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:
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Download data |
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:

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.
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.
Economic Consequences
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:

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:
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Implied ERP spreadsheet |
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.
Investment Consequences
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.
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:
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Download spreadsheet |
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:

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.
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.
https://m.janatna.com