As you know I’ve been immersed in all things inflation, GDP, potential recession, commodity shortage, rising interest rates, and falling growth stocks.
I’ve put together information from the research as to what this all might mean. I’ll attempt to draw conclusions as we go but firstly the backstory to give context.
Where we were
- If we go back pre-Pandemic the economic trajectory was low interest rate, slow growth, low inflation. It was reasonable to think in 2020 we may have been headed for a mild recession. The yields on high quality fixed interest assets were mostly negative to par with inflation and the growth stocks were doing well whilst value stocks were moribund as they had been for a decade.
- Pandemic then hits, markets fall 35% plus. Central Banks hose money everywhere, everything stabilises. An awesome achievement, never done previously. The risk of a vicious depression staved off.
- COVID initially a complete unknown. How long would it disrupt and by how much? Central Banks decided as did most Governments to risk doing too much rather than too little to protect economies and individuals. They knew they’d been too timid after the Great Financial Crisis of 08-12 and were not making the same mistake.
- The creation of effective vaccines came at the earliest point even remotely thought possible. Dr Fauci initially estimated 5 years as the likely time scale. But the variants kept coming and uncertainty persisted. So, stimulus kept being added and that in retrospect was unnecessary.
- 2021 saw bubbles in high-risk assets such as SPACS and Crypto and strongly performing markets in stocks and domestic property. The markets rotated to value sectors which had their best year in a decade. In retrospect this was probably partially a signal that markets expected higher rates and value does better than growth with rising rates.
- Inflation was high, with Central Banks initially confident this was temporary and would not raise rates in response.
- Unexpectedly, employment numbers became incredibly tight. Literally a large lump of the workforce appeared to have been furloughed and then dematerialised. It quickly became known as the great resignation. As a consequence, wages started rising rapidly especially at the lower end of the market in retail and hospitality. In the U.K. BREXIT added to labour shortages.
- By October/November with inflation high and employment so tight the Central Banks started to say they needed to act by raising interest rates. They may still have believed that things would normalise, but they had to be seen to be doing something.
- Markets started to reprice assets based on a rising rate environment as we came into 2022. It was still likely that the majority of the supply/demand imbalances causing price spikes would fairly quickly normalise, so rates were not likely to rise significantly quickly.
- Russia invades Ukraine – massive commodities shock and highly inflationary.
- China locks down with Covid – massive potential supply chain shock.
- Inflation prints for April for the US and U.K. come in at over 8%.
- Markets have their worst starts to a year, certainly within the last 50 years
Where are we now?
Firstly Europe is in a world of difficulty with its energy provision. This gets more visible in the autumn and winter when heating ramps up. Costs will be very high so expect to see Governments make direct assistance payments to households. Post Covid they know it’s popular and works.
Secondly, inflation numbers are backward looking. They are what has happened not what is happening.
If we look at the most current economic numbers, they are starting to tell a different story.
The ISM or purchasing managers index number is approaching 50 which is no growth. It’s trending down very sharply so likely to go sub 50 which is recessionary.
This means the demand for goods (which rocketed higher in the pandemic when supply was constrained) is now collapsing.
Thirdly, Target and Walmart just both announced horrendous quarterly numbers due to huge inventory excess. Simply put, they hugely over ordered during the pandemic as they couldn’t satisfy demand and now there is far less demand and can’t sell the stock. They will have to discount it and reduce ongoing orders until balanced stock levels are achieved.
This is pretty much the general case.
There are no longer shortages everywhere, prices are reducing as inventories rise at the same time demand is falling. This is deflationary.
Fourthly entiment indicators are as poor both from businesses and the public as they ever have been. As bad as the GFC. So, activity is reducing which is deflationary.
Fifthly, all the main causes of inflation spiking in 21 (excepting energy and food) are showing sequential reductions. As an example, the used car market in the US went from an average price pre-pandemic of $20000 to a peak of $29000, this is now falling month after month so it’s deflation in this market and it’s a big element of the inflation calculation.
Sixthly, housing costs have almost doubled in terms of mortgage fixed rates. The affordability is circa 35% lower than this time last year and prices are also 10-20% plus higher.
The domestic property market in general (excluding special areas where demand exceeds supply) will more likely either stagnate or fall for a time going forward. If inflation averages 4-5% and house prices don’t rise then this does the same job as a fall in value in a zero-inflation environment. It should also be remembered that high inflation is great for property values when combined with debt.
If inflation is 5% the debt element gets deflated over time. This is why historically people in the U.K. bought homes and Germans didn’t.
They had little inflation; we had a lot.
The central bank hikes
Once you focus on this, what’s happened makes a lot more sense.
The Central Bank, be it the BOE or Fed have their base rate, and all pretty much went to zero due to Covid.
The markets however express their view of the likely trajectory of future rates by how they price the various terms of Government debt, in the case of the US the Treasury rates.
Now in normal times the short end of rates (the Treasuries with short maturity durations) price around the Fed funds rate and the longer durations offer higher returns due to the risk of owning something for up to 30 years.
The 10-year Treasury is pretty much the average or neutral rate the market thinks rates will be at. This averaged around 2.3% over the last decade. So, to see what markets are thinking and how their view is changing, look at the movement of the 10-year rate.
- April 2020 the rate was 0.65%
- Jan 2021 the rate was 1.7%
- October 2021 the rate was 1.5%
- April 2022 the rate was 3.2%
- Rate now around 2.8%
So, from the time the Fed started to say it was intending to raise rates (October), the 10-year more than doubled before the first-rate rise occurred, which only took the Fed funds rate to 0.5%.
The reality of rising rates then, already pretty much fully happened.
Every rate which a business or consumer will now be charged is based off the 10-year Government bond.
US 30-year fixed rate mortgage rates went from 2.5% to 5.5% in the space of 6 months.
The market has listened to the Fed talk and it’s changed the rates to where it thinks they’ll stop. The question going forward is whether markets need to increase rates more or if they’ve overshot and reduce them.
Markets have front run the Fed so aggressively in hiking the 10-year rate, this has impacted equity prices which have dramatically rebased to a much less favourable scenario. But the market doesn’t know what will actually happen. It’s priced in a bad outcome where inflation is difficult to bring down.
So, the only question really is, will it fade quicker than expected or is it actually really sticky? If we just knew that we’d know all we needed.
Long duration assets
Interest rates matter to the valuation of high growth companies far more than value stocks. The market sees interest rates as a cost on growth so the higher they go the lower the growth multiple applied to valuation. Brad Gerstner at Altimeter calculates each 1% rise reduces growth stock valuation by 15-20%.
So, it’s obvious that high growth stocks like Snowflake, Shopify and Crowdstrike would suffer as rates pushed higher.
If you use Gerstner’s metric, then rates rising from 1.5% to 3% should have reduced values by around 30%.
If you add on multiple contraction which is really to say a timid market less full of animal spirits, then it’s quite possible to see why high growth shares have come down 50% plus.
What is interesting though is the average reduction in technology stocks using the drawdown %age above assumes a 4.5% interest rate and no growth in earnings.
It’s also interesting that the valuation of tech stocks is back or below the multiples pre-Covid.
So, what if the rates never get to 4% or even 3%? What if they settle back to the long-term average of 2.3%? Then it would appear the drawdowns are overdone.
Bernanke says: follow the TIPS price
Ben Bernanke the previous Fed President was asked recently how he viewed inflation prospects. He answered that if you wanted to know then follow the price of TIPS.
These are the inflation version of Treasuries where the yield is the rate of inflation. The market then moves the yield above or below the regular 10-year rate depending on whether it views inflation expectations as greater or lesser. The current 10-year TIP rate is 2.5% so about 10-15% below the ten-year rate. It has only recently stated to discount a lower inflation expectation.
The chart of truth
The chart below is what Raoul Pal calls his chart of truth.
It shows that the interest rates from 1985 until now with a lower high in each cycle.
That’s to say interest rates are falling consistently in a downward wave.
The question therefore is, has a 40-year cycle now broken?
Or the pandemic caused a load of short-term volatility and disruption, but the fundamental trajectory of economies will return to their previous path?
There are a lot of smart people who are saying that inflation is going to be difficult to remove and labour shortages are going to keep pushing up salaries.
They further point to inflationary pressures from
- Decarbonisation / net zero targets
- Commodity shortages
- The retreat of Globalisation
- Fiscal spending and Onshoring
These are all reasonable points and to some extent all will have an impact.
There are equally smart people who say:
- Technology destroys inflation, and this will get faster. We have seen this in the last 10 years.
- The disruptions of Covid are falling away rapidly and inflation will in some big elements become deflationary as prices reduce.
- Commodities are cyclical, higher demand will create higher supply which reduces price. This happens over and over.
There is huge discussion over whether the U.K. or US goes into recession. It’s quite likely mainland Europe is already in one.
The reality though is that normal recessions clear out excess.
Too much borrowing, leverage, employment and consumption.
Companies and consumers are borrowed to the hilt, and everything runs out of steam.
They can be brutal and destructive, but they purge.
This is just not how we are set up currently:
Bank lending is very muted.
Corporate balance sheets are stuffed with cash and in great shape.
Levels of borrowing are very low and long-term fixed rates are at low levels both for companies and individuals on average.
So yes, we may get a contraction in consumption, but the labour market will stay strong, and debt is not an issue.
So, an oddity of a recession and not as destructive as previously.
What seems clear is that inflationary pressures excluding food and energy are abating rapidly.
Both Amazon and Walmart, two of the largest US employers said they are over staffed. Multiple large companies are announcing hiring freezes or headcount reductions.
People are being hit by higher energy and food prices so have less disposable income just as interest rates are rising to remove more.
There is a ferocious tightening of financial conditions coming and the evidence is that economies are already slowing rapidly or starting to contract.
Is this an environment where labour holds sway over wage rises or businesses have pricing power? Probably far less than the last 18 months.
My gut feel is that inflation slows quicker, economies start to show stress, the Fed and BOE stop rate hikes sooner and rates fall in bond markets as they are recognised to have been overly pessimistic.
The economy rebalances back to a slower growth, lower rate as pre-pandemic although both inflation and rates are possibly higher due to the new elements of fiscal spending, onshoring and energy/ decarbonisation / net zero targets.
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