Stocks fell modestly yesterday after Senate Majority Leader Mitch McConnell delayed a vote to raise stimulus payments to $2,000 each. Instead, he called for a debate on the issue, as well as the fate of two other controversial topics the President favors but Congress does not. Mr. McConnell has not made it clear how he will present the measure for a vote, or if he will even allow a vote. The mood of the Republican caucus will most likely dictate whether there is a vote or not. The majority hasn’t supported a payment higher than $600 in the past. But the Georgia Senate runoff elections are next week. A vote against the measure, or no vote at all, may harm the chances of Republicans in the two races, even though both endorsed raising the payments to $2,000. An empty endorsement won’t help if Republicans scuttle the increase in the Senate. Whether raising the payments is a good or bad idea is somewhat irrelevant to the election. What is relevant is what the voters want. It would seem clear that more voters would want to receive $2,000 than $600. Thus, if the increase passes with support from the two Republican candidates, the issue would no longer be an election talking point. If it doesn’t pass, the Republican candidates will have to defend their party’s position regardless of how they feel personally. Timing is everything.
The payments, if made, would boost 2021 GDP forecasts. They have already been increased as a result of the passage of the stimulus bill containing the $600 payments. How the money will be raised (more borrowing) is a subject to be deferred to another day. With interest rates at or near zero, the cost to service our monstrous debt levels isn’t critical. What happens if rates rise is simply tomorrow’s concern to today’s market.
As 2020 ends, it is worthwhile to look at where we stand. A year ago, I suggested the S&P could rise potentially to 3200-3500 for reasons that became irrelevant once the pandemic struck in mid-winter. Earnings will end up nowhere near what I had suggested a year ago, while interest rates, thanks to central bank action, are much lower. As of last night’s close, the S&P 500 stood at 3727, near its all-time high, thanks to the benefit of low rates plus increasing optimism that the pandemic’s impact will fade noticeably come springtime with the broad arrival of effective vaccines. Earnings forecasts for 2021, which hovered around $160-165 just a few months ago, are inching up to $170 or even a little higher. To put that number in perspective, in 2019 the earnings were $163. Thus, forecasts for 2021 now show a full earnings recovery (not necessarily a full GDP recovery) within a little over a year, despite the fact that significant GDP sectors, like travel & leisure, will still be operating at a fraction of 2019 levels. With that said, a year from now hopefully most of us will be able to celebrate a festive and normal New Year’s Eve, plan our vacations without fear of pandemic, and fill football stadiums every Sunday.
While earnings recovery centers on how much and how quickly, the forecast for interest rates is hazier. Long rates are the key for stock prices. Right now, the 10-year Treasury yield sits just under 1%, while the 20-year yield is a bit under 1.7%. These rates key off of inflation expectations. For parts of the economy, hit hard by the pandemic, excess supply almost certainly dictates that pricing power remains with the buyer. That keeps rents low, for instance, and rental payments are a big component of the consumer price index.
On the other hand, returning demand, rising faster than supply, will push prices higher in other sectors. We see that most vividly today in housing prices. But it also shows in commodities, from timber to iron ore to oil. Thus, any accurate inflation forecast needs to resolve the clash between economic segments stuck in a world of excess supply and those benefitting from strong demand. While most forecasters predict some increase in inflationary pressure in 2021, few see it being a significant factor, at least in the first half of the coming year. They point to capacity utilization still hovering around 80% or less, with way too much money already sloshing around looking for a home. The inflation we have seen to date has all been in the value of financial assets. It is now extending to non-dollar currencies. Eventually it is logical to extend to consumer prices themselves. But for that to happen, robust demand has to return and that won’t happen until the pandemic ends.
If there is a marker, perhaps it relates to Fed action. Right now, the Fed is committed to buying over $100 billion in bonds each month to support economic growth. It sees the current rate of inflation lagging its 2% long-term target. It believes more bond purchases can and will stimulate enough demand to lift inflation above its 2% target. It has expressed a willingness to let inflation sustain itself at a pace higher than 2% for some period of time before reversing course and ending its bond purchase program. That is certainly unlikely early in 2021. Even if inflation were to rise above 2% tomorrow and stay there, no Fed action would take place for many months.
But markets look ahead. To make a yearly market forecast requires investors to look into their crystal balls and see where inflation expectations lie a year from now. Does the pandemic disappear by mid-year, or do residual fears still impact how we act a year from now? When unleashed, do we go on a spending spree, and have we changed behaviors during the pandemic that will prove to be lasting? Most importantly, when does the Fed stop buying bonds?
When the Fed was last on the sidelines, 10-year Treasury yields centered around 2.5% and P/Es were 16-17 times forward earnings. If 2022 earnings could reach $190-200, and I use the higher end of both the P/E and earnings ranges, that would suggest a target of 3400 or about 10% below current levels. However, assuming the Fed remains active and P/Es are 20-22 for a sustained period, the S&P can rise to 4000-4400.
Another factor is the change in Presidents. Right now, markets seem satisfied with Biden. That could waiver next week if Democrats win both primary elections. Such a win would increase the odds for some form of tax increase next year. But a 50-50 Senate isn’t likely to support a very progressive agenda. Based on cabinet choices to date, Mr. Biden isn’t taking an overly progressive stance so far. And with a pandemic still raging, now is hardly the time for broad tax increases. Will taxes rise for the very wealthy? A Republican win in one or both of those races would likely reduce the chances. At the same time, a loss in both doesn’t guarantee it. As for the stock market, it keys off of earnings, not individual tax rates. The rate markets care about is the corporate tax rate. Getting 50 Senators to agree to raise those taxes isn’t impossible, but it will be a challenge.
Putting all this together, it would appear markets will have many fewer headwinds in the first half of the year. The Fed will still be providing active support. The government will be spending to provide pandemic support. The current viral surge will end as the weather starts to get warmer. The impact of vaccines will start to kick in. Earnings, therefore, should rise faster than interest rates. The path toward 4000 is clear. But if a strong economy brings more inflationary pressure, if 10-year Treasury yields move past 1.5% or maybe even past 2.0%, then P/Es above 20 won’t be sustainable. Stock and bond markets can move in opposite directions for only so long before a correction sets in. Long term, P/Es above 20 are only sustainable if rates remain near historic lows. That is only possible if inflation remains absent. And that is unlikely with rapid Fed bond purchases and money supply growth near 25%.
With so much debt outstanding at all levels, keeping rates below normal is key to long term happiness. While the Fed verbalizes letting inflation run hot for a while, letting it run away would be a disaster. The Fed wants a strong economy but not an excessively strong one. That dilemma will be more in focus a year from now. Thus, without making a firm prediction for the S&P at the end of 2021, I believe the market’s performance in the first half of the year will be better than in the second half. At the same time, I believe economic momentum will increase throughout the year in conjunction with a fading pandemic. The market could end the year as low as 3300-3400 should interest rates return to their 2010-2019 range, or as high as 4400 if inflation remains where it is today for another year or more. The key is all about inflation expectations, not earnings. When those expectations shift, headwinds will start to increase for equity investors. Note I have not used the recession word once in this note. Any correction will relate to valuation, not the economy. Valuation corrections can be large, but they are rarely long lasting.
Have a very Happy New Year. 2021 can only be better than 2020 for everything not related to the stock market.
Today, Carson Wentz turns 28. LeBron James is 36. Tiger Woods celebrates his 45th birthday.
James M. Meyer, CFA 610-260-2220