Dollar should support international equity markets

The current S&P 500 drawdown looks consistent with a healthy correction in an ongoing bull market. The market was overdue for one. As I wrote in October: "I think a deeper drawdown (e.g., 10-15%) or several months of sideways consolidation would be a healthy development for the medium to longer-term prospects of the bull market."

From the beginning of last year to last week's close, the S&P 500 forward earnings multiple fell from 27.0 to 19.9, a 26% decline. Meanwhile, the market was up 17% over that period. Valuations are now back to 2017 levels.

As I wrote in my June 2020 report: "P/E ratios (both forward and trailing) tend to spike coming out of recessions. Forward P/E spikes as forward 12-month earnings estimates drop and the market prices in a recovery further out. And trailing ratios spike as realized trailing earnings drop. After post-recession spikes, P/E ratios tend to come down as earnings grow faster than the market rises, lowering the multiple."

One of the biggest concerns in the market today is Fed rate hikes and quantitative tightening (QT). In the last cycle, Fed QT was likely a contributor to the Q4 2018 correction, but it's worth noting that the market regained momentum and made new all-time highs despite ongoing balance sheet reduction.

The last QT (2017-2019) reduced the Fed's balance sheet by 15% over a two-year period, going from $4.5T to $3.8T (a $700B reduction at an average pace of about $30B/month). The balance sheet is currently about $8.9T - so 15% would be $1.4T. $2.5T would likely be the max reduction given that the Fed won't want to reduce bank reserves below $1.4T (currently at $3.9T). $2T of US Treasuries are maturing over the next 24 months. That might imply a max monthly run-off pace of $85B/month on average if everything was allowed to mature without reinvestment. MBS (mortgage-backed securities) are long-dated but frequently pre-paid. The Fed would likely prioritize MBS reduction over US Treasuries. QT is expected to start in the second half of this year.

The ECB and BoJ are together continuing QE at around $70B/month, so anything more than $70B/month in Fed balance sheet reduction would likely start to reduce the aggregate G3 central bank balance sheet.

Notably, the dollar hasn't been able to sustain upward momentum since late November, even given the continued hawkish pivot from the Fed and downside volatility in risk assets. A weakening dollar should support international equity markets.

Medium-term, a review of the data suggests the market outlook continues to be supported by the ongoing economic expansion and a remaining wall-of-worry to climb. As always, the outlook requires constant reassessment. And everyone needs to put probability and reward-to-risk assessments in the context of their strategy, process, and time horizon.

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