Episode 42: Is more or less volatility ahead for US equity markets?
15 Feb 2022
After the relatively stable upward march of US equity markets in 2021, January was a wild ride for investors. Year-to-date, US stocks have been volatile, with multiple days where markets were up or down several percentage points, and extreme intra-day volatility as well. Should investors expect more volatility in the weeks and months ahead?
In episode 42 of The Flip Side, Global Head of Research Jeff Meli and Head of US Equity Strategy Maneesh Deshpande present arguments for the possibility of both more and less volatility ahead, taking into account factors including rate hikes by the US Federal Reserve, goods and services consumption, labor force participation rates, and companies’ exertion of market power.
Jeff Meli: Welcome to this episode of The Flip Side. I'm Jeff Meli, the Head of Research at Barclays. I'm joined today by Maneesh Deshpande, our US Equity Strategist. Thanks for joining, Maneesh.
Maneesh Deshpande: Thanks for having me, Jeff.
Jeff Meli: All right. Today we're going to talk about the US equity markets. After having quite a run last year, stocks started off 2022 with a big sell-off and a big surge in volatility.
Maneesh Deshpande: That's right, Jeff. Year-to-date, US stocks have been quite volatile, with the S&P 500 Index down 10% at one point. Even more remarkable has been the volatility. We've had multiple days where markets have been up or down several percent points, and the intraday volatility has been extreme as well.
Now, markets have stabilised since then, albeit at lower levels, but I think we are in for sharp year still. The forces driving the volatility in January, such as high rates are not going away, and there are big changes coming to consumers that will pose a real headwind for stocks.
Jeff Meli: Well, I disagree, Maneesh. I think investors are overestimating the extent to which rates will rise and big companies in the US, I think, are very well positioned to continue to make money in this environment.
Maneesh Deshpande: I'll start with a more pessimistic outlook. The biggest driver right now is the Fed. It has signaled very strongly that it is about to start to tighten monetary policy to combat inflation that has been surprisingly persistent.
Jeff Meli: Yes, that's right. We're forecasting that the US Federal Reserve will hike interest rates five times this year. We also think that it will end the asset purchases that it started at the height of the COVID pandemic, both low, really zero interest rates, and the asset purchases were used to support the economy and markets at the start of the pandemic.
But at this point, we're back to full employment, inflation is high, and these measures are no longer needed and they might even be doing harm. Mind you, I'm not that convinced how much hiking is actually going to be necessary.
Maneesh Deshpande: Well, necessary or not, it's coming, Jeff. And we have a long history of what happens to equities during the hiking cycle. Equity valuations, that is how much the market is willing to pay for future earnings, fall.
Jeff Meli: Yes, but there's a lot of reasons why that relationship exists. So first of all, as rates rise, investors have more options to generate yield, so they don't need to be so heavily invested in equities.
Also, when interest rates are higher, the cost of borrowing goes up. So corporate debt is more expensive, and corporations are less likely to make big investments that are going to generate future growth. So all of that combines to lower equity valuations.
Maneesh Deshpande: Yes, and as the hiking cycle progresses, the current one that is, I expect multiples to fall just like history suggests. This process is going to lead to more volatility over the course of the year.
A major problem, by the way, is that valuations are quite high right now for US equities, which means they have more room to fall. For example, consider the price-to-earnings multiple, which is the ratio of the market value of a stock to its current earnings, which is a common way to judge valuations. Currently, this is about 20 for The S&P 500. That is 10% higher versus pre-pandemic levels.
Jeff Meli: Well, Maneesh. I have two objections to this narrative. First of all, at this point, the US Federal Reserve has very well telegraphed the path forward. Investors have reacted, for example, in interest rate markets, these hikes are fully reflected. I don't see why equity markets should continue to react to a series of events that we should all see coming months ahead of time.
Maneesh Deshpande: And the market is actually more aggressive than what we are forecasting and it is pricing in six to seven hikes this year, and even a 90% probability that there would be 50 basis point hike in March.
However, I would note that equity and fixed income investors views are not always aligned. There is a big difference between knowing, or at least, expecting that rates will rise and seeing it in reality. I suspect many traditional equity investors might only react when the rates actually go up.
Jeff Meli: Well, Maneesh, my other objection is that you're only giving part of the history. It is true that equity multiples fall, as you say, during a hiking cycle. But it's also true that at the start of a hiking cycle, equity prices don't fall. Instead, equity prices just rise more slowly than they were doing before. That's because earnings keep going up.
Companies typically make money during hiking cycles, usually because they coincide with pretty strong economic conditions. So investors get a lower multiple on higher earnings, but the net is still higher prices. That's kind of an important piece to leave out.
Maneesh Deshpande: I'm not leaving it out actually, Jeff. I think what I'm trying to say here is that I think this time around, it’s going to be quite different from what history suggests. The main reason for this is that I think corporate earnings are not going to rise in this cycle, or at least, not enough to outweigh lower multiples. The reason for this is a reversal in some COVID-related changes in consumer spending that are going to affect corporate profits.
Jeff Meli: Now, consumer spending in the US has undergone an amazing transition over the pandemic, where we all shifted our spending away from services and into goods.
So in percentage terms, goods have gone from about 30% of consumer spending pre-pandemic to about 35% right now. That's a 5% shift. It might not sound like that much, but keep in mind how much money US consumers spend every year. That 5% equates to something like $800 billion of extra spending on goods each year.
Maneesh Deshpande: It is a shocking shift. Anyone trying to buy a car and appliance, some furniture has seen that all of this extra spending has resulted in backlogs and scarcity. Services like travel and entertainment were obviously impaired during the pandemic, most notably from 2020 and still haven't recovered.
Jeff Meli: Yes. I mean, the shift from services to goods isn't really surprising. First, like you said, for a period of time, we simply couldn't spend on services, things were just shut down. And then some of this shift is because of the nature of the pandemic, so like we all had to buy home office goods, for example.
Maneesh Deshpande: Yes, while the rotation from services to consumption was not surprising, in my mind, the magnitude was quite shocking. I think this was a direct result of the extraordinary levels of fiscal stimulus passed in the US during the pandemic. We clearly see this and the fact that the goods consumption spiked during those three months when the fiscal stimulus checks were mailed out.
In other countries, while there was a similar substitution, the magnitude of the shift was not as large as we have seen in the US Just to put the fiscal stimulus in perspective, we think it was more than four times the amount of wages lost as millions of people lost their jobs.
Jeff Meli: All right. But once the epidemic fears ease, services, consumption should rebound and that should be good for GDP and good for profits.
Maneesh Deshpande: Sure, except our analysis shows something quite different, which is that the goods demand is what really drives corporate profits. That's why corporate profits had such a spectacular run during the pandemic. But this cannot last. Eventually, spending will normalise.
We are two or three years ahead of trend on good spending. And when that reverses, earnings will fall. I think that might just start this year, as Omicron fades and we hopefully get back to some semblance of normalcy.
Jeff Meli: I think it's a strange sentiment, Maneesh, since the US is such a services-oriented economy. I mean, surely, there's got to be lots of listed companies in the services sector.
Maneesh Deshpande: It is a bit surprising. You're right that they are certainly listed companies in the services business. But keep in mind what the Bureau of Economic Analysis which puts out these numbers called services is really the wide swath of services, including things like doctors, lawyers, hairdressers, small retail stores, et cetera. Most listed companies actually traffic in goods.
I think one reason why investors are not focused on this point, historically, is that we have never seen this type of divergence between goods and services consumption before. The sensitivity to goods was in the data. Our analysis shows that, but it just wasn't that important because the two types of spending were so highly correlated.
Jeff Meli: Well, Maneesh, that goods story is interesting. But I've got a different take on the path forward, and we'll start same place you did with the prospect for higher rates. But I think we're overestimating how high rates are actually going to go.
Maneesh Deshpande: So you think the market is wrong?
Jeff Meli: Well, I mean, look, there's almost no doubt at all about the near-term path, rates are going to go higher imminently. It's really a question of just how many hikes we actually get this year. And I think that the supply side issues that have driven inflation are likely to ease much more quickly than we realise, and that will reduce how much hiking actually needs to happen. The first supply side issue that I think could ease is problems with supply chains.
Maneesh Deshpande: But, Jeff, the supply chains still remained in disarray. Companies can't get goods to consumers and scarcity is driving up prices. And keep in mind that this story was there for the last six months, it has lasted longer than most economists expected.
Jeff Meli: Yes, but the Omicron wave is receding in the US at this point pretty quickly. It's basically following the same trajectory it did in other countries like South Africa that experienced it before us. And you combine that with improved therapeutics, I think we could be looking at a major reduction in the effect of COVID on supply chains, and those problems could ease pretty quickly I think if the virus fears of abate.
Maneesh Deshpande: I'm not that convinced. A lot of supply chain issues are overseas and I suspect the US will get the therapeutics before other parts of the world. And as long as China, which is very important manufacturing hub, continues its zero COVID policy, we will see the supply chain products continue. Keep in mind China is still shutting down whole cities at the first sign of a COVID outbreak.
Jeff Meli: I think the international point is a good one, Maneesh, but I would also keep in mind what could happen to goods prices if you're right about the change in consumption. We could see serious deflation in goods prices. I think it's likely that companies are overordering now because of the problems with supply chains.
They're trying to bulk up their inventory, get whatever they can onto their shelves or to their consumers. And if we end up with a glut of goods and the consumption shifts, you could see goods price really fall. That would, by itself, reduce the need to hike interest rates.
Maneesh Deshpande: Yes, but there are other components of inflation, for example, those linked to housing, and even more recently, those linked to services which have begun to form. So I think that is what is really worrying the Fed, and to some extent, the market, that it's not just that the headline inflation is going up, but it is widening to other categories. And these other categories are much more sticky. They do not turn on a dime. But all this bolsters my case that we are in for a volatile here.
I want to emphasise, though, that I agree with you that the economy might do well, which will give the Fed more leeway to continue hiking, I think, but the key thing is that the decoupling of corporate profits with the economy that I expect could be a headwind for equities.
Jeff Meli: Also, Maneesh, supply chains are only part of the inflation story. The other part that I think could have an effect is the millions of people who are working pre COVID who are still out of the workforce.
One reason, I think probably the most important reason that they've remained out of the workforce is lingering fears about the virus. I think those were only made worse by Omicron. As that fades, the workforce could expand by literally millions of workers. There'll be another boost to supply.
Maneesh Deshpande: I think it is unrealistic to expect everyone to come back to work, Jeff. At least, some of the change in labour force participation is cultural, I think. People have a different view of work-life balance now, what you want out of careers, et cetera.
Jeff Meli: Well, that is true. But I'd point out, I don't need all of the missing workers to return and all problems with supply chains to go away to remove some of the pressure on the Federal Reserve. I think some improvement along both of those dimensions could allow the Fed to get a grip on inflation much more easily than people currently expect, and therefore need to hike by less. That would remove one of the major catalysts for volatility, which again, I think sounds pretty good for stocks.
Maneesh Deshpande: Well, all of this requires a return to a more normal operating environment. But I think that again bolsters my point, I think that all this would come with reduced goods consumption, and that is bad for stocks.
Jeff Meli: Now, I think there's another piece of the puzzle that is supportive of big public companies. Many economists believe that large companies in the United States have accumulated what's called market power. That's the ability to set prices, either the prices they pay, like to their workers or their suppliers, or the prices that they charge to their consumers.
We agree with this. Our analysis shows that many important sectors in the US do exhibit the signs of market power. And if that's right, the big companies in those sectors will be able to defend their margins and remain very profitable despite any of the headwinds that you're talking about.
Maneesh Deshpande: It is the case that margins have been very robust through the pandemic. But actually, the most recent data speaks against your theory, I think. One theme in the Q4 2021 earnings that are in the process of being announced is that margins appear to have begun to fall. So it doesn't appear that companies have been able to pass through all the recent inflation to the customers as they were able to do last year.
Also, given the supply chain pressures, companies had been meeting demand but dipping into inventory, which was of course accumulated earlier at lower prices. As they rebuild those at current prices, they could see – begin to see some margin pressures.
Jeff Meli: Well, this is just the early trend domination. Over time, inflation will give these companies the air cover they need to raise prices. Look, corporates may have been caught flat footed by this surge in inflation just like everybody else, but they do have the ability to adjust. And companies with market power have even more ability to adjust. Who could tell if higher prices are because of increased wage costs, problems with supply chains, or rather specifically intended to support the bottom line?
Maneesh Deshpande: I'm also worried about the steps that the Biden administration is taking to counter this. Between a more skeptical view of mergers and a host of industry-specific proposals to address the use of market power, I think companies in the US may struggle to use this to their advantage in the future.
Jeff Meli: The administration is trying to address this issue. But they're basically going after every industry at once, partly because they associate market power with market share. And it is the case that big companies have increased their market share in just about every industry in the US
But our analysis shows that the issues with market power are actually more narrow. Many industries that are highly concentrated don't actually have any of the other signs of pricing power that are more problematic. So I think the administration is spreading itself too thinly. It's trying to solve problems that don't exist, and that makes its efforts likely to be less successful even when they actually have a point.
Maneesh Deshpande: But keep in mind that this is not just a US problem. So as you know, Europe has had much more success on this issue and is more aggressive in taking action. Most large US companies are international. So I don't think we should rely on market power as a buffer against all the headwinds I see for stocks.
Jeff Meli: Well, we're going to see this play out pretty quickly since we believe the first rate hikes are coming in March. Well, thanks for joining me, Maneesh. Clients of Barclays can read our latest research on "Equity Strategy Outlook 2020, Proceed with Caution,” and "Equity Strategy - Too Early to Buy the Dip,” both available on Barclays Live.
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About the analysts
Jeff Meli is Global Head of Research at Barclays, based in New York. Jeff joined Barclays in 2005 as the Head of US Structured Credit Strategy and has held a number of other senior positions in the research department, including Head of Credit Research and co-Head of FICC Research. Jeff spearheaded the firm’s response to regulatory changes in Research, including MiFID II, and has revamped the department’s approach to content monetisation. Jeff leads the development of the Research Data Science Platform, tasked with integrating new data sets and modern data techniques into investment research. He writes regularly about special topics in credit markets, liquidity, and financial market regulation, and hosts The Flip Side, a podcast covering current events in finance and macroeconomics. Previously, he worked at Deutsche Bank and J.P. Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.
Maneesh S. Deshpande is Head of US Equity Strategy and Global Equity Derivatives Strategy at Barclays. Maneesh joined Barclays in September 2008 from Lehman Brothers, where he worked in a similar role. Prior to that he established and ran the Systematic Portfolio Trading desk at Goldman Sachs, was the Head of Principal Trading at Morgan Stanley Japan, and the Head of US Interest Rate Options Trading at BNP Paribas. Maneesh earned a PhD in Theoretical Physics from the University of Pennsylvania and a BS in Electrical and Electronics Engineering from the Indian Institute of Technology, Madras.