By Gary Black
Last Wednesday’s (30/7) one-two punch of 4% second quarter GDP growth, plus the Fed’s language that inflation had moved closer to its longer-term target, gave the equity markets a severe case of agita.
The S&P 500 Index fell -2.7% for the week, its worst percentage decline in the past two years. We expect the recent surge in volatility to continue near-term as the consensus shifts about how quickly the Fed will raise short-term rates in 2015. The worry, of course, is that the Fed will suddenly wake up and realise it has fallen behind the proverbial eight ball in controlling inflation and be forced to ratchet up short-term rates in a messy rather than predictable fashion.
Everyone seems to agree the Fed will be forced to raise rates at some point during the next two years with inflation nearing the Fed’s 2% target. Does it really matter whether these rate increases begin in November 2015 or May 2015? With 209,000 US jobs created in July and now six continuous months of 200,000-plus job growth, bond vigilantes have called the Fed’s zero-rate monetary policy “inappropriate” at best and “irresponsible” at worst, with the U.S. economy expected to grow by 2.0% to 2.5% this year. Put differently, the vigilantes say an average growing economy deserves an average monetary policy, not the one adopted in 2008 to get the country out of the worst financial crisis since the 1930s.
Our view is that the market isn’t worried that short-term rates are headed higher. Instead, we believe the market’s concern is that the Fed will be forced to ratchet short-term rates higher—three, four, five times over a short period—to control inflation that may accelerate well beyond the Fed’s 2% target as economic growth shifts into high gear.
Like a stock that misses earnings and falls to a new equilibrium that reflects the lower earnings and then moves higher, once the market discounts the change in consensus thinking about Fed policy and accepts that rates will rise earlier rather than later, stocks can take off again as investors get comfortable with 3% long-term GDP growth, 2% inflation, a 1% fed funds rate, and 3% to 4% 10-year Treasury yields.
We continue to believe we are in the fifth or sixth inning of a secular bull market, with a recovery cycle prolonged by the severity of the 2008-2009 financial crisis, the recession, and 55% market correction, combined with Washington’s impotency in crafting new fiscal policy to stimulate economic growth through tax incentives rather than government spending.
In our view, valuations remain very attractive relative to both inflation and long-term interest rates. Assuming global GDP growth of 3% in 2015 and beyond with little inflationary pressures, we believe corporate profits can continue to grow by 6% – 8% over the next several years. That is good for stocks, and particularly for growth stocks, which remain depressed with forward P/E multiples at just 1.2x the forward P/Es of value stocks but offer twice the forward revenue growth and 50% more earnings growth.
In sum, for now, too much good news is bad news, but once the markets adjust to the emerging consensus that 1% short-term rates and 3% to 4% long-term rates are indeed just fine, we believe equity markets can move to new highs, supported by 3% long-term GDP growth, low inflation, and M&A and buyback activity that remains highly accretive, given compelling valuations and cheap financing.
Gary Black is executive vice president, global co-chief investment officer at Calamos Investments
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