In my early 2021 posts on inflation, I argued that while the higher inflation that we were just starting to see could be explained by COVID and supply chain issues, prudence on the part of policy makers required that it be taken as a long term threat and dealt with quickly. Not only did they not do so, but the fiscal and monetary actions they took in 2021 exacerbated inflationary pressures. By the start of 2022, the window for early action had closed and for much of this year, inflation has been the elephant in the room, driving markets and forcing central banks to be reactive, and its presence has already induced me to write three posts on its impact. In my first on May 6, 2022, I put the surge in inflation, in 2022, in historical context and argued that it is unexpected inflation that shakes up the economy and caused damage to financial assets, and that until we reached a steady state, where expectations and actual inflation converge, markets would continue to be unsettled. In a follow-up post on May 20, I looked at the disparate effects of inflation on individual companies, positing that safer companies with pricing power are more protected against inflation than riskier companies in competitive businesses. In a third post on July 1, 2022, I pointed to inflation as a key culprit in the retreat of risk capital, i.e., capital invested in the riskiest segments of every market, and presented evidence of the impact on risk premiums (bond default spreads and equity risk premiums) in markets. In terms of content, I am afraid this post will contain nothing new, but the fresh uncertainties about inflation, and its impact, that have opened up this summer require at least an updating of the numbers.
Inflation: Actual and Expected
In September 2022, there is no denying that inflation is back, and with a vengeance, though we can still debate how quickly it will fade, and to what level. The happy talk of 2021, where many policy makers and investors were dismissive of its emergence, attributing it almost entirely to the COVID recover and supply chain problems, has largely faded and a grim acceptance has set in that we have an inflation problem, the solution to which may be perhaps as painful as the problem. One reason investors and businesses are struggling with this latest bout of inflation is that they have been spoiled by a decade of low and stable inflation, and as a consequence, have neither planned for high and unstable inflation, in their business models, nor developed analytical tools to deal with that inflation. To see the inflation break in 2022, relative to history, I report on four widely used measures of inflation in the US - the consumer price index (CPI ), with & without seasonal adjustments, the producer price index (PPI) and the GDP Price Deflator below:
Source: Federal Reserve, St. Louis (FRED)
On every measure, inflation exploded in the first half of 2022, with a leveling off, albeit at high rates in the summer. The table below the graph also backs up my point about the 2011-2020 time period being an outlier, in terms of inflation being low (with the average at 1.73%) and stable (with the standard deviation across the years of 0.81%). The graph above is one of actual inflation, but as I have emphasized all through this year, it is expected inflation that drives markets, and it is on measures that try to capture inflation expectations that you see the turn in 2022. While spending the bulk of 2021 in denial, investors seem to have woken up, and expected inflation numbers are reflecting that. In the charts below, I graph out the inflation that consumers are expecting in two different surveys, one from the University of Michigan and the other from the NY Fed that show the rise in expected inflation:
As you can see, in both surveys, the expected inflation number has risen, to 5.20% in the University of Michigan survey and to 5.7% in the NY Fed survey. This rise in expected inflation also shows up in a different survey of expectations, from the Fed (St. Louis), measuring the probabilities of expected inflation in consumer expenditures:
Fed Reserve, St. Louis
After a decade where most expected inflation to be less than 1.5%, with a small percentage even expecting deflation, more than 80% now expect inflation to be higher than 2.5%, in the future and none expect deflation. The problem with survey-based expectations is that they are volatile and often are responses to recent experiences with inflation. There is a market-based estimate of inflation that comes from the US treasury market, where a comparison of yields on a treasury bond with that on a inflation-protected treasury bond of equivalent maturity provides a measure of expected inflation. This measure is reported, for the 10-year US Treasuries, from 2003 through September 2022, in the graph below:
On September 23, 2022, the market-imputed inflation number stood at 2.37%, the difference between the 10-year T.Bond rate of 3.69% and the 10-year TIPs rate of 1.32% on that day. It is lower than the survey-based inflation expectations, but it a long term expected inflation rate, and you can use the term structure of Treasury and TIPs rate to extract an expected inflation term structure:
Put simply, investors are expecting inflation to peak over the next year and subside in the long term, close to the levels that we saw in the last decade. That may be hopeful thinking, and the returns on stocks and bonds over the rest of the decade will be determined by the correctness of this assessment; if investors are under estimating expected inflation in the long term, as they did in the 1970s, we are in for an extended period of malaise in markets.
Inflation’s First Order Effects: Interest Rates and Exchange Rates
Since 2008, it has become fashionable to attribute all movements in interest rates to Fed action or inaction, and as a consequence, we have lost sight of the fundamentals that determine interest rates. The most critical fundamental, and the one that best explains big movements in rates, over time, is expected inflation. For the last decade, it was not quantitative easing or Fed alchemy that kept interest rates low, but low inflation, in conjunction with anemic real growth.
As investor expectations of inflation have risen in 2022, treasury rates have risen inexorably, across the term structure:
In keeping with our earlier assessment of investors expecting higher inflation in the near term, than the long term, rates have risen across the term structure, but short term treasuries have risen more than long term treasuries. To get a measure of the damage done to bond prices as a consequence, note that the increase in the 10-year treasury rate from 1.51% to 3.69%, in 2022, has resulted in a return of -16.45% on a constant maturity bond.
As rates have risen at different rates in the short and the long term, the US treasury yield curve, which started the year with a steep upward slope has become distorted, and on September 23, 2022, the 2-year rate, at 4.20%, was higher than the 10-year rate, at 3.69%, with a relatively flat curve beyond 10 years:
Source: US Treasury
While I am remain a skeptic on inverted yield curves as cannot-fail predictors of recessions, the message in the distortions in the yield curve on September 23, 2022, is not a positive one about the future of the economy.
The other first order effect from inflation, and the Fed's reaction to it, has also been in the currency market, where the US dollar has soared against almost every currency, with the Euro and the British pound trading at or close to historic lows.
At one level, this is interest rate parity at play, as US interest rate rise faster than rates in other countries. At another, it is a flight to safety, as worries about the global economy and markets take hold. At every level, though, exchange rate movements that are this strong create chaos and disruption in the economies of both the strengthening and weakening currencies.
Second Order Effects: Risk Capital and Risk Premia
If the only consequence of higher expected inflation was higher interest rates, the damage from it would be contained and perhaps even neutralized by earnings and cash flows growing at higher rates, aided by inflation. However, higher inflation almost always seems to be accompanied with more uncertainty about inflation, and it is this second order impact that does real damage, in terms of how it impacts risk capital. In my July 2022 post, I defined risk capital broadly as capital invested in the riskiest segments of each asset class, and used the picture below to illustrate its reach:
Note the contrast between risk capital and safety capital, and in a healthy market, you need a balance between the two, with the excess of safety capital leading to stagnant economies and markets, and an excess of risk capital creating bubbles in markets and distortions in the economy. The last decade, for better or worse, has seen an explosion of risk capital, aided and abetted by central banks and policy makers. Inflation’s return to the center stage has, at least for the moment, broken the spell, and risk capital has withdrawn significantly from markets.
Venture capital: The VC focus on start-ups and young companies makes it a focal point of any measure of risk capital, and it has ebbed and flowed over time, with sharp pullbacks in the aftermath of the dot-com bust in 2001 and the banking crisis in 2008. The graph below updates venture capital investments, by quarter, from the first quarter of 2020 to July/August 2022:
Note the drop off in venture capital in the first quarter of 2022, and the even steeper decline in the second quarter suggests that this may not be a temporary retreat.
Initial Public Offerings: The exit path for the most successful of the ventures backed by VCs is an initial public offering, and the number and dollar value of initial public offerings operates as a proxy for the availability of and access to risk capital. In the graph below, we look at the this statistic across time, updated again through 2022:
Source: Jay Ritter for historical and Pitchbook for recent IPO data
Here again, the drop off in initial public offerings, both in number and value in 2022 has been dramatic, and if history is any guide, there will not be a quick comeback.
High Yield Bonds: High yield debt has always been part of the landscape of corporate bond markets, but for much of the last century, it was composed of investment grade debt that had been downgraded, as a consequence of corporate distress. Since the 1980s, companies with low ratings have been able to make issuances of their debt, with the demand for this original issuance high yield debt coming from bond buyers willing to take on additional risk. In the graph below, I track the issuance of high yield bonds over time, with a focus on the most recent quarters:
As with VC capital and IPOs, note the drop off in high yield debt issuances in 2022, both in dollar value terms, and as a percent of total bond issuance.
As risk capital has moved to the sidelines, the price of risk, i.e., the premium that investors demand for taking on risk has surged. You can see this in rising default spreads in corporate and sovereign bond markets, where spreads, which started 2022 at close to historic lows have risen, and more so for the lowest ratings.
In the equity market, the only immediate weapon that equity investors have for adjusting their price of risk assessment, i.e., the equity risk premium, is the stock price, pushing stock prices down, if they want higher equity risk premiums. It is for that reason that my assessments of equity risk premiums are model-agnostic and are based upon stock prices today and expected cash flows in the future being used to back out an expected return on stocks. Those assessments in the long term (1960-2021) and in the last two years (from January 2022 to September 23, 2022) are shown below:
There are two things that stand out about equity markets in 2022. The first is the surge in the equity risk premium from from 4.24% on January 1, 2022, to 6.05%, on September 23, 2022, an increase on par with what we have seen during market crises (2001, 2008 and 2020) in the past. The second is that as equity risk premiums have jumped, the treasury bond rate has more than doubled, from 1.51% on January 1, 2022, to 3.69% on September 23, 2022. In contrast to the afore-mentioned crises, where the treasury bond rate dropped, offsetting some of the impact of the rise in equity risk premiums, this inflation-induced market reaction has caused the expected return on stocks to rise from 5.75% on January 1, 2022, to 9.75%, on September 23, 2022; that increase of 4% dwarfs the increases in expected returns that we witnessed in the last quarter of 2008 or the first quarter of 2020.
Third Order Effects: The Economy and Psyches
The first and second order effects of inflation have been significant and damaging, but the question that remains unanswered is about the long term effects on the economy, and more importantly, on investor and consumer psyches. As you have probably noticed, perceptions of where the economy is headed have worsened, as we have gone through 2022, even in the face of relatively good news on unemployment. Much of the blame for the darkening forecasts has been directed toward Jerome Powell and the Federal Reserve, and while there is much that you can critique about how the Fed has played its cards during this crisis, it is inflation that is in the driver’s seat, not the Fed. Interest rates have risen this year because of inflation expectations rising, and it is these higher rates (and expected inflation) that are leading the Fed to act. In short, the Fed has two choices, neither of which is appealing. It can do nothing, which is the path that some of its critics would rather have it take, and interest rates will continue to rise, perhaps at an even faster rate, as inflation expectations surge. Alternatively, it can try to reclaim the narrative, by acting to slow the economy down, perhaps even putting it into a recession, with length and severity still to be determined. Rock, meet hard place!
As investors, our assessments of how inflation and the economy will evolve in the coming years will determine how much we should pay for stocks and bonds today. Having chronicled how inflation has changed the level of interest rates and the price of risk, let us bring in the remaining questions on earnings, cash flows and growth that we need to address to evaluate whether the market has under or over reacted to inflation:
In the sections below, I will focus on how I see inflation playing out in assessments of earning and growth, for the S&P 500 companies, as well as in their cash returns (dividends and buybacks).
Earnings: At the start of 2022, optimism was pervasive among analysts that the economy would continue to show strength and that earnings at US companies, up almost 47% in 2021, would grow strongly in 2022 and 2023. That optimism about the economy has faded, but there has not been a concurrent drop in estimated earnings, as you can see in the table below:
Source: Factset, Ed Yardeni
The earnings estimate for 2023, for S&P 500 companies, stood at 243.46, down only 0.6% from what it was on January 1. There are some subtle signs that forecasts of a recession are finding their way into earnings estimates. First, as you can see in the table, analyst estimates for what companies would generate as earnings in 2023 rose every month from January to June, but have dropped, albeit only slightly, during the summer. Second, the percentage of companies that are offering negative guidance about future earnings stood at 54%% in September 2022, suggesting that they see stormy weather ahead.
Cash Flows: Investors in public equities have no direct claim on earnings, and are reliant on companies returning cash to them in dividends, and increasingly over the last few decades, in stock buybacks. The dividends paid change relatively little from period to period, making them sticky, but stock buybacks are more volatile, with sharp cutbacks during crises or when companies become more concerned about their economic futures. The table below graphs dividends and buybacks, by year, going back to 2001, and also the dividends and buybacks, by quarter, just for the last four years:
Note the rising proportion of cash returned in buybacks, over the last 20 years, and the pullbacks in 2008/2009 and the first two quarters of 2020, in response to crises. That buyback number has largely recovered from its COVID swoon, and hit an all time high in 2021, with $734 billion in stock buybacks, across the S&P 500 companies. After rising again in the first quarter of 2022, we did see a pullback, albeit a small one, in the second quarter of 2022, with the possibility that there will be more coming in the third and fourth quarters of the year.
Long term inflation and interest rates: Having spent all of 2022 trying to hit a moving target on expected inflation, and the resulting interest rate, the one guarantee for the future is that there is more change coming. To make a judgment of direction, we have no choice but to take a stand on where inflation will settle in after supply chains are fixed, COVID is in the past and perhaps after the economy has cooled down. If we will revert back to inflation of 1-2%, as the market seems to believe we will, we will face a very different end game than if we revert back to 1980s levels of 3-4%.
With the caveat that I have absolutely no new insights or information into this process, I did make my estimates for the S&P 500, with the resulting valuation shown below:
I think that the given market pricing today, and my expectations of expected earnings and cash flows, stocks are very mildly over valued on September 23, 2022. I trust my judgments enough that I will leave my existing equity holdings intact, but I am not quite ready to jump in and make bets on market direction now. Clearly, your assumptions for the future will be different from mine, and I have a Do-It-Yourself (DIY) valuation of the S&P 500 that you can use to make your own judgment. In the table below, I list out the valuations that I get for the index with various combinations of 10-year treasury bond rates, equity risk premiums and assumptions about earnings in the future, relative to analyst forecasts:
S&P 500 Intrinsic Value Scenarios
If you are bullish, the assumption that makes the biggest difference is where you see equity risk premiums converging, with premiums closer to 4% yielding undervaluation on the index, even with significant earnings shocks built in. At the other end of the spectrum, if the equity risk premium stays at 6% or higher, the only scenario where you arrive at a value close to the index is if the 10-year T.Bond rate drops to 2% and earnings estimates come in as expected, with significant corrections to come, in scenarios where rates stay higher and/or earnings come in below estimates.
Given a choice between allowing inflation to play itself out and initiating polices that trigger a recession, there are some who are pushing for the former, arguing that trading off the certain pain that comes with a recession for the uncertain benefits of lower inflation is not good policy. I sympathize, but the dangers of letting inflation play out is that if it does so in unpleasant ways, where it stays high and volatile, its effects are going to be far more long term and more damaging. High and volatile inflation corrodes economies and markets from the inside out, destroying faith in currencies and making investors and businesses behave in dysfunctional ways.
Thanks so much for writing a piece with a view in it, albeit a heavily caveated and measured one. Thank you
Love the chart on inflation, real GDP, and 10 year treasury rate. Super interesting! I've followed you now since you were on Invest Like the Best with Patrick O'Shaughnessy, hands down my favorite episode and it can never be topped.