the energy and financials sectors could be seen coming back to life as well, although there is a lot of wood to chop before they catch up to the broader market.
At the same time, the dollar is back near its lows and emerging market (EM) currencies are making new recovery highs. And with the 10-year Treasury yield back up to 77 basis points (bps), all the signs of an early cycle reflation trade are there.
Part of the story has been the resilience in the economy. We all saw the market stage a V-shaped recovery back in the spring, wondering whether stocks were out over their skis, but it turns out that expectations for a U or L-shaped recovery may have been too pessimistic.
The consensus GDP forecast (via Bloomberg) for the third quarter keeps getting raised, even as the decline in the second quarter gets revised upward. Current expectations are for the 32% decline in Q2 (annual rate) to be followed by a 29% rebound in Q3.
What's driving stock prices? Maybe Fed-funded fiscal stimulus
While part of the strong tape can be attributed to hopes/expectations of another fiscal relief bill, the broadening/rotation we are seeing could also be the result of the markets pricing in the possibility of a future macro policy playbook that calls for lots of fiscal policy expansion funded by a Fed that is following the 1940s reflation playbook (massive QE combined with sharply negative real rates).
The prospect of a 1-2 punch of fiscal largesse “enabled” by the Fed suggests that the surge in the money supply that began with COVID could continue for some time, and that this could be the long-awaited catalyst for a big rotation from growth to value and from deflation to inflation. Perhaps the narrative is that we are transitioning from a COVID-induced firehose of money supply growth to one created by structural fiscal expansion. Either way it spells liquidity, which has a habit of finding its way into asset prices.
We can call it modern monetary theory (MMT),* or MMT-lite, but either way it is potentially a brave new world for the markets. Before COVID, companies didn’t really know if everyone who could work from home would be just as productive doing so. But then we all found out in a real-time experiment that it is indeed possible.
Perhaps the same is happening with fiscal and monetary policy. What was an abstract idea (MMT) all of a sudden is a real-time experiment. We are 7 months into the COVID-era and despite a $3 trillion increase in debt “offset” by an equal increase in the Fed’s balance sheet, so far the financial world order has not collapsed (despite what the gold bugs say). That could well be a green light for policy makers as they go through their policy shopping lists in January.
For now, Bloomberg’s proxy for the global money supply is making new highs again, which tells me that the market may not be far behind.
If this continues, an ongoing expansion in the money supply could lead to inflation and a rotation from growth to value.
Read Viewpoints on Fidelity.com: Are value stocks ready for a revival?
Which brings me to earnings season
Earnings season starts up next week and I think it could be a good one. The chart below shows that the Q3 estimate has been flatlining for months. That rarely happens, since usually the companies are busy guiding analysts down to a number that can just be beaten. But during COVID there has been little to no guidance, and therefore little to no updates to the estimates. This tells me that Q3 earnings season may end up surprising to the upside, much like Q2.
Weekly data as of 10/11/2020. Source: Bloomberg
As for the timeline, I continue to find that the global financial crisis (GFC) is a good analog for this market cycle, as it relates to the timing of the price bottom vs. the earnings bottom. Below I show an analog of the 2 cycles, with the S&P 500 Index (SPX) drawdown in the upper left, the earnings drawdown in the lower left, the difference between expected fiscal year 2 (FY2) earnings and fiscal year zero (FY0) earnings in the upper right, and the subsequent realization of earnings over that 2-year time frame in the lower right.
Data as of 10/11/2020. Source: Bloomberg, FMRCo.
So far so good, which tells me that earnings are likely bottoming now. If earnings are bottoming now, the market can finally start to grow into its valuation and be less reliant on the fiscal/monetary impulse.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
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