In Search of a Steady State: Inflation, Interest Rates and Value
The Genie is out of the bottle...
The nature of markets is that they are never quite settled, as investors recalibrate expectations constantly and reset prices. In most time periods, those recalibrations and resets tend to be small and in both directions, resulting in the ups and downs that pass for normal volatility. Clearly, we are not in one of those time periods, as markets approach bipolar territory, with big moves up and down. The good news is that the culprit behind the volatility is easy to identify, and it is inflation, but the bad news is that inflation remains the most unpredictable of all macroeconomic factors to factor into stock prices and value. In this post, I will look at where we stand on inflation expectations, and the different paths we can end up on, ranging from potentially catastrophic to mostly benign.
Inflation: The Full Story
I wrote my first post on this blog in 2008, and inflation merited barely a mention until 2020, though it is an integral component of investing and valuation. Since 2020, though, inflation has become a key story line in almost every post that I write about the overall market, and I have had multiple posts just on the topic. To see why inflation has become so newsworthy, take a look at the chart below, where I graph inflation from 1950 to 2022, in the United States:
While I report multiple measures of inflation, from the consumer price index (adjusted and unadjusted) to the producer price index, to the price deflator used in the GDP, they all tell the same story. We have had a long stretch of low and stable inflation, and that is especially true since the 2008 crisis. In fact, the average inflation rate in the 2011-20 decade was the lowest of the seven decades that I cover in this chart. Just as important, though, is the fact that variation in inflation, from year to year, was lower in 2011-2020 in every other decade, other than 1991-2000. It reinforces a point I made in my inflation post last year, where I argued that to understand inflation's impact on asset values, you have to break it down into its expected and unexpected components, with the former showing up in the expected returns you demand on investments, and the latter playing out as a risk factor.
Investors who are old enough to remember the 1970s point to it as a decade of high inflation, but that is only with the benefit of hindsight. At the start of that decade, investors had no reason to believe that they were heading into a decade of higher inflation, and initial signs of price increases were attributed to temporary factors (with OPEC being a convenient target). In fact, expected inflation lagged actual inflation through much of the decade, and the damage done to financial asset returns that decade came as much from actual inflation being higher than expected inflation, period after period, as from higher inflation.
It is precisely because we have been spoiled by a decade of low and stable inflation that the inflation numbers in 2021 and 2022 came as such a surprise to economists, investors and even the Fed. Early on, the inflation surge was explained away by the reopening of the economy, after the COVID shutdown, and then by stressed supply chains, and expectations about future inflation stayed low. However, as reported inflation has remained stubbornly high, and neither COVID nor supply chains provided sufficient rationale, market expectations of inflation have started to go up. I capture this shift using two measures of expected inflation, the first coming from the University of Michigan's surveys of consumer expectations of inflation for the future and the latter from the US Treasury market, as the difference between the ten-year treasury bond and the ten-year inflation-protected treasury bond (TIPs) rates:
Consumer expectations of inflation reached 5.40% in March 2022, hitting levels not seen since the early 1980s. While the market-implied expected inflation rate has also climbed to a ten-year high of 2.85%, it is clearly lower than the consumer survey expectation. There are three possible explanations for the divergence:
Short term versus Long term: The consumer survey extracts an expectation of inflation in the near term, whereas the treasury markets are providing a longer term perspective, since I am using ten-year rates to derive the market-implied inflation.
Consumers are over adjusting: The big inflation surges have happened in gasoline, food and housing, all items that consumers use on a continuous basis, and it is possible that they are over reacting and adjusting expected inflation up too much, as a consequence.
Markets are under adjusting: Alternatively, it is possible that it is consumers who are being realistic, and it is that the bond markets which are under adjusting to higher inflation, partly because many investors have operated only in a low and steady inflation environment, and partly because some of these investors have a belief that the Fed has super powers when it comes to setting interest rates and determining inflation.
I have always argued that the notion of the Fed as this all-powerful entity that sets rates, determines economic growth and keeps inflation in check is a myth, and a very dangerous one at that, since it gives license to policy makers and investors to behave rashly, expecting a safety net to protect them from their mistakes.
As inflation, actual and expected, has made a return, it is not surprising that the ripple effects are being felt across the economy, with the ripples sometimes resembling tidal waves. The most direct effects have been on interest rates, where we have seen rates rise quickly, and to levels not seen in years. In the chart below, I look at how the treasury curve has shifted in the recent periods:
To provide a sense of how much rates have changed just in 2022, compare the yield curve on January 1, 2022 to the one on May 5, 2022. On January 1, 2022, the yields on the very short end of the maturity spectrum (1-6 month treasuries) were close to zero, the ten-year treasury bond rate was 1.51% and the long end of the yield curve had an upward slope. On May 5, 2022, the treasury yields for the short end had risen, with the 1-month rate reach 0.50%, the ten-year treasury bond rate had breached 3% and the term structure had leveled out for the long end of the spectrum (with the 2-year yield moving towards the 10-year yield, which in turn was close to the 20-year and 30-year yields). Of course, the "Fed did it" crowd will argue that this is all Jerome Powell's doing, an indication of how little they understand about both what rates the Fed does control (the Fed Funds rate is at the very shortest end of the spectrum, and it is not a trading rate) and how willing they are to ignore the data. If you were to graph out when the Fed woke up from its inflation-denial and when treasury rates started rising, it seems clear that it was the treasury market that is causing the Fed to act, rather than the other way around.
As treasury rates have risen, markets also seem to have been more wary about risk, and how it is being priced. In the chart below, I start with the default spreads in the corporate bond market and you can see the increase in spreads that have occurred just over the course of 2022:
Default spreads have risen across every ratings class, but more so for lowly-rated bonds than for bonds with higher ratings. Here again, there are some who would attribute this to the Russia-Ukraine conflict, but that would miss the fact that bulk of the surge in spreads happened before February 23, 2022, when the conflict started. In the equity market, I capture the price of risk with a forward-looking estimate of expected returns on stocks, computed from the level of stock prices and expected future cash flows, and I graph both the expected return and the implied equity risk premium (from netting out the risk free rate) in the graph below:
In equity markets, the shift in expected returns has been significant, perhaps even dramatic, as the expected return on stocks, which started 2022 at 5.75%, has moved above 8% for the first time since May 2019, with some of that shift coming from a higher treasury bond rate (1.51% to 2.89%) and some of it coming from a higher equity risk premium (4.24% to 5.14%).
As the inflation bogeyman returns, the worries of what may need to happen to the economy to bring inflation back under control have also mounted. Almost every economic forecasting service has increased its assessed probability for a recession, with variations on depth and length. In a note published in mid-April, Larry Summers and Alex Domash go as far as to put the likelihood of a recession at 100%, based upon a joint indicator, i.e., that a combination of inflation > 5% and unemployment<4% has always led to a recession within 12 to 24 months, using quarterly data from the 1950s to today. While I remain a skeptic about historic rules of thumb (downward sloping yield curve, for example) to make predictive statements about future economic growth, I think that we can state categorically that there is a greater chance of an economic slowdown now than just a few weeks ago.
As the storm clouds of higher inflation and interest rates, in conjunction with slower or even negative economic growth, gather, it should come as no surprise that equity markets are struggling to find their footing. At the close of trading on May 5, 2022, the S&P 500 stood at 4147, down 13.3% from the start of the year value, accompanied by increased volatility. To the question of whether to sell, hold on or buy in the face of weakness, the answer will depend on your macro assessments of the following:
Steady State Interest Rate: As noted in the last section, the ten-year bond rate has doubled this year, an uncommonly large move for US treasuries, and there are three possibilities for the future. The first is that the bulk of the move in rates is behind us, and that treasury rates now reflect updated expectations of inflation. The second is that, like the 1970s, we will play catch up with inflation, and that rates will continue to move up, until expectations on inflation become more realistic. The third is that inflation is either transient, and will revert back to the lows we saw last decade, or that the economy will go into a recession and act as a natural break on inflation and interest rates. Note that in all three cases, it is not the Fed that is driving rates, but what is happening to inflation.
Equity Risk Premium Path: The equity risk premium of 5.24%, estimated at the start of May 2022, is at the high end of historical equity risk premiums, but we have seen higher premiums, either in crises (end of 2008, first quarter of 2020) or when inflation has been high (the late 1970s). I think that what happens to equity risk premiums for the rest of the year will largely depend on inflation numbers, with high and volatile inflation continuing to push up the premium, and steadying and dropping inflation having the opposite effect.
Earnings Estimates: The strength of the economy has been a big contributor to boosting actual and expected earnings on companies in the last two years, and these higher earnings have translated into more cash returned in dividends and buybacks. The earnings estimates for the S&P 500 companies from analysts, at the start of May 2022, reflect that strength and there seems to have been no adjustment downwards for a recession possibility. That may either reflect the fact that equity analysts are not among those who expect a recession (or expect only a very mild one, with little impact on earnings) or the possibility that there may be a lag in the process between the economy weakening and analysts adjusting expected earnings.
To see how these three forces play out, consider what I would term the status quo scenario, where you assume that today's treasury bond rate (3%) is the steady state, that earnings estimates will largely be delivered and that the equity risk premium will stabilize around current levels:
The intrinsic value that you get for the index (4181) is almost spot on to the actual value, and that should not come as a surprise, since it reflects the consensus view on rates, earnings and risk premiums. However, there are wide divergences from the consensus on all three inputs and in the table below, I estimate the index values under these divergent viewpoints:
As you can see, the range of values is immense and they include scenarios ranging from the upbeat to the catastrophic. At one end of the spectrum, in the most benign scenario, which I will title Much Ado about Nothing, inflation turns out to be transient, fears of economic collapse are overstated and the equity risk premium reverts back towards historic norms, and the market looks under valued, perhaps even significantly so. At the other end, in perhaps the most malignant scenario, titled The Seventies Show, inflation continues to rise, even as the economy goes into recession and risk premiums spike, leading to a further correction of close to 50% in the market. In the middle, the Volcker rerun, Jerome Powell discovers his inner central banking self, cracks down on inflation and wins, but does so by pushing the company into a deep recession, making himself extremely unpopular with politicians up for election and the unemployed. There is a fourth possibility, where you Live and let live (with inflation), where we (as investors and consumers) accept a higher inflation world, with its costs and consequences, as the price to pay to keep the economy going.
One of the costs that come with the last scenario is that inflation eats away at trust in not just currencies, but in all financial assets, and that investors will turn away from stocks and bonds. In the 1970s, the asset classes that benefited the most from this flight were gold and real estate, and the question is which asset classes will best play this role now, if inflation is here to stay. I do think that securitizing real estate has made it behave more like financial assets, and removed some of its power to hedge against inflation, but there may be segments (such as rental properties, where rent can be raised to match inflation) that retain their inflation fighting magic. Gold's history as a collectible gives it staying power, but the truth is that it is not big enough or productive enough as an investment class for us to all hold it. That, of course, brings us to cryptos, NFTs and other, more recent, entrants into the investment choice list. In theory, you could make the argument that these new investment choices will operate like gold, but you have two serious barriers to overcome. The first is that they have not been around for long, and that history is full of collectibles, from tulip bulbs to Beanie Babies to Pokemon cards, that people paid high prices for, but failed to hold their value. The second is that in the limited history that we have for cryptos and NFTs, they have behaved less like collectibles (holding or increasing in value, as stocks and bonds collapse) and more like very risky equities, going up when stocks go up, and dropping when stocks go down. In fact, higher and sustained inflation may be the acid test of whether there is any substance to the bitcoin as millennial gold story, and the results will make or break those holding cryptos for the financial apocalypse that they see coming.
The inflation genie is out of the bottle, and if history is any guide, getting it back in is going to take time and create significant pain. It is the lesson that the US learned in the 1970s, and that other countries have learned or chosen to not learn from their own encounters with inflation. It is the reason that when inflation made itself visible in the early part of 2021, I argued that the Fed should take it seriously, and respond quickly, even if there existed the possibility that it was transient. Needless to say, the Fed and the administration chose a different path, one that can be described as whistling past the graveyard, not just ignoring the danger with happy talk, but also actively taking decisions that only exacerbated the danger. Needless to say, they now find themselves between a rock (more inflation) and a hard place (a recession), and while you may be tempted to say "I told you so", the truth is that we will all feel the pain.