Will taper talk and rising inflation kill the bull market?
by Jurrien Timmer, Director or Global Macro, Fidelity Investments
- Late summer is a seasonally weak time for stocks but investors may be more likely to worry this year since the Fed has begun to introduce the idea of tapering asset purchases and COVID is an ongoing threat.
- There are questions about the longevity of the bull market in stocks due to this uncertainty. But when we look at the drivers of today's markets, there are factors that are not likely to vanish overnight.
- Those factors include an aging population in need of income, ultra-low interest rates, and strong performance in large-cap growth stocks.
Labor Day has come and gone, and with that milestone the stock market is entering its seasonally vulnerable time of the year. The window from late August through September tends to be a seasonally weak one for stocks, followed by a brief "retest" window in early October.
Add to this a massive fourth COVID wave in the US, plus a Federal Reserve (Fed) that is firmly in pre-taper mode, and investors can be forgiven for questioning the resiliency of the S&P 500, which on Friday (August 27) closed at yet another all-time high (4,509).
With Fed Chairman Powell's Jackson Hole speech now out of the way, the market has been put on notice that the taper is coming soon. When exactly we don't know yet, but likely before the end of 2021 and maybe all the way through 2022.
The Fed has a needle to thread in terms of when and by how much it needs to reduce its asset purchases. If it wants to start raising interest rates in 2023, it will need to reduce its asset purchases from $120 billion per month to zero first. That means it needs to start the taper soon, which is why we are now getting the signals from the Fed.
Assuming the Fed will be in full taper mode in 2022, ironically its demand for US Treasurys will be disappearing right as the US Treasury Department will have run down its cash balance at the Fed (via the Treasury General Account or TGA), and presumably right as it may need to issue several trillion in new debt to fund the infrastructure bill and potentially also the American Families Plan.
As the chart shows below, the market is currently pricing in 4 rate hikes starting in 2022. Both the bond and stock markets seem pretty chill regarding the Fed's timeline. No taper tantrum so far.
Perhaps the market is (rightfully) concluding that it will ultimately win the taper battle. Either the Fed tapers and the system can handle it, in which case the market yawns and goes up (think 2017). Or the Fed goes too far and the market has a tantrum and the Fed is pushed back into a more dovish stance, after which the market immediately recovers (think late 2018 into early 2019).
Another possible reason why the stock market is holding up is that the fourth COVID wave in the US has so far resulted in very few new restrictions. The Goldman Sachs Effective Lockdown Index (ELI) remains near its lows at 8.1, despite the fact that the percentage of US hospital beds occupied by COVID patients has surged form 2.2% in June to 13.9% in August. The ELI peaked at 54.3 in 2020.
Take the long view: Look at what's driving markets
How do we navigate all these unknowns? My approach is to take the long road. The older (and wiser) I get, the more I realize that worrying about every wrinkle in the market cycle is a waste of my mental and emotional energy.
It's hard to see the big picture if I'm constantly fretting over the small stuff. After all, most of our mental gymnastics are just ruminations of the ego mind. I used to frantically try to time every little inflection point, until I realized that there's an inverse correlation between the clarity with which I think and the time spent staring at flickering lights (unless they're at Burning Man).
For me the strategic questions are: What are the broader forces that have shaped the current investing landscape, and when and how will they change?
In my view, the structural drivers of today's market are:
- Demographics and the resulting need for income, which has led to very low rates and, therefore, higher equity valuations (as investors search for yield)
- Ultra-low interest rates resulting from the massive debt load
- The ability of large-cap growth stocks to produce the cash flow that investors are searching for
These 3 drivers produced the secular bull market (in stocks and bonds) that we are in now, and could well remain in for another 5-7 years. These drivers explain much of the market's behavior of the past 10-plus years, and (in hindsight) have provided a useful roadmap to keep investors on the right side of the markets when things go upside down.
While many investors focus on the traditional P/E ratio (especially, the sky-high Shiller CAPE*), in my view the valuation metric that matters most is price-to-total-cash (dividends + buybacks). If cash flows are what are being rewarded by investors, then what we pay for those cash flows should be the metric.
By this metric, at 34x the S&P 500 is no more expensive than where it was at this point along the previous 2 secular bull markets. Ultimately, this ratio went to 40x at the top of the 1949–1968 bull market and to 60x at the top of the 1982–2000 bull market.
Interestingly, the chart above suggests a timeline of another 5–7 years before the secular bull market ends. That's the peak of the demographic trend as well as the peak in the price analog.
Interest rates and inflation
But what will happen to interest rates now that inflation is running hot and the Fed is soon tapering? Cyclically, there is probably more upside than downside for bond yields in the coming months (for the reasons mentioned earlier), but over the long-term the trend in yields remains firmly "down and to the right."
Perhaps the secular trend will change soon (an argument that I have heard many times over the years), but I'm not betting on it. Japan is a decade ahead of the US in terms of demographics, and their long-term yield is zero. The Bank of Japan has tamed its bond market, and the Fed may well do the same, despite what it thinks it will do over the medium term.
Even if the current rise in inflation turns out to be structural rather than transitory, that doesn't mean nominal yields will automatically go up. For a highly indebted economy that is levered to low rates, it's easier for me to envision a repeat of the financial repression regime of the 1940s (negative real rates) than a return to the hawkish late 1970s (high real rates).
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.