Markets rallied sharply yesterday, essentially recovering what they lost on Monday. As we keep repeating, the major characteristic of a market in transition is heightened volatility. This week’s action to date certainly puts an exclamation point on that statement.
In terms of the economy, not much has changed since last Friday. As the Covid-19 Delta variant wanes, growth starts to look a bit firmer. It would be even better without supply chain bottlenecks, but most of those will improve over the next twelve months. As they do, some (not all) of the current inflationary forces will fade as well.
On the political front, Democrats found out last week that trying to get everyone, progressive and moderate, to agree to spend almost $5 trillion isn’t going to work. There are some who will advocate gamesmanship and simply shorten sunset provisions to make the package seem palatable with a small but fictional top line number. That has no chance either. The reality is that Democratic leadership is going to have to do some hard pruning. They should. Whatever passes will be better with at least some of the excess fat sliced away. While Speaker Pelosi now sets an October 31 timeline to pull everything together, don’t expect that to happen. Even the President acknowledges that it could take weeks or months to come anywhere near the finish line.
With the spending and tax bills now off the front burner for a moment, the focus shifts to the necessity to raise the debt limit. Forget the arguments of the Republican and Democratic leaders. The reality is that Democrats control the White House and both chambers of Congress. This is a problem they can solve on their own. They may not want to, but here’s the stark fact: If the ceiling is raised, no one is going to care who did it or how it was done a few weeks from now. If it isn’t raised, the Democrats will shoulder most of the blame because the whole world knows they can get it done on their own. Thus, they have absolutely nothing to gain from brinksmanship except to try and score political points. If leadership can’t figure that out, markets will tell them loudly over the coming days. Treasury Secretary Yellen’s deadline is October 18, a week from Monday. It will probably take the Democrats about a week, assuming no obstacles, to get the ceiling raised. If next Monday or Tuesday there are no signs of progress, markets will speak loudly. For all these reasons, any logic suggests the Democrats and the President will relent from this foolish fight before then, but nothing is certain until it happens. Just over a decade ago, a similar battle that went to the edge resulted in S&P lowering the credit rating on U.S. debt. The Vice-President at that time was Joe Biden. I am sure he remembers that.
The assumption, therefore, is that (1) the debt crisis will end within two weeks, and the fiscal spending battle will take a back seat until about Thanksgiving, until every Democrat falls into line. There are two certainties: the final package will be a lot smaller than progressives want, and (2) many of the important details, especially on the tax side, will change between now and then.
Thus, once the debt issue is cleared up, attention reverts back to the economy. The good news is that growth in Q4 should show signs of improvement as the Delta variant’s impact fades. As for supply chain problems, they have been more persistent than most expected just a few months ago. They will take quite a bit longer to solve than most believe, but supply and demand will rebalance. Supply will grow. As for demand, no one really knows how much double and triple ordering is going on today. Look at the housing market. The frenzy of last spring brought a lot of new supply to market, and more is coming this Fall. While the market for new homes remains tight, demand overall is more balanced. Over the past year we have seen shortages of everything from toilet paper to ketchup packets come and go. The important thing is that the situation is likely to be a lot better 6-9 months from now than it is today. Markets like improving trends.
Two big questions remain: What happens to the bond market and interest rates when the Fed stops buying bonds? And what is the likely inflation rate as we cross into 2023? The correct answers to those two questions will tell you where the 10-year Treasury bond yield will be. Right now, consensus is in the 2.00-2.50% range. I doubt that range is too high. If it is low, the question is how low?
Fundamentally and logically, assuming no more Covid-19 surges, the economy should be getting back to normal by 2023. That means growth will be more a function of demographics and production, less dependent on fiscal and monetary stimulus. That would suggest real growth of less than 3%, nominal growth of 5% or more, and inflation in the 2-3% range. Earnings per share in 2023 may approximate $250 for the S&P. If interest rates and P/Es normalize, the P/E on forward earnings could be about 17. That would be a bit higher than history would suggest, but given the domination of tech companies at the top of the S&P 500, a higher-than-average multiple makes some sense. Doing the math yields an S&P target a year from now not far from where the market is today. For it to be materially higher, either earnings must be much higher than $250 or interest rates must be near 2% or below. Conversely, lower earnings and/or higher rates would set us up for a weaker than expected market.
While earnings have grown rapidly, the real thrust since the Great Recession has been a steady decline in interest rates against a backdrop of virtually no inflation. Growth over the past dozen years has chipped away all the excess capacity. That, in part, contributes to today’s supply chain problems. The two biggest factors that impact inflation are shelter costs and wages. In both cases, it appears tight supply ensures higher inflation than we have witnessed in over a decade. If that persists, markets are likely to have difficulty making a lot of headway over the next year or two.
Actress Elisabeth Schue, of Karate Kid fame, is 58 today. Clemson Tigers football star, Trevor Lawrence, is 22.
James M. Meyer, CFA 610-260-2220