The markets are likely to go through a process of
recalibrating stock and bond prices to accommodate higher inflation, higher
interest rates, and a Fed that is less willing to step in with support when the
economy or capital markets feel distress. Stock prices may experience downward pressure
when faced with higher interest rates but upward pressure with stimulus-induced
economic growth. All else equal, downward pressures will result in sharper market
declines during a period of unusually low resilience that I expect to begin in
December.
We may find that stimulus-induced strong economic growth more than compensates for the lack of resilience - and we may miss some positive returns if this happens. But our philosophy is to reduce our exposure to stocks when the market is vulnerable. Moving in and out of stocks
is cheap and easy to do. We need to be looking ahead to the period after the next Plant
season when it is appropriate to be aggressive.
This
post discusses the current situation and a possible future condition that will be more economically rational and, I believe,
better for the economy, for stocks, and for our portfolios. I believe we need
to adjust our thinking to this emerging new reality because parts of it have not
been experienced for decades.
Sharp Minds Expect a
Deep Decline in Stock Prices
Jeremy Grantham is a well-respected investor thinks
it will be big. Here is a Q and A he had with Reuters in July 2021
(https://www.reuters.com/business/bubbles-bubbles-everywhere-jeremy-grantham-bust-ahead-2021-07-20/):
· Q:
What is your take on equity valuations now?
· A:
Looking at most measures, the market is more expensive than in 2000, which was
more expensive than anything that preceded it.
· My
favorite metric is price-to-sales: What you find is that even the cheapest
parts of the market are way more expensive than in 2000.
· Q:
What might bring an end to this bubble?
· A:
Markets peak when you are as happy as you can get, and a near-perfect economy
is extrapolated into the indefinite future. But around the corner are lurking
serious issues like interest rates, inflation, labor and commodity prices. All
of those are beginning to look less optimistic than they did just a week or two
ago.
· Q:
How long until a bust?
· A:
A bust might take a few more months, and, in fact, I hope it does, because it
will give us the opportunity to warn more people. The probabilities are that
this will go into the fall: The stimulus, the economic recovery, and
vaccinations have all allowed this thing to go on a few months longer than I
would have initially guessed.
· What
pricks the bubble could be a virus problem, it could be an inflation problem,
or it could be the most important category of all, which is everything else
that is unexpected. One of 20 different things that you haven't even thought of
will come out of the woodwork, and you had no idea it was even there.
· Q:
What might a bust look like?
· A:
There will be an enormous negative wealth effect, broader than it has ever
been, compared to any other previous bubble breaking. It's the first time we
have bubbled in so many different areas – interest rates, stocks, housing,
non-energy commodities. On the way up, it gave us all a positive wealth effect,
and on the way down it will retract, painfully.
I have met Jeremy a
few times for one-on-one conversations and have a great deal of respect for
him. He has a strong interest in valuations and has often been early in prior calls for markets to decline.
I believe it will be a shift in resilience that starts the
bubbles to pop. Based on the MRI research, the timing of that period of low resilience is likely upon us now. My theory of what pops the bubble is different than his, and I will discuss it in a future post.
Inflation Is Now Increasing
Inflation has been in
the news recently. This month’s inflation reading is expected to indicate that
prices have moved up over 6% since last year, the highest rate since 1991. (https://finance.yahoo.com/news/consumer-price-index-what-to-know-this-week-190934215.html)
I believe there will
be higher inflation and that a good case can be made that there should
be higher inflation for an extended period, and Powell would probably agree with me on this.
Powell as an Inflation
Fighter
Many articles on
Powell’s recent reappointment focused on the need to battle inflation, as
indicated by headline: “Biden Picks Jerome Powell to Lead the Fed for a Second
Term as the US Battles Covid and Inflation.”
(https://www.cnbc.com/2021/11/22/biden-picks-jerome-powell-to-lead-the-fed-for-a-second-term-as-the-us-battles-covid-and-inflation.html)
I believe that the
Fed’s efforts to fight excessive inflation are important. They should strive to
keep inflation from getting out control as it did in the 1970s. But I also
believe the ultimate goal of the Fed and the policy makers around the world will not be
extremely low inflation, such as the low levels of the 2008 to 2018 period - but
instead a moderate level of inflation. A level of 2 to 4 percent might be more
realistic for a protracted period.
Global Economies Have
Recently Confronted Something Worse than Inflation: Deflation
After the global
financial crisis in 2008/9, inflation declined so much that the major concern
among central banks around the world was not inflation but deflation – where
prices decline over time. While this sounds good, it tends to harm economic
growth. When consumers get a sense that prices will be lower in the future,
they put off purchase to wait for better prices. When they do that, production
declines and economic growth slows. Here is an article about deflation and I
have included (below) the key passage (https://www.thebalance.com/what-is-deflation-definition-causes-and-why-it-s-bad-3306169):
· Deflation
slows economic growth. As prices fall, people put off purchases. They hope they
can get a better deal later. You've probably experienced this yourself when
thinking about getting a new cell phone, iPad, or TV. You might wait until next
year to get this year's model for less.
· This
puts pressure on manufacturers to constantly lower prices and develop new
products. That's good for consumers like you. But constant cost-cutting means
lower wages and less investment spending.
For much of the
10-plus years after the global financial crisis, central banks sought to induce
inflation and the US Federal Reserve set an inflation target of 2%,
annually, which it struggled to achieve. Here is a quote from one of many articles on the topic from 2015 (https://www.cnbc.com/2015/10/13/the-us-is-closer-to-deflation-than-you-think.html.):
· Nonvoting
member James Bullard, who heads the St. Louis Fed, is among those pushing for a
rate increase, as he believes policy has helped make “cumulative progress
toward committee goals,” as he said in a speech Tuesday.
· Fed
Gov. Lael Brainard, who does have a vote on the FOMC, countered that
deflationary pressures argue against an increase.
· Our
economy has made good progress toward full employment, but sluggish wage growth
suggests there is some room to go, and inflation has remained persistently
below our target,” Brainard said in a speech Monday. “With equilibrium real
interest rates likely to remain low for some time and policy options that are
more limited if conditions deteriorate than if they accelerate, risk management
considerations counsel a stance of waiting to see if the risks to the outlook
diminish.
How Inflation Might Be
Used to Address Our High Levels of Debt
Inflation is likely to
be higher over the coming years not only because of Covid stimulus, infrastructure, and climate spending, but also
because higher inflation addresses a more fundamental problem the US and other
countries have. The article below requires a subscription, but I have included
key sections below (https://www.bloomberg.com/opinion/articles/2021-11-16/greenspan-s-bond-yield-conundrum-has-returned-to-haunt-markets):
The writer, John
Authers, does a good job of laying out a few key points:
- This
chart is from Deutsche Bank’s indefatigable financial historian Jim Reid and
goes back to 1800. It compares debt/GDP ratio with real yields defined as the
prevailing 10-year rate subtracting the five-year rolling average of
inflation:
[Note
from JHansen: The above chart focuses on just the US. I have added three big
blue arrows to indicate the three earlier periods of low real yields
(dark blue line labelled “SmoothRY”) and high Debt-to-GDP ratios (light blue line), plus, in yellow, the current period.
The key thing to note is the high debt-to-GDP levels under the four arrows.
Generally speaking, high levels are bad.]
· On
this view, real yields have been as low as this three times before in the last
200 years: during the U.S. Civil War, the Great Depression, and finally in the
aftermath of the Second World War. In all cases, for obvious reasons, debt
spiked. That has happened again [yellow arrow, JHansen], although not for
reasons as horrific as a war or a depression.
· The
low real yields associated with the Second World War came during a period of
explicit “financial repression” when the government held them [real bond
yields] low to make it easier to pay off the debts incurred to finance the
conflict, and the Fed had to surrender its independence for a matter of years.
The Reid hypothesis is that with another epic debt pile to pay off, another
episode of financial repression lies in our future. He also suggests that a
combination of inflation (to reduce the value of the debt) and repressed yields
(to make it cheaper to service) mean that real yields will stay negative for
the rest of his career, and that this unenticing option is superior to the
alternatives:
· Financial
repression has always won out. The previous debt spikes occurred around the
Civil War, WWI and WWII. This latest climb had been steadier (but substantial)
until Covid, which may explain why real yields have steadily but consistently
declined. However, the economic response to Covid has been more akin to a war
time response, with debt and spot real yields both spiking in opposite
directions just like that seen around and after the wars discussed above.
· [W]ithout
financial repression, real yields would likely be consistently positive at the
moment given the weight of global debt. But given this global debt pile, that
would strongly increase the probability of financial crises across the world.
So the risk to my “rest of my career” view is that something happens in the
years ahead that prevents the authorities using financial repression. If this
occurs then the global financial crisis may look like a dress rehearsal for a
much bigger event. So the incentives for the authorities are there.
· Beyond
that, a world of financial repression would continue to be a world of TINA,
where we are left grudgingly to buy stocks because There Is No Alternative
[TINA = There is no alternative. Low yields mean that bonds deliver lower returns to investors. - JHansen]. It’s not appealing, and arguably
it’s not really capitalism, but it might be the best way forward. It’s also a
worryingly good explanation for the continued low long yields.“
Low “real yields”
means that the yield on bonds is low compared to the inflation rate, and “long
yields” are yields on long term bonds.
"Financial repression" is known to those at the Fed. Here is quote from a Fed paper on the topic (https://www.richmondfed.org/publications/research/econ_focus/2021/q1/economic_history):
A Tool of Debt Liquidation: In many countries during 1945-1980, financial repression effectively lowered the real returns to government debt holders and helped governments reduce their debt-to-GDP ratios, according to research by Reinhart and M. Belen Sbrancia of the IMF. Based on their calculations, real returns on government debt were negative in many countries over 1945-1980. The real returns to bond holders averaged -0.3 percent in the United States, and real returns were even lower on the bonds of those European governments that had been particularly ardent practitioners of financial repression, coming in at -6.6 percent in France and -4.6 percent in Italy. ... Ever since McKinnon and Shaw, financial repression has been associated with inflation...
Given this
discussion, we might expect 1) bond yields and interest rates to increase enough to introduce greater
sensitivity to stock valuations over the short term and improve only slightly
the long-term return to some bond sectors, 2) interest rates still low enough to encourage
economic growth despite there being elevated inflation. 3) some upward pressure on stock prices because stocks have pricing power and can pass on any their higher costs to their customers, If this does turn out
to be the case, investing in stocks will be most beneficial because of TINA –
there is no alternative.
One Final Opinion:
Expect to “Muddle Through” as Opposed to Expecting a “Crisis to be a Cleanser”
When I started in the
investment business years ago, I thought of the economic and stock market
cycles as periodic waves of getting rid of the old, inefficient aspects of the
economy and allowing new ones to grow. While this rhythm does indeed take place,
the periodic purges and sprouting new ways have never been as big as I thought
they should have been. It is true that when the housing crisis started in 2007, it
seemed that financial leverage and novel ways of packaging investments had
become excesses before the crash of 2008, and these excesses were addressed.
When the dot-com
bubble inflated in the late 1990s, there was much talk about the extreme
valuations of companies with little or no revenue, and the subsequent bust of
the bubble addressed those excesses. After the run-away inflation of the 1970s,
it was clear that inflation had to be addresses, and Paul Volker increased
interest rates and inflation was tamed by the early 1980s.
To be sure, these were
major adjustments, but it surprised me at those times just how much of the
economy continued and absorbed these changes. It surprised me how much stayed
the same.
I think I had in mind
the experience of the Great Depression when the stock market dropped about 80-plus percent, the economy in the 1930 was indeed a shambles, and it took years (and probably
WWII) to get back on its feet. After that collapse, the economy and the country
were completely different in many ways. I think I was expecting change of
similar magnitude. But now, I realize that this expectation was unrealistic.
The economic collapse
after the 1929 stock market crash was different. At the time the Fed and the
government responded with a tough-love approach. There were government and
business leaders who expected and maybe even welcomed a cleansing crisis that
would abolish the excesses and provide fertile soil for new economic growth.
This is a quote from a very interesting Federal Reserve history piece (https://www.federalreservehistory.org/essays/great-depression):
· A
few governors subscribed to an extreme version of the real-bills doctrine
labeled “liquidationist.” This doctrine indicated that during financial panics,
central banks should stand aside so that troubled financial institutions would
fail. This pruning of weak institutions would accelerate the evolution of a
healthier economic system. Herbert Hoover’s secretary of treasury, Andrew
Mellon, who served on the Federal Reserve Board, advocated this approach.
However, as the
article indicates, this view is now considered by the Fed to be a mistake.
Instead, during a crisis the Fed should be very benevolent so the economy does
not collapse and gets back to growth quickly – economic growth addresses many
problems. One need only look at the response to the Covid crisis to see that this
mindset still prevails at the Fed and in our broader government, which have been
excruciatingly benevolent. But the Fed has concluded, rightly I believe, that
addressing the subsequent excesses resulting from benevolence when the economy
is stronger is much better than not being benevolent during a crisis.
This means that we
will muddle through each crisis and muddle through the effects of the remedies
used to prevent economic collapse during each crisis. At present, this means
addressing inflation while promoting economic growth and allowing the debt
level to shrink in proportion to the growing economy.
I expect the Fed to
allow the economy to run “hot,” which means that it will encourage economic
growth and allow a moderate level of inflation to take place. Stocks will be
likely be the main investment that produces a strong return in these future
conditions. Thus, after an initial period of recalibration and potential
decline, I expect stocks and to be influenced by the natural cycles of resilience.
I always pay attention to what Jeremy Grantham says. He may be right about a big decline that results in lower stock valuations. But even during the collapse of the internet bubble in the early 2000s, the natural cycles of resilience still allowed the MRI-based process to generate good returns. The same was true in the 1970s with its high inflation and the 1980s when inflation was fought. The same was true before and after the stock market peak in 1929. I expect our portfolios to do well in the environment described above and in other environments that are used to muddle through. The natural cycles persist.
Again, the implication
for us is to get out of the stock market when it is vulnerable and to be ready
to participate later in the growing
economy, to earn high returns in our portfolios, and to keep well ahead of
inflation when markets are resilient.
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