Inflation numbers have
been coming in high now, for more than a year, but for much of the early
part of 2021, bankers, investors and politicians seemed to be either in
denial or casually dismissive of its potential for damage. Initially,
the high inflation numbers were attributed to the speed with the economy
was recovering from COVID, and once that excuse fell flat, it was the
supply chain that was held responsible. By the end of 2021, it was clear
that this bout of inflation was not as transient a phenomenon as some
had made it out to be, and the big question leading in 2022, for
investors and markets, is how inflation will play out during the year,
and beyond, and the consequences for stocks, bonds and currencies.
Inflation: Measurement and Determinants
As the inflation debate was heating up in the middle of last year, I wrote a comprehensive post
on how inflation is measured, what causes it and how it affects returns
on different asset classes. Rather than repeat much of that post, let
me summarize my key points.
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Measuring inflation
is not as simple as it looks, and measures of inflation can vary
depending on the basket of good/services used, the perspective adopted
(consumer, producer, GDP deflator) and the sampling used to collect
prices. That said, the three primary inflation indices in the US, the
CPI, the PPI and the GDP deflator all told the same story in 2021:Download historical inflation numbers -
While news stories focus on reported (and past inflation, it is expected inflation
that should drive investment, and measures of these expectations can
come from surveys of consumers (University of Michigan) or from the
market, as the difference between the treasury bond rate and the
inflation-protected treasury bond, of equivalent maturity:Download data Using
the ten-year bond, it is clear that while inflation expectations have
inched up in the bond market, but that rise is far more muted than in
the actual inflation indices, and consumer expectations of inflation now
significantly exceed the bond-market imputed estimate for expected
inflation. -
While the implied inflation in bond rates is low, investors seem to be anticipating higher inflation.
Using a measure that the Federal Reserve has developed, I report the
percent of investors expecting inflation to be greater than 2.5%,
representing one end of the inflation expectation spectrum, and those
expecting deflation, representing the other, in the graph below:Download data As
you can see the 93.96% of investors were expecting inflation to be
greater than 2.5%, by the end of December 2021, up from 6.74% in
December 2020, suggesting a sea change in the market. Conversely, the
percent of investors expecting deflation has dropped to a vanishing low
number, suggesting that Cathie Wood has little company, in her contention that deflation is the real danger to markets and economies.
undeniable fact is that inflation came back in 2021, but the question
of why it happened, and whether it will stay high, is hotly debated. To
those who believe that it is a spike that will dissipate over time, it
is another casualty of COVID, as a combination of virus-driven supply
chain issues and government spending to offset shutdowns has driven
prices up. In this mostly benign story, inflation will go back down,
once these pressure ease, though it is unclear to what level. To others,
and especially those old enough to remember the 1970s, it does seem
like a return to more unsettled times, with potentially dangerous
consequences for the economy and markets.
Interest Rates and Inflation
Inflation
and interest rates are intertwined, and when their paths deviate, as
they sometimes do, there is always a reckoning. While we have
increasingly given central banks primacy in discussions of interest
rates, it remains my view
that markets set rates, and while central banks can nudge market
expectations, they cannot alter them. Put simply, no central bank, no
matter how powerful, can force market interest rates down, if inflation
expectations stay low, or up, if investor are anticipating high
inflation.
US Treasuries: A Mostly Uneventful Year
After a turbulent year in 2020, when COVID shut the global economy
down, and interest rates plunged and stayed down for the rest of the
year, 2021 was a more settled year, with long term rates rising
gradually over the course of the year, but short terms rates staying
put:
Treasury Rates Data |
While
treasury bills continued to yield rates close to zero, rates increased
for longer term treasuries, with 2-10 years rates rising much more than
rates on the longest term treasuries (20-year to 30-year). For those who
track the slope of the yield curve, and I am not one of those who
believes that it has much predictive power, it was a confusing year. The
treasury curve became steeper, but only at the shortest end of the
spectrum, with the slope rising for the 2-year, relative to the 3-month,
but not at all, when comparing the 10-year to the 2-year rate. Beyond
the 10-year maturity, the slope of the yield curve actually flattened
out, with the difference between the 30-year rate and the 10-year rate
declining by 0.34%.
Corporate Bonds: No Shortage of Risk Capital
In
my last post, I chronicled the movement in the equity risk premium,
i.e. the price of risk in the equity market, during 2021, but the bond
market has its own, and more measurable, price of risk in the form of
corporate default spreads. Using bond ratings classes to categorize
companies, based upon credit risk, I looked at the movement of default
spreads during 2021:
Download data |
Corporate
default spreads decrease across ratings classes, but the decline is
much larger for lower rated bonds, with the default spread on high yield
bonds registering a drop of 1.25%. Note that the decrease in default
spreads, at least for the lower ratings, mirrors the drop in the implied
equity risk premium during the course of 2021. Read together, it
suggests that private risk capital continued to not just stay in the game, but increased its stake during the course of the year, extending a decade-long run.
Expected Inflation, Interest Rates and Bond Returns
While day to day movements in interest rates are driven by multiple forces, including the latest smoke signals coming from central banks
and investor sentiment, the longer term and drivers of interest rates
are fundamental. In particular, if you start by breaking down a long
term riskfree rate (like the 10-year treasury bond) into an expected
inflation and an expected real interest rate components, you can also
reconstruct an intrinsic risk free rate by assuming that the real growth
in the economy is a stand-in for the real interest rate and that most
investors form expectations of future inflation by looking at the
inflation in the most recent year(s):
Download data |
In this picture, the actual ten-year treasury bond rate is superimposed against a rough measure of the intrinsic risk free rate (obtained by adding together the actual inflation rate and real growth rate each year) and a smoothed out version
(where I used the average inflation rate and real growth rate over the
previous ten years). Not only has the intrinsic risk free rate moved in
sync with the ten-year bond rate for most of the last seven decades, but
you can also see that the main reason why rates have been low for the
last decade is not the Fed, with all of its quantitative easing
machinations, but a combination of low growth and low inflation. Coming into 2022, though, the intrinsic risk free rate is clearly running ahed of the ten-year treasury bond rate,
and if history is any guide, that gap will close either with a rise in
the treasury bond rate or a decline in the risk free rate (coming from a
recession or a rapid drop off in inflation).
Unexpected Inflation and Asset Returns
Note that it is expected inflation that drives interest rates, and
that the actual inflation rate can come in above or below expectations. In my post on inflation last year, I drew a contrast between expected and unexpected inflation,
arguing that financial assets are affected differently by each
component. If expected inflation is high, but it is predictable,
investors and businesses have the opportunity to incorporate that
inflation into their decision making, with investors demanding higher
interest rates on bond and expected returns on stocks, and businesses
raising prices on their products/services to cover expected inflation.
Unexpected inflation is what catches us off guard, with unexpectedly
high inflation leading to a reassessment of pricing (for all financial
assets) and an uneven impact across businesses, leaving those with
pricing power in a better position than those without that power.
To assess how inflation has affected asset returns over time, I broke
down the actual inflation rates since 1954 into expected and unexpected
components each year, using a brute force assumption that the average
inflation rate over the last ten years is the expected inflation rate.
(In the last two decades, we have had access to more sophisticated
measures of expected inflation, including the difference between the
nominal treasury bond and TIPs rates, but not in earlier years). In the
graph below, I look at annual returns on stocks, treasury bonds and
corporate bonds, with the unexpected inflation numbers also shown:
during periods of higher or lower inflation, as can be seen in the
extended stretches of higher than expected inflation, in the 1970s, and
lower than expected inflation in the 1980s.
it is not immediately visible in the graph, returns on stocks and bonds
are affected by unexpected inflation, and to illustrate by how much, I
broke the 94 years of data into five quartiles, based upon the level of
unexpected inflation, with the lowest (highest) quintile representing
the years when inflation came in most below (above) expectations, and
estimated the annual returns (nominal and real) for stocks, treasuries
and corporate bonds in the table below:
treasuries and corporates, the returns generally get worse, as
inflation comes in above expectations, with real returns showing the
damage from unexpected inflation. With equities, the sweet spot in terms
of returns is when inflation is at or below expectations, and the worst
scenarios are when inflation comes in well above expectations. I also
looked at how inflation plays out on equity sub-groupings, on two
dimensions, the first being market capitalization and the second being
price to book, with the former becoming a stand-in for the vaunted small
cap premium and the latter for the value versus growth question.
perhaps providing some insight into why the vaunted small cap premium
seems have to disappeared over the last two decades of muted inflation.
Similarly, the value effect, computed as the premium (or discounted)
return earned by low price to book stocks over high price to book,
becomes more pronounced during periods when inflation is greater than
expected and much less so, during periods when inflation is lower than
anticipated.
same approach with gold and real estate, with the caveat that historical
data on the former is more limited, I get the following results:
gold and real estate both do better than financial assets, when
inflation is greater than expected, there is also a clear difference
between the two investment classes. Real estate operates more as a
neutral hedge, delivering returns that are, for the most part, unscathed
by unexpectedly high inflation, but gold is a bet on inflation,
delivering the highest returns, when inflation is much greater than
expected, and negative returns, when it is lower than expected. Much as I
would like to extend this analysis to newer investment classes, there
is not enough historical data on crypto currencies or NFTs to allow for
the analysis. As I noted in my inflation post in 2021,
though, the early evidence is not promising for these new investment
categories, at least as inflation and crisis hedges, since they have
behaved more like risky equities, at least on a day-to-day basis and
during the 2020 crisis, than like gold.
Much of this post has been about inflation in the US, and by
extension, in US dollar terms, it is worth emphasizing that inflation is
a currency-specific phenomenon. While inflation in the US dollar, by
dint of its status as the currency in which commodities are priced, can
sometimes spill over into other currencies, it remains true that you
can have high inflation in one currency, while there is low inflation
in other currencies. Inflation differences across currencies play out in
two domains, with the first being interest rates in different
currencies and the other being exchange rate.
I start every one of my discussions of discount rates with a truism,
by stating that the riskfree rate that you start with should reflect
the currency in which you have decided to do your valuation. That then
becomes the springboard for estimating risk free rates in different
currencies, following one of two paths. In the first, you start with
government bond rates in the local currency, in different currencies,
and adjust those rates for default risk in the local
currency government bond. (Government bonds in local currencies do
default, and account for a significant proportion of sovereign defaults
in the last 50 years). My estimates for the start of 2022 for the
currencies where local-currency government bonds are available is below:
Download data |
Riskfree
rates are highest in currencies, like the Zambian Kwacha or Turkish
Lira, where inflation is highest, lower in low-inflation currencies and
even negative in currencies, where deflation may be the long term
prediction. I am using the default spreads based upon the local
currency sovereign ratings for the countries in question, with the
government bond rate being the risk free rate only for currencies where
the issuing government in triple-A rated. If you dislike this
assumption, or do not believe that the government bond rate is a
market-set number in a particular market, there is a second approach,
where you start with the risk free rate in US dollar or Euros, and
adjust it for differential inflation, i.e., the difference in expected
inflation between the US and the country in question:
Thus,
if the US treasury bond rate is 1.5%, and expected inflation rates in
the US and Indonesia are 1% and 4% respectively, the approximate
riskfree rate in Indonesian Rupiah will be 4.5% (=1.5% + (4%-1%)) and
the more precise riskfree rate in Rupiah will be 4.52%
(=1.015*(1.04/1.01)-1). While the expected inflation rate in dollars may
be an easy get, it is more difficult to get expected inflation rates in
other currencies, but the IMF has estimates for the next five years at this link.
rates over time are also driven by those same inflation differentials.
Drawing on one of the oldest relationships in exchange rates, purchasing
power parity, you can extract the forward exchange rate in a currency:
Thus,
currencies with higher inflation can be expected currency devaluation
over time, relative to currencies with lower inflation. As with interest
rates, in the short term, there are forces, ranging from central
banking intervention to momentum and speculation, that can cause rates
to deviate from the inflation script, but in the long term, it is almost
impossible to break the cycle.
Connecting this linkage to the discussion of US inflation in the
prior sections, here are the takeaways. If you believe that inflation
will stay high, not just in the US, but across the globe, the exchange
rate effects will be muted. If, on the other hand, you believe that the
inflation shock will vary across countries, your actions will be more
nuanced. For the countries where you believe that local inflation will
decrease, relative to the US, the US dollar will weaken against their
currencies, augmenting returns you will earn in their markets (stock or
bond). For countries, where you see local inflation surging more than
you expect to see in the US, the US dollar will strengthen against their
currencies, reducing the returns you make in their markets. As with the
discussion of asset returns, it is not expected inflation that is the
source of exchange rate risk, since you can incorporate those
expectations into exchange rates, but unexpected inflation, which, when
extreme, can cause significant revaluations of currencies.
As with any historical data assessment, I could give you the
standard boilerplate disclaimer that past performance is not always a
good predictor of the future, but to the extent that the past provides
signals, your expectations of how inflation will play out in the coming
year will play a key role in your asset allocation and stock selection
decisions. If you believe that last year’s surge in inflation is a
precursor to a long time period when inflation is likely to stay high,
and come in above expectations, you should be shifting your holdings
away from financial to real assets, and within your equity holdings,
towards small cap stocks, stocks trading at lower pricing multiples
(PE, Price to Book) and companies with more pricing power. If, on the
other hand, you believe that inflation worries are overdone, and that
there will be a reversion back to the low inflation that we have seen in
the last decade, staying invested in stocks, and especially in larger
cap and high growth stocks, even if richly priced, makes sense.
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