The Treasury worked hand in glove with the Federal Reserve over the past couple of years to transfer trillions of newly created dollars into bank accounts of individuals and corporations.
This policy was “a necessary humanitarian effort to keep our economy functioning through this COVID-19 crisis. By propping up aggregate demand, we aim to prevent a larger than necessary decline in economic output. Failing to do so would risk a depression and profound human suffering.”
I went on to warn that “many more dollars will be chasing a smaller amount of goods and services. The result will be inflation.”
Today, CPI is galloping above 8%. Now, the bond market is pricing a swift return to low and stable inflation. Investors ought to beware of the risk of interpreting this implicit forecast from bond prices as an unbiased estimate of the future path for interest and inflation rates.
Inflationary expectations can become a self-fulfilling prophesy. Expectations of higher inflation cause people to ask for higher wages and set product prices higher – feeding future inflation. Hence, the Fed actively seeks to manage inflation expectations. In so doing, they risk credibility. For example, they almost comically retired the word “transitory” in November 2021 after their failed effort to “talk down” inflation.
Four cyclical scenarios
SOFT LANDING. Today’s nominal 10-year US Treasury yield is near 3%, 10-year Breakeven Inflation (BEI) is also near 3%, therefore providing a 10-year real TIPS yield of about zero. The five-year BEI of 3.2% assumes that CPI falls toward the Fed’s target near 2% soon given that today’s year-over-year CPI is running at 8.5%. If the Fed manages to achieve this benign path for inflation and interest without causing a recession along the way, then the recent decline in stock prices may be behind us. While the present S&P 500 earnings yield of a little above 4% is well below its long-term average of 7%, it provides a reasonable risk premium relative to today’s long-term real rates of 0%.
RECESSION. Today’s bond market pricing might be right but the required tightening, taking the Fed Funds rate to 3% by early 2023 along with aggressive quantitative tightening, may cause a recession. If so, we may expect the stock market to price in a higher risk premium until it perceives the end of the recession. Stocks would likely fall further from here, but valuations may remain within the elevated range we have experienced over the 21st century.
PROLONGED INFLATION. If the Fed fails to tame inflation, then stock and bond prices have further to fall. BEI will rise along with nominal interest rates and investors will suffer losses in their bond portfolios. History, and common sense, teach that high inflation coincides with high volatility of inflation, interest rates, and equity prices. Volatility in capital market prices is like a thermometer displaying an elevated temperature. It reveals a disease. Following this analogy, the disease is flawed economic policy. High volatility raises risk premiums and lowers stock prices.
STAGFLATION. If the Fed fails to tame inflation and we have a recession or two, then expect capital markets to behave as in the late 1970s and early 1980s. Interest rates will soar toward or above the then-current rate of inflation. Equity prices will tank and P/E multiples will contract.
In the last period of stagflation, Shiller’s CAPE fell to below 10 in 1977, bottomed at 7 in 1982, and failed to rise back above 10 until 1985. With today’s CAPE well above 30, a fall even to just to 10 implies a frightful decline of stock prices.
Secularly rising real rates
Zero and negative real interest rates are not normal. As Larry Summers first explained in 2020, the global economy has been in a savings glut, which has persisted for the past two decades, thereby reducing real discount rates and raising P/E multiples.
China’s mercantilist growth model, US corporations’ pursuit of monopoly profits through financial engineering and low investment, and underinvestment in public infrastructure across the developed world all contributed to this excess of desired savings over actual investment.
Now, three secular forces are increasing the demand for real investment and thereby likely raising the global level of equilibrium real interest rates: increased military spending; reshoring of supply chains and manufacturing capacity (chip fab plants and rare-earth mining, for example); and dramatically increasing investment in sustainable energy.
To get inflation back under control, the Fed may need to raise interest rates to above the level of expected inflation. Unfortunately, today’s huge public debt, now over 120% of GDP versus just over 30% at the end of the 1970s, may not allow such a steep rise in nominal rates. Continued money creation may be required to service our debt when interest rates rise, thereby prolonging the inflation cycle.
Implications for investors
I perceive at least even odds that the Fed fails to get inflation under control soon. Can a fed funds rate of 3% tame CPI running at 8%? I also see even odds that we experience a recession before the end of 2023. I see a greater than one-in-three chance of both events happening: high inflation and a recession, or stagflation.
If I am correct, investors will wish to reposition portfolios to protect the real value of their financial capital. They may reduce exposure to equity beta and nominal duration by selling mainstream stocks and bonds in favour of commodities and real assets whose prices have historically risen in response to rising inflation.
Investors may protect the real value of their bond principal by swapping out of nominal bonds and into TIPS. Lastly, as is evident from recent movements in stock prices, investors will flee from longer-duration growth stocks and rotate into lower-duration and exceptionally cheap value stocks.
Chris Brightman is partner, CEO and CIO at Research Affiliates
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here