STRATEGY: Stocks rallying because incoming data increasingly matching Fed view of “patience on rates”
3Q2021 productivity drops to lowest in 40 years: not viewed as inflationary –> proof market moving towards Fed view
Productivity in the US (essentially gap between GDP and labor cost change) dropped to the lowest in 40 years, coming in at -5%. On the surface:
- this is mathematically due to “weak GDP”
- but historically, falling productivity means labor markets heating up
- thus, is normally an inflation signal
Yet, there was no “inflation” reaction in markets:
- 10-year yield fell –> not inflation reaction
- Fed futures show decline in odds of a hike –> dovish reaction
- Cyclical stocks rally –> no “hike” in sight
Futures market see diminished odds of a Fed hike in 2022
In fact, take a look at the probabilities of a Fed hike in June 2022 (we picked mid-2022 for reference) and you can see the odds of a hike have dropped sharply in the past week.
- During September, as inflation fears surged
- Odds of a June 2022 went parabolic
- In past week, these odds are falling sharply
In other words, the market is beginning to agree with the Fed.
BofA and JPM credit card data shows pent-up demand is alive and well –> Epicenter top-line upside
This week, there have been multiple signs that an acceleration of consumer demand is coming. Below is data from BofA credit cards and you can see that travel and services spending:
- Travel spending (airlines + lodging) is growing at 10%-plus
- This is the fastest pace in 2021
- The inflection happened after September
- Just as Delta-variant surge peaked
This is a reminder that COVID-19 trends are having a real-world impact on consumer behavior.
…JPMorgan CC data shows that consumer spending is above 2019 levels
Similarly, the magnitude of this consumer spending recovery is evident below. Credit card spending (CC) by JPMorgan cardholders:
- Spending is +20% versus 2019
- Spending is +5% versus pre-COVID-19 levels
- Acceleration took place after September 2021
By any measure, consumers are embarking on a spending surge, following a decline associated with the Delta-variant surge. At a minimum, it is a reminder that we are not at “peak everything” for consumer spending.
STRATEGY: Year-end rally got “gasoline” this week –> Two things incremental this week: markets beginning to agree with Powell’s view of transitory + Margins to surge +200-400bp past ATH
In the past week, two things stand out:
- Financial markets seem to be starting to agree with Fed view, that inflation risks are transitory (let me explain)
- S&P 500 operating margins are showing little signs of peaking
The dual combination of this strengthens considerably the case for a “everything YE rally.” After all, the case for the stocks to rise is fundamentally stronger:
- not just the “seasonal case” which is strong
- S&P 500 margins expanding = falling equity risk premia + higher EPS
- higher EPS = stock upside
- lower risk premia = P/E expansion
- Fed being patient = falling rates
- falling rates = P/E expansion
So you can see the dual benefit of this improvement in the perception around market risk/reward.
Was this the most important statement from the Fed?
The FOMC press conference on Wednesday was a pivot point for markets. And while many key announcements and statements were made, including the tapering announcement, I think Fed Chair Powell’s most important statement is below:
Powell is making an observation that is logical. It is a multi-part view and something we have written about previously:
- Inflation is visible in the economy now
- Bottlenecks are driving higher prices, given high demand
- Labor markets are also tight now, leading to wage increases
- This tightness, however, is not due to the ‘Philips curve’
- Powell noted the low “employment to population ratio” –> lots of supply of labor out there
- COVID-19 risks, taking care of someone with COVID and other factor keep labor sidelined
- This means, inflation is not due to lack of economic slack
In other words, does it make sense to tighten monetary policy if there is slack in the economy? In fact, Powell stressed that achieving “maximum employment” is a stronger focus for the Fed.
- This make sense
- Take a look at the capacity utilization of manufacturing and of labor below
- Capacity utilization of assets is only 75%, generally a recession reading
- Employed to population ratio (Labor utilization) is only 59%
- This is the same figure as it was in 2010
Until labor participation recovers, there is plenty of labor slack
Would the Fed have tightened in 2010? It would not have made sense back then. And it would not be appropriate today. The takeaway, in our view, is that until labor participation rates recover, there is plenty of slack.
MARGINS: S&P 500 operating margins at all-time highs and could rise 200-400bp further
S&P 500 operating margins reached an all-time high in 3Q2021 as shown below:
- Operating margin reached 15%
- This is approximately EBIT margin
- Prior ATH was 14% in 2008 and 2014
- Current margin is already +100bp higher
For reasons discussed below, we think S&P 500 margins will surge further from here.
Recall the words of Nietzsche — that which does not kill us makes us stronger.
Before I give our rationale for rising profit margins, there is a key event that impacted all corporates in 2020. They all faced extinction risk as the global economy shut down. Moreover:
- in 2020, no biz had any visibility into 2021 and beyond
- topline collapsed for many companies
- every business “circled the wagon” and re-engineered their processes
- since 2020, every business has faced the risk of constant interruption
- since 2020, every business has faced constantly changing gov’t policy
- since 2020, every business has faced uncertainty of its workforce
This was a depression that no business has seen in 5 generations, or basically since the start of the industrial revolution. Thus, every company in the S&P 500 had to assess how to navigate in this environment.
…Despite surging unit labor costs, margins surging –> PPI is a leading indicator for margin expansion
The chart below is a bit confusing, but shows 3 things:
- Unit labor costs –> 40% of service industry expense
- PPI inflation –> similar to CPI but the inflation for producers
- S&P 500 operating margin
Notice something?
Every surge in PPI has been associated with surges in S&P 500 operating margin. While, at first glance, this sounds counter-intuitive, there is some logic to this:
- inflation happening now while demand robust
- companies therefore “pass through” higher costs
- inflation results in inventory holding gains (buy at lower price, sell at market)
- cost of debt is low, given monetary policy
- in 2021, companies are managing costs stringently
- this is apparent in 3Q2021 calls
Therefore, higher PPI is leading to higher margins.
…ATH margins seen in Discretionary and Technology in 2010 –> mistake to “fade that”
I know there are many who believe in “mean reversion” — therefore, they see all-time high in margins and want to sell that. This would be a mistake, however:
- in 2010, Consumer Discretionary margins hit an all-time high
- the collapse stemmed from the Ch. 11 collapse of GM during GFC
- in 2010, Technology margins hit an all-time high
- this after struggling for a decade post-Internet bubble
…Since 2010, Consumer Discretionary margins further expanded +1,000bp and Technology +400bp
Look at how margins have since progressed for both sectors since 2010:
- Discretionary margins surged to +1,000bp further to 25%
- Technology margins surged +400bp further to 11%
In other words, it would have been a mistake to fade those margin ATH!!!
2022 EPS: Consensus too low at $220? Could EPS be $240 or higher?
Here is the simplest way to contextualize margin upside risk. Take 2022 Consensus EPS:
- Street looking for $220 or so
- Operating margin of 14%
- What if margins are +200 to +400bp higher?
- 2022 EPS would be $256 to $289
- Wow
In other words, S&P 500 EPS could really surprise to the upside in 2022. There are some reasons for this:
- 2022 EPS of $240 means
- Demand surprise –> Global economy recovers?
- Margin surprise –> supply chain glitches ease?
- Margin surprise –> labor shortage eases?
- Margin surprise –> cost re-engineering?
Implied 18.5X 2022 P/E is not that demanding
At $240, S&P 500 is 18.5X 2022 EPS. This does not seem demanding to me:
- 10-yr P/E is 65.5X (inverse of 1.56% yield)
- Investment grade P/E is 47.6X (inverse of 2.1%)
- High-yield P/E is 23.4X (inverse of 4.27%)
So how is an 18.5X P/E for equities expensive? Also, remember many Energy stocks trade at 3X P/FCF. So there are many sectors well below 18.5X.
BOTTOM LINE: Even if Fed announces “taper” this might be inline with market expectations
I realize it feels a bit consensus to be expecting a year-end rally. And it is better when there is a “wall of worry” to climb. The Fed and FOMC could inject some needed worry into the markets. And to an extent, this is a good thing, as long as underlying fundamentals are positive. Still, there are some reasons to remain positive:
- Market is broadening (above)
- Market has positive seasonals (above)
- Economic momentum is broadening as more nations open
- US vaccination efforts are expanding, with boosters and children
- Overall confidence of consumers is strengthening = improved spending
That said, we could see some short-term turmoil around the FOMC. But we would be buying that weakness. Our recommended strategies are:
- Energy
- Homebuilders (Golden 6 months) XHB -0.45%
- Small-caps IWM -0.03%
- Epicenter XLI -0.02% XLF -0.12% XLB -0.10% RCD
- Crypto equities BITO 2.31% GBTC 2.36% BITW
Into 2022…
– Industrials
Figure: Way forward ➜ What changes after COVID-19
Per FSInsight
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
