The Inflation Shift Continues – What It May Mean
I have been suggesting in my work this year that the major, secular driver of ever-higher stock market valuations may be changing. I have written my views that the new upward bias in inflation is not just a temporary upward push in inflationary pressure but may prove to be a more durable shift in overall global inflationary pressure.
By this, I’m not suggesting the world’s pricing structure is shifting back to what we saw in the 1970s and early 1980s, which was a “cost-push” inflation spiral. I don’t think we will see a sustained 5%+ inflation environment unfold. I suspect durable inflationary pressure will prove to be more in the 2.5% – 4% range.
This shouldn’t be surprising to those who understand the history of the U.S. economy. After all, since 1960, the inflation rate in the U.S. has averaged 3.7% annually.1 The period of very low inflation pressure came into its own following the financial crisis of 2008-2009. For the 11 years from March 2009 until December 2020, inflation averaged 1.5%; far below longer-term U.S. economic norms. Given a 50-year time horizon, the period of very low inflation that we experienced from 2009-2020 was an outlier. Normally, inflation has run higher than the Fed’s 2% “target” range, and 3%-type inflation has tended to be the norm.
The Federal Reserve is starting to signal that monetary environment will be changing as price inflation appears to be more durable than the Fed first realized.
I have argued in the past that other major drivers of longer-term deflation/disinflationary pressures are easing. These longer-term pressures include:
- An upward shift in global nationalism, leading to a lessening in growth of global trade.
- The maturation of nationalistic shift in China, which should lead to lower overall industrial development in China that has brought ever-lower prices to consumer goods on a global scale. Additionally, the shift in China toward a more aggressive communistic state may lead to further global dislocation.
- Demographics in the developed world. With the aging of the populations of most western societies, a “worker shortage” is developing. This may lead to an upward shift in the portion of national GDP that eventually moves toward labor costs and away from returns on capital.
Inflation in the U.S. (Consumer Price Index per the folks at the St Louis Fed) collapse from 14.6% in 1980 to less than 1% recently, was, of course, accompanied by a like-collapse in U.S. Treasury bond yields. From August 1981 through April 2020, the 10-year U.S. Treasury note yield fell from 15.8% to 0.6%.
Since bond yields collapsed, bonds became less attractive to investors, who turned to the stock market for returns. The price to earnings ratio (a decent measure of “valuation”) soared from 7x earnings in 1980 to today’s 22x earnings.2 If the S&P 500 was selling at 7x earnings today, the index would be selling at 1540 (7x expected earnings of $220 next year)3 instead of the current level of 4355. By this argument, the 40-year collapse in interest rates and inflation currently accounts for 65% of the value of the S&P 500.
Now, I don’t expect interest rates and inflation to rise back to the double-digit levels we saw 40 years ago. But I suspect the days of ever-lower interest and inflation rates is probably behind us. It makes sense for us to at least consider that a new capital market preference regime may be at hand.
Deep Dive – What This May Mean
The capital allocation decision investors make is driven by many factors. Probably the most important factors center on the needs of the investor. But the decision to manage risk and return exposure and preferences is something all investors share. The need to understand what macro environment – either deflation or reflation – we are in is of critical importance for all who place capital in the financial markets.
As noted above, I suggest the days of ever-lower interest and inflation rates may be ending. Going back in time, we can see that the exchange rate for the U.S. dollar tends to strengthen during times of deflation/disinflation pressure and tends to fall during times of reflection acceleration. A movement on the downside in the foreign exchange (FX) rate implies a higher inflation rate and higher “real” asset prices. As such, during periods of U.S. dollar weakness, reflationary assets, regions and sectors tend to perform better than beneficiaries of disinflationary pressures.
According to an article in Barron’s magazine, “Dollar Decline is Underway,” the folks at Neuberger Berman think that the U.S. dollar FX rates have been in a seven to 10-year trading “cycle.” They make the case that the dollar entered a secular decline in March of 2020 (see chart above). They suggest that the dollar, on balance, should show weakness on an FX basis over a multi-year period of time.
This view holds that gross domestic product (GDP) projections from the International Monetary Fund (IMF) forecasts a decline in the United States’ proportional contribution to global GDP starting in 2022. This dynamic of growth deceleration, as compared to the rest of the world, has historically been associated with periods of dollar weakness.
They go on to report that since early in the 20th century, a weakening dollar and relatively stronger U.S. inflation has coincided with outperformance of European equities as compared to the U.S. markets. Additionally, they add that the emerging market space has tended to outperform “developed” markets when these fundamentals have been present.
This performance “shift” has tended to persist outside of equity markets as gold has outperformed returns on U.S. Treasuries and copper price change has been stronger than that of gold, as the dollar weakened, and U.S. growth flagged.
My outlook is calling for a deceleration of GDP growth in the U.S. In addition, I believe the rest of the world will show a slower rate of growth decline than here in the U.S. in 2022. While I believe inflation won’t top 3% next year, the U.S. inflation rate will probably eclipse that of most “developed” economies.
We obviously will continue to monitor the inflation and growth developments on a global scale as this period of rising inflation pressure combined with slower overall economic growth rates persists.
1St. Louis Federal Reserve
2,3Yardeni Research data.
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation. It is not possible to invest directly in an index.
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