#1022 - Is the Bull Run for Stocks Over? | With Jurrien Timmer

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1:12is the stock bull run over hi everyone welcome to the real vision daily briefing i'm maggie lake with me today is irian timmer director of global macro at fidelity investments hi irian it's great to have you with us today thank you for having me it's a pleasure so we started that the the show with that question as a nod to the fact that we figured that it's what everyone must ask you as you're making your way across the country, talking to all sorts of investors and clients of Fidelity. But if we look at today, we had a bit of a mixed picture for stocks. The main indices managed to stabilize after some early selling pressure because, of course, everyone's watching treasury yields.

1:52They're higher once again. So let's start really with that. What do you what are you expecting for yields? How closely are you watching them and what do you think the trajectory is from here? Yes, it's a great question. And before I answer, I would just mention that going back to the year 1900, if we add up all the days that the S &P or whatever the stock market was in question at the time was in a state of drawdown of at least 5%, you get to 65 % of the time. So when the market goes down 5%, 6%, as it did over the last few weeks, it's just something to keep in mind. Also, this 6 % drawdown came after a 28 % rally from October 27th of last year until March of 28th of this year in a completely straight line without any correction.

2:46So it's always good to kind of - A little perspective. A little perspective. But your question hits the nail on the head because bond yields are the epicenter for the markets. And that's something that changed or that started to happen in 2022, of course, when we had the big rate reset, when the Fed went off to zero bound, inflation was a clear present danger, and the Fed raised 525 basis points, bond yields rose dramatically, duration and convexity, which are sort of bond geek things. They matter for stocks, too, because when you plug in rates into a discounted cash flow model and they come off of a very, very low base and they rise substantially, it really affects the present value of future cash flows, which is how we value any asset, including equities and bonds.

3:38And so to me, rising yields are the thing that are most likely to give the stock market a wobble here. It's what happened last October when the S &P fell 10 % from its then cycle high. And that happened because the bond yield, the 10-year, went to 5%. And so right now we're about 460 or so. We went to about 470. But at the beginning of the year, we were at 3.78%. The two-year yield was at 4.15 because the market was way over its skis in terms of the number of rate cuts that were expected. Today, the two-year is around 5%. And we have to go back to the old days of the Alan Greenspan Fed model, you know, back in the 80s and before to really kind of look at the market through this new lens, or at least in my view, it's a new lens.

4:38So no longer are we in a period where falling yields are the problem because we have deflation risks like we did during the financial crisis. now it's rising yields because they pressure equity valuations. Now, that doesn't mean the stock market has to go down necessarily. It just means that it has an inverse effect on the P-E ratio. And the good thing about the stock market right now, and why I don't think that the rally is over, is because earnings are now growing at 12 % year over year, which is something we could not say last October when it was the last time that the market wobbled because of rising yields.

5:18Again, you put the numbers into a discounted cash flow model, earnings in the numerator, the cost of capital in the denominator. When the numerator isn't growing, a change in the cost of capital will have a larger impact on valuations than when earnings are growing. And so that provides a good underpinning for the market, 6 % wobbles and all. So what is supporting the earnings growth right now as opposed to what we saw in the fall? What's changed? Earnings are growing. So earnings fell very modestly last year, about 2.5%. It's my sense that we've all been waiting for this recession because of the inverted yield curve, etc.

6:03But you could argue that we had sort of a mini almost recession in sort of the second half of 22, the first half of 23. The PMI was under 50. There was a drawdown in excess labor demand. And all of those things have now sort of passed. The PMI is back above 50. The employment data are pretty good. The consumer data are pretty good. So the economy has recovered from this almost recession, let's put it that way. And profit margins are rising again. So last year was really about falling margins, 2022 as well. Revenues per share, at least in nominal terms, never even fell last year. It was just earnings per share.

6:48And so margins are now improving. And whether it's just a broadening economic cycle or whether this is the AI story, although it's probably a little early for the AI story. But regardless, Q4 earnings season was an important one. So that was last quarter because the earnings beats. Earnings always beat. It's kind of the oldest game in town. Companies like to lower expectations and then beat them. So there isn't necessarily a signal in that. But the degree to which by which those estimates are beaten, there is a signal there. And the beat was large in Q4. And right now, of course, we're in Q1 earnings season.

7:31And as of last Friday, only about 77 stocks reported. So it's still a little bit early. But there's been a fairly broad lift in economic activity and therefore earnings activity. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Today's Real Vision Daily Briefing is brought to you by Chintai, your partner in asset tokenization. Licensed and regulated by Singapore's monetary authority and powered by the innovative Chex token, Chintai offers a compliant, one-stop solution for bringing real-world assets on chain.

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10:00That's so interesting. So what do you think that says about the economy, about the U.S. economy? The economy is resilient. I mean, there's no other way to put it. I mean, we've had and still have, you know, the biggest yield curve inversion ever. And, you know, you never want to say this time is different. But, you know, this economy post-COVID has been a hard one to sort of pigeonhole because we've never, other than the 1940s, we've never seen this kind of double-barreled fiscal and monetary policy response. And one of the reasons why I think we have this resilience, there's a number of reasons, but one of them is that consumers and corporates termed out their debt back in 2020 and 21.

10:43So if you were sitting on a fixed-rate 30-year mortgage at under 3%, what the Fed does may not affect you as much than if you're in a variable rate mortgage, which a lot of people were in before the pandemic. So same thing with high-yield corporates. They termed out their debt. And so that makes the economy less interest rate sensitive. And of course, the fiscal side has been very important as well. I mean, liquidity has been growing. The monetary base is up 11 % year over year, even though the Fed is supposedly very restrictive. And so part of that is fiscal. the government's running 7 % deficits in an expansion time, which is, you know, unusual.

11:30Janet Yellen at Treasury is being very clever in how she is managing the debt, right, shortening the maturity of issuances. It's almost like she's doing QE for the Fed, even though the Fed is doing QT. So there's a lot of different things going on that has allowed the economy to really be resilient. And the other larger question that we can't really prove or disprove in real time is that the whole premise that the Fed is restrictive assumes that a neutral rate is maybe 3%. Well, maybe it's not 3%. Maybe it's 4 % or 5%. And so maybe the Fed actually isn't that restrictive or at least not as restrictive as maybe we all think it is.

12:17and therefore they haven't inflicted enough pain on the economic cycle to slow it down. So there's a lot of variables that - Yeah, a lot of moving parts, right? And there's a little bit for everyone because even today we had S &P flash PMI was a four month low, durable goods outside of transportation, didn't look particularly strong. So for those who think, oh, it's finally coming, you can kind of have something to hang your hat on. But then there are all these other indications that you mentioned that show an economy that's in really good shape. So what's the risk here? What are you concerned about?

12:52Well, I mean, obviously, where do you start? Where do you start? There's always geopolitics. Of course, we can't certainly can't dismiss that. And I get asked that question a lot. And, you know, the very detached, cold hearted answer is that if it's not systemically important to the economy and earnings and interest rates, then it really doesn't require a change in terms of expectations. Of course, it's systemically important in a lot of other ways, but as investors, we have to kind of remain detached and focus on the math. And so earnings inflected last year in the third quarter, so we seem to be still fairly early on in the earnings upswing cycle.

13:39So they could always start to falter. But to me, that's not the most probable scenario. The most probable scenario, it's not really economic. But again, it's coming back to the markets and interest rates. To me, the greatest risk to the equity rally, which I think is still in about the seventh inning or so, if we count the start in October of 2022. But to me, it is yields, right? So we've gone from 3, 7, 8 to now 4, 6, 4, 6, 5, completely on the back of real rates. And so that doesn't even count a possible return of the term premium, which is the risk premium that investors supposedly demand when they are committing money for the very long term.

14:28And like any risk premium, it should be positive. but it's been negative over the past decade or so because of the heavy hand of central bank policy. And so we're at 465 without any help from the term premium, which is still around zero. And so if the term premium were to rise in addition to real rates rising, the 10-year could be at 5 % before you know it. And the last time that happened, the stock market fell 10%. I think it's on better footing now because we have earnings now playing their part, But it still highlights this, what I would call a baton pass from the valuation phase of a rally to the earnings phase.

15:11And it doesn't always happen smoothly. And the S &P has rallied six points in terms of the PE from October 2022 to the most recent high, from 15 times forward earnings to 21.2 times. We're down at about 20 now. And so it makes sense that we're wobbling and maybe that wobble extends to 10%. But I think the economic cycle remains in good shape. But you raise a good question. And that is that the scenario that certainly no one was talking about three months ago, but that some people are talking about now is, what if the Fed actually isn't done raising rates? Like, what does that do? And I think they're done.

15:58I think the Fed believes it's done. We would need for TIFF's break-evens to accelerate for, I think, for the Fed to get worried that inflation expectations are getting unanchored. And the five-year, five-year forward, TIF's break even is like a 2.4. So there's not much to see there. But if that were to happen, if inflation started to reaccelerate and inflation expectations started to get unanchored, then the Fed would have to raise rates again. And then you worry about maybe this time they go far enough that it actually does unravel the economic cycle. And one interesting period in history to consider in that regard is the second half of the 1960s.

16:41So this goes back a while. But the second half of the 60s bears some resemblance to the last four years or so because back then we had guns and butter, Vietnam War, the entitlement spending programs under President Johnson. We've had sort of the war on COVID. We obviously have massive spending on all kinds of things, including now debt service. And back then, we had social unrest. We had kind of a tech boom in 68. So there are some similarities. But the one that's, I think, very interesting is that in 66, the market wobbled, the economy started to weaken, and the Fed pivoted. and it turns out it pivoted prematurely because it did not appreciate the inflation risk that was already lurking and it had to walk back that pivot and then raise rates some more and we didn't have a recession in 66 to 68 but we did get the one in 1969 and 70 and so it was a matter of recession delayed but not averted and and so again it's one one episode in history but it's one that I think of because the fiscal policy, the fiscal dominance was certainly in place then, and it is now.

17:58And I think the Fed hopefully is looking at that period and say, we don't want to repeat that mistake. And that's why the Fed has been leaning more hawkish recently. Yeah. And I always wonder if the setup's the same, but now you layer on that so many people connected to the markets through technology, information flows so fast that does everything things speed up. So what would have been a recession turns into something else or a correction just accelerates because once you start that move, you just have the momentum of it. Because we've seen more of that. Everything seems a little bit more reactionary and extreme.

18:38And by the way, and I think that the Fed, not to be critical of the Fed, but the Fed plays a role in that, right? Because it now has all this forward guidance, right? The dot plot and all these statements, all these speeches. I mean, that never happened under Greenspan. Greenspan was purposely very opaque. And he famously said something like, if you think you understood what I just said, then I'm not expressing myself very well. But the financial crisis and the drop to the zero bound on interest rates required the Fed to create forward guidance and the dot plot, because it needed to tell the market that it wasn't going to raise rates anytime soon.

19:20But you could argue that in a period of a normal interest rate environment, where inflation is the danger, not deflation, that forward guidance really doesn't serve a purpose. And so the Fed itself was the one last November and December that signaled the pivot. Absolutely. And doubled down on it in March when they walked it back. Yeah, and now they have to walk it back. And what the Fed obviously realizes, but what that does is when the Fed makes signals like that, it is as if the Fed is already easing because the market anticipates that financial conditions ease. And so the Fed is easing and tightening without lifting a finger other than making speeches and publishing a dot plot.

20:07And so you wonder if that creates the very whipsaws that you're describing because everyone is over-consuming a lot of data and that lowers the signal-to-noise ratio. But you could argue the Fed is sort of complicit in that. Yeah, absolutely. So I'm curious as I'm listening to this and I think you rightly point out that rates are the real risk, where those yields go, how high do rates go. Is there a pain threshold that you worry about in terms of how high the 10-year, say, has to get, or is it speed of the move that's more concerning to you? I would say it's probably both, but the speed I think matters a lot.

20:49And in October of last year, it started slow and then it went fast. It's gone fairly fast the last month or so. But again, it's about the balance between earnings and interest rates. It's always about earnings and interest rates. And in that valuation model, sudden changes will have an impact. And so we are on a better footing because earnings are now growing at 12%. If you look at the forward estimate, where last October, they were basically still shrinking a couple of percentage points. But again, these sudden moves will have an impact. And actually, just coming back to the Fed model, 87, of course, was the perfect storm for the Fed model.

21:33And I'm not suggesting we're going to have an 87 repeat. But in 87, bond yields rose pretty dramatically and the stock market completely ignored it. And the Fed model, again, the difference between the bond PE, which is the inverse of its yield, and the equity PE really, really accelerated very sharply. And then, of course, we had the crash in October, and I'm not expecting a repeat of that. But that was one where these two variables moved fairly quickly and by a lot. So I think if you got both of those, then that is going to be a problem. If it's only one, it's still going to matter, but it won't have quite as much of an impact.

22:16We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:26Yeah, great and frightening historical reference. So I get a lot of research notes that land in my box from different people that come through. And there was one today, but I think this sums up. We talked about briefly before we came on air that it's a very murky macro outlook. Even really seasoned people are divided or unsure about what the future holds because we have all of these changes now, like all the fiscal stimulus and what's temporary, what's maybe a sign that it's a new, more permanent regime change. One of these, just the bullets at the top, I think really sum up this. The transition towards secular inflation is accelerating, but investors are woefully, still woefully unprepared.

23:12Rate cuts are not coming. Risk premia too high. The 2 % inflation target is dead. Long bonds and expensive growth stocks should suffer. That is really summing up the people who are very worried about inflation. Do you, how, where do you fall in, in your concern about inflation? So inflation to me looks like, you know, three is the new two or three and a half is the new two. And our inflation analysts, you know, I think, and, and it's, it's relatively consensus now that, that, you know, it's, it's going to be, you know, that last mile of getting, you know, from nine to three was relatively easy because of base effects and that sort of thing.

23:55But going from three to two or from four to two is going to be much harder when you have a really tight labor market and people have changed the way they spend money and behave. I mean, I'm on airplanes a lot and it's just the sticker shock still of hotel rooms and airfares. It's ridiculous. And so the economy has has evolved since the pandemic. And so it may be hard to get back to 2%. So if you look at core PCE, we're at 2.8. But if you look at the two-year or the five-year rate of change in core PCE, we're like at three, three and a half. Super core PCE is around between three and four. And again, it speaks to what is a neutral policy, right?

24:44We like to look at R-star, which is supposedly the neutral real rate. And that, according to the Fed, is around 1 % or so. So you add 3 % or 4 % inflation, you get to 4 % to 5 % as a neutral rate. Or if you look at it another way, if you just say, in periods of economic expansion like we are in today, soft landing, if you will, normally real rates would be plus 1%, plus 1.5%. I mean, that's kind of been the norm. and so you add one to one and a half to three or four you get to four to five percent as a neutral rate and we're only at five and three eights and so maybe that was not enough to really slow down the economy but you know you raise a good question and that is you know what what does this do to the kind of investing paradigm that we all grew up in basically which is the 60 40 model where until a few years ago, all you had to do was, okay, I got some S &P, I got some Bloomberg Ag, and I'm good to go.

25:49I don't really have to look any further than that, because those were the two anchors in a portfolio, and the only two you really needed, right? If you diversified into international stocks or commodities or gold or what have you, it didn't really help you because the sharp ratio on that 60 and 40 were so good. But before the late 90s, for many decades, we were in the opposite paradigm. We were in a period where stocks were positively correlated to bonds. And again, those were the Fed model days. And we're used to a regime where, OK, you own the 60. If there's a wobble in the 60, there's a recession or liquidity, financial crisis, or whatever it is, the 40 is going to bail you out, right?

26:38And that's how the risk parity model got what was even founded. But before the late 90s, it was the opposite. It was actually increases in yields that were the source of the problem for stocks rather than the solution to the problem. And so in that environment, if we're going back there, and we have been back there since 2022, right? In memory of 2022, it was that the Fed raising rates, that caused yields to rise, of course, that caused valuations to come down in the stock market. Last October, same thing. Last couple of weeks, the same thing. So in that environment, what does a 60-40 look like?

27:18I think you still want to own bonds, but they're for coupon clippers now. Bonds are for coupon clipping. They're not for total return when there's a shock to the stock market. And so that changes the role of bonds. It doesn't dismiss the need for bonds because they do provide a real rate of return now since 2022. But you want to look for other assets that, you know, there's not much that is negatively correlated, but there is some stuff that's at least non-correlated. And gold is one, what we call alternatives, liquid alts, like managed futures or long short equity. There are other instruments, asset classes that can play a role.

28:04And so to me, amongst all the questions that we're raising here about the murky, unsettling outlook in this era of fiscal dominance, You know, that should be the thing that should be on everyone's mind who is an investor is, okay, what does a portfolio look like in this kind of environment? Like I think you still want to own stocks. They are the proven compounder over very long periods of time. So to me, that remains an anchor. But maybe you sprinkle some other stuff in there that does provide protection that if there is too much fiscal stimulus or there is too much inflation, that it will help with the performance.

28:45Yeah, that's an excellent, excellent point. And I imagine that this must be the question that you get everywhere. Because, I mean, you know, what you're talking about, 60-40, I think every single one of us has looked at a 401 that we got through work, and they give you that pie chart, and it's all done based on percentages and your age on stocks and bonds and where you should be on your age. That has been the standard, and that's what everyone's made their decisions on. How quickly does this need to change, Urien? What are you telling people? Do they need to go look at their holdings right now and rethink how many bonds they have or what their percentage of bonds is?