The United States’ economic recovery from the pandemic is a two-part story. The first chapter, which played out in 2021, was about returning the economy to full employment. The Federal Reserve kept the funds rate below 0.1 per cent throughout the year to achieve this.
Despite a few bumps in the road caused by new Covid-19 variants, the central bank has nearly achieved its target of full employment. In November, the unemployment rate for non-farm jobs was 4.2 per cent, according to the US Bureau of Labour Statistics – far short of the 14.8 per cent peak in April 2020 and almost level with pre-pandemic levels.
The Fed is supposed to be agnostic about its impact on the stock market. However, one effect of its full-employment strategy has been to turbocharge US equities. Companies’ share prices theoretically reflect the fair value of their future cash flow. When interest rates come down, the value of this future cash flow increases relative to the returns investors could get depositing their money elsewhere. Investors are happy to pay more for the unrealised cash these companies promise to one day make.
This effect is particularly pronounced with US growth tech stocks because their value is dependent on speculative long-term projections, a point reflected in this year's continued ascent of the tech-dominated Nasdaq market, where the average forward price/earnings (PE) ratio has jumped from 22 up to 28.
Tesla is often seen as the posterchild for outlandish valuations. The electric vehicle (EV) manufacturer's own share price rise has made it four times more valuable than Toyota, despite making a 60th of the operating profit. This uber-bullishness is evident across the US EV market: Rivian, an EV company with zero revenues, listed last month at a $66.5bn valuation. Within a week, its share price had more than doubled.
When the market is priced so optimistically it becomes more sensitive to shifts in sentiment. The emergence of the Omicron variant helped prompt a sell-off in November, but indices quickly regained some of their poise. Investors on high alert to buy every dip will no doubt have picked up on President Joe Biden’s promise to fight Omicron without “shutdowns or lockdowns, but widespread vaccinations and boosters”.
Economic recovery could hurt racy valuations
Ironically, a strong economic recovery amounts to another big market threat. With employment stabilised, the Fed is now focusing on the second chapter of the post-pandemic recovery: preventing runaway inflation.
Since March, the US consumer price index has consistently exceeded 5 per cent. Fed chairman Jerome Powell had previously called this a “transitory” phenomenon due to exceptional supply chain issues. By November, Powell said it was time to “retire that word”. Following the remarks, and sensing interest rate rises on the horizon, investors sent the Nasdaq down 2 per cent.
Mindful of these forces, Goldman Sachs expects US core inflation, currently at 4.9 per cent, to hit 4 per cent next year and settle around 2.2 per cent in 2024 – still a full 60 basis points above the 2015 to 2019 average. As a result, the investment bank expects the Fed to pull forward the first rate hike to July next year, followed by a second rate rise in November.
Is the 'bubble' about to burst?
The Shiller ratio, named after Nobel-prize-winning economist Robert Shiller, calculates prices relative to the average inflation-adjusted earnings from the previous 10 years. The S&P 500 ratio is currently 39. It has twice before been above 30: in 1929, just before the Great Depression, and in the late 1990s prior to the dotcom bubble bursting.
Optimists will say that a stock market crash such as in 1929 and 1999 is unlikely given the underlying health of the US economy. The US still has $2.4tn of pent-up savings. The consensus forecast is for 4 per cent gross domestic product growth next year.
The expected knock-on boost to demand means brokers haven’t revised down their forward free cash flow forecast for the S&P 500 or the Dow Jones Industrial Average, despite rising wages and input costs.
But it is not just value stocks that might find favour in this environment. The most likely outcome is that the Fed slowly raises interest rates to bring inflation under control next year while the economy keeps growing, albeit at a slower rate. While that could still result in rising company cash flows, higher rates may lead to a gradual re-rating downwards and rotation towards value.
Value companies are not immune to the impact of tighter monetary policy, either. With that in mind, a different type of business could be best suited to this environment. The Dow includes huge cash-generating companies with strong brands and pricing power, such as Visa (US:V), Apple (US:AAPL) and Johnson & Johnson (US:JNJ). All these three companies saw their prices rise as the Nasdaq dipped at the start of December. This offers a precursor to what might occur if the Fed needs to raise rates above expectations next to tackle the no-longer-transitory inflation. If 2021 was about growth potential, then 2022 might be the year for present cash flows.