High on my list of first world problems is inflation. More precisely the absence of inflation.
Some of us hope (business) and some of us remain on the lookout (central banks) for the return of inflation.
Everyone is over “lower for longer” but what if, for the remainder of our working lives, inflation is dead?
There may not be much to celebrate. We don’t know how to operate in that environment.
The following is taken from David Hackett Fischer’s The Great Wave.
The 20th Century Price Revolution began in 1896 and no one has declared it dead.
It gets worse! The periods of price equilibrium are longer than our working lives.
We don’t know what it is like to live in price equilibrium….until now….and we are struggling to believe.
It is natural we lived through this:
US 10 Year Nominal Bond Yield
We should be confused. We have returned to an informal pegging of bond prices (QE) and we could be at the beginning of a new price equilibrium.
A Brief Background to My Conspiracy Theory
Up to March 1951 the US Fed had an obligation to support the bond market at pegged prices.
Inflation was institutionalised in 1975 with the Cost of Living Adjustments (COLA). Prior to 1975 social security benefits were set by legislation.
The COLA inflation snowball was eventually stopped by Volcker 1983.
TIPS were first issued in 1997. So was this the true beginning of market set asset pricing
I am being generous and using 1983 as my starting point. What if 2007 marked the end of the invisible hand? Perhaps we have only had 24 years of market set asset pricing and the experiment did not end well.
In summary, what if the current environment is permanent not transient?
The US 10yr TIPS yield remains below 0.50%.
The natural rate for US 10 yr TIPS is generally considered to be 2%.
So what has to occur for this to happen? A string of incredibly positive events that move us into the realm of fantasy.
The Goldilocks economy for the US Fed can be witnessed in their wage growth target.
Real rates will not normalise if business and government leaders are waiting for rates to normalise.
In developed world, markets we have finally witnessed asset prices reacting to the lower risk-free rate. We have also witnessed a narrowing in risk premia for some asset classes.
Should Risk Premia Across All Asset Classes Be Lower?
If rates normalise, victory will be declared and QE will have saved us from a financial black hole.
If the system can be saved what does this mean for risk premia?
The long term average market implied ERP is approximately 5% (S&P 500 trailing earnings yield less the 10 year TIPS yield).
An ERP at 5% is too high if the system can be saved.
The current market implied ERP is approximately 3.7%.
If you apply the Fed model: inflation is the ERP. The US equity market is still undervalued.
According to the Fed model, equity and bond markets are in equilibrium when the forward S&P 500 earnings yield equals the 10 year Treasury yield. At the moment equities are undervalued with a forward earnings yield of 5.7% versus the 10 year Treasury yield of 2.2%.
Whatever model you chose, the consequences of being saved looks uncomfortable.
A plodding US industrial company that grows in line with GDP could comfortably trade at 25x earnings. This a market implied ERP of 3% assuming the 10 year TIPS are at 2%.
If you are a bottom up investor it is time to review the assumptions page on your models.
Do my ramblings have an application now?
It could explain why value stocks have under-performed the market.
We still data sort value stocks with a 10x earnings cut-off. We haven’t moved the bar to accommodate the changes in the risk free rate.
When you sort for 10x earnings and below you identify all of the sunset sectors and companies.
Remember Charlie Munger’s greatest piece of advice?
Warren you have to stop buying sunset businesses.
In the current climate the value stocks data sort cut-off should be 20x earnings. This will dramatically increase the probability of capturing a business that will survive the next twelve months.
Interest rates will normalise when capital applies an appropriate rate of return.
Capital will not set an appropriate rate of return because it is concerned that interest rates will normalise.
We could be here for a while.