by Jurrien Timmer, Director of Global Macro, Fidelity Investments
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
Fall Colors
We are racing into the fourth quarter, and between earnings season, the Fed, China, geopolitics, and the election, there is plenty to keep us busy. As always, the key is to capture the narrative of the market amid a sea of signals and noise.
Bullish Broadening
For equities, the bullish march continues. The bullish broadening continued last week, with both the cap-weighted and equal-weighted S&P 500 making new all-time highs.
Breadth is healthy, with 80% of stocks above their 200-day moving average. And as the daily chart shows below, last week produced a nice breadth thrust in terms of new highs.
Below we see that the baton is being passed from the Mag 7 to the broader market without knocking down the overall index (as happened in July).
Not like 1999
I think there are two reasons why the broadening so far has been fairly benign. One: while the leadership has indeed been narrow, it’s much less so than was the case during the late 1990’s. Back then, the index went up while most stocks went down. This time around, most stocks are going up, just not as much as the mega growers. It’s the distinction between absolute breadth and relative breadth. Two: as the chart shows below, the Nifty Fifty are only 25% more expensive than the bottom 450. At the dot.com top in 2000 (as well as the Nifty 50 extreme in 1974), that spread was 100%.
Earnings Season
Earnings season is now underway, and with 72 companies reporting so far, 76% are beating estimates by an average of 620 bps. As the weekly squiggles chart shows below, estimates are generally coming down. This is normal, of course, but it shows that while earnings are still growing, they are no longer accelerating. The earnings cycle is maturing.
Dufecta
The US stock market has benefited from a rare combination of growing earnings and expanding valuations. This typically doesn’t happen at the same time, but when it does, the rallies get extra powerful.
A nuance in the above chart is that the valuation side continues to be driven by the mega growers. The chart below shows the price to free cash flow (FCF) ratio for both the cap-weighted and equal-weighted S&P 500. The mega caps have now reached a new cycle high in terms of valuation, while the rest of the market remains closer to its historical range.
China Stimulus
In recent weeks, the broadening has gone abroad, namely to China. That has put both China and EM at or near the top of the leaderboard (which shows rolling 3-month returns).
Chinese equities have given back some of the recent gains as investors await the next policy actions, but given that past stimulus rallies have produced at least 5 P/E-points in gains, this one just seems to be getting started.
Policy Normalization
As for the Fed, the market and the Fed seem to be on the same page in terms of expecting only a moderate pace of rate cuts into the end of this year and for 2025. It’s really just a normalization of the restrictive policy stance, rather than a full easing cycle. I still think that 3.5-4.0% is a reasonable target zone for a soft landing.
What happens to the Fed’s balance sheet, however, is another matter. The Fed has made it clear that the Quantitative Tightening (QT) will continue, even as rates are now coming down.
Balance Sheet Gymnastics
One of the reasons for this restrictive stance (presumably) is that the banking system remains awash in reserves, at a time when fiscal policy is expansive and the central banks around the world are cutting rates. In the US, bank reserves are down from their COVID peak of $4.19 trillion, but remain higher than before the pandemic.
It has been a strange journey for the Fed’s balance sheet. On the surface, one would think that an almost $2 trillion runoff could have been devastating for a liquidity-driven market, but that has not been case. The reason lies in the obscure plumbing of bank reserves, reverse repos (RRP), and the Treasury’s cash balance at the Fed (TGA).
The chart below shows the change in the Fed’s system open market account (SOMA), RRP and TGA, from the start of the Fed’s tightening cycle in 2022. The Fed’s SOMA is down $1.9 trillion, but this has been mostly offset by the other two factors.
This has resulted in a liquidity profile that has remained relatively neutral despite the Fed’s actions.
These offsets go a long way in explaining why the market has been able to ignore ongoing balance sheet tightening this year. With liquidity conditions stable, the market has instead focused on rate cuts, which are now getting underway.
Another Liquidity Wave for 2025?
As the next chart shows, the RRP program is now down to $260 billion (from a peak of $1.8 trillion), while the TGA has been replenished to $829 billion (up from zero during the debt ceiling drama in 2023). It remains a big question what will happen next year if another fiscal cliff is looming.
If that forces the Treasury to take “extraordinary measures,” then it might start spending down that TGA account again. That would inject liquidity into the system, as it did in the first half of 2023 (offsetting the Fed’s balance sheet runoff).
One might think of spending down the TGA as a form of backdoor QE. If it happens while the Fed is cutting rates and fiscal deficits continue to grow (the current one is already $1.8 trillion), then it’s easy to see the markets awash in liquidity next year. Indeed, this is the signal from the broader market, as well as gold and bitcoin.
Fiscal Dominance
The topic of fiscal dominance remains relevant as we anticipate the election in just a few weeks. The government already spends $1.1 trillion on debt service, and the deficit and debt will likely continue to grow, regardless of the outcome in November.
For the bond market, the Fed’s role in an era of ongoing fiscal expansion makes a difference. The 10-year Treasury has a term premium of only 13 bps, which seems low against a national debt that is $36 trillion and climbing rapidly.
Sweep or Gridlock?
As for the election, we will find out (hopefully) soon enough what kind of government we will have next year. The two main scenarios so far have been considered relatively benign for the markets: either a Republican sweep or a Democratic President with Republican-controlled House and Senate. But a third scenario is increasingly emerging: a Republican President with a Republican-controlled Senate but a Democrat-controlled House. That outcome could dampen the prospects for legislative changes, especially the extension of the 2017 tax cuts.
The chart above shows the 2-year return for the stock market, from Presidential election to the subsequent mid-term election. On the left are all 2-year periods, in the middle are the sweeps, and on the right are the gridlocks. Since 1900, sweeps have been mostly bullish, regardless of party, while divided governments have been more mixed (especially for the Republicans). For the Republicans, the batting average is 4 out of 7, and for the Dems it’s 3 out of 4. It’s a small sample size, and of course there are always much larger forces in motion at play (GW Bush during 2008, for instance).
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