- The economic outlook is bleak.
- Bond yields are likely to fall.
- Falling bond yields are bullish for equities.
Wednesday, April 8, 2015
The recent economic telemetry suggests weakness:
> The Atlanta Fed forecasts 0.1% growth for 1Q15.
> The PPI is negative and core inflation is zero.
> The CRB index is down 30% since July.
> Five-year expected inflation is 1.6%.
> The real funds rate has risen from -4% to 0% (per St Louis Fed).
> Employment growth is slowing and participation continues to decline.
We are seeing the result of the premature withdrawal of fiscal and monetary stimulus in the face of a fragile recovery. Fiscal policy has been tightening for five years, and monetary policy has been tightening since 2012 (as measured by money growth). The credit aggregates have stopped shrinking but household credit has not resumed growth. The credit markets are still suffering from PTSD. Restrictive policy is the wrong medicine for this malady.
The data says to me that we are looking at negative shocks to inflation and the bond market which will push the 10-year yield back down to the 1.5% neighborhood. It has already fallen from 3% at the beginning of last year to 1.9% today. It has plenty of room to go lower: it fell as low as 1.4% in mid-2012.
Generally speaking, falling bond yields are bullish for equity valuations because (1) they lower the discount rate for future cashflows; (2) they drive investors out of bonds; and (3) they raise the equity risk premium. Since the Crash, the 10-year yield has fallen from 3.5% to 1.9%, or by 45%, while over the same period the Wilshire US Large-Cap Total Market Index has risen from 17,000 to 60,000.
The equity risk premium (ERP) measures the difference between the long-term risk-free rate and the expected return from equities over a similar horizon. Damodaran at NYU uses 8% as the expected return from equities and the 10-year yield as the risk-free rate. The historical return from equities has been volatile and the choice of time period will produce different results. For example, the total equity return since the Crash has been 21% per annum. It is important to remember that the return from equities is price appreciation plus dividends. This is why the total return indices outperform price indices.
Damodaran calculates today’s ERP at 5.5%, which is mid-range for the post-Crash period but quite high for prior periods going back to 1961.
Because the expected return from equities has been set at 8%, changes in the ERP reflect changes in Treasury yields: lower yields = a higher ERP. Therefore the risk to equity valuations is not fluctuations in earnings, dividends or even prices; the risk is higher bond yields. To decide whether stocks are currently cheap requires the investor to make a judgement about future bond yields. When I look at the data dashboard today, I see many things that suggest lower yields and only a few things that suggest higher yields (falling unemployment and rising employment costs). Therefore, I believe that stocks remain attractive and should go higher in the event that economic weakness results in lower bond yields.
Monday, January 12, 2015
- Bond yields are dangerously low.
- Prices are falling and inflation expectations have become unanchored.
- The Fed will have to act, and bond prices will have to fall.
- Stocks are more remunerative than bonds right now.
Bond prices have soared and bond yields have declined by one-third since Janet Yellen became Fed chairman. Over the past six months, five-year expected inflation has declined from 2% (the Fed’s target) to 1.2%, a decline of 40%, and far below the Fed’s target. The Fed’s inflation target has lost credibility in the bond market.
In 1933, Irving Fisher wrote about deflation risk: “The more the economic boat tips, the more it tends to tip.” On the same topic, Ben Bernanke said that “the best way to get out of trouble is not to get into it in the first place”. In other words, deflation is much easier to prevent than to correct, as the ECB is learning at this very moment.
One of the Fed’s stated goals is to anchor expected inflation so as to avoid inflationary or deflationary pressures from building. Something happened in 2014 which caused inflation expectations to become unanchored, perhaps the premature taper of QE or the constant talk of a rate hike. It doesn’t really matter what caused expectations to become unanchored, because inflation expectations are the Fed’s job to manage, not an exogenous variable to be lamented. Deflation is a currency-specific monetary problem, and there is no such thing as “global deflationary pressure”. The Fed’s failure to anchor inflation expectations has created a big bond bubble that will need to be popped.
It is difficult to argue that the bubble won’t ever be popped because there is a “new normal” of low everything. The only way that we can have such a new normal is if the Fed were to permanently abandon its inflation target. Assuming it doesn’t do that, assuming that at some point it moves to raise inflation and expectations, the bubble will burst. We can’t live forever with five-year Treasuries yielding 50 bips less than the Fed’s inflation target.
I have just argued that the Fed will have to act in order to raise both expected inflation and bond yields. But please note that the bond market strongly disagrees with me: it has made it clear that it does not expect the Fed to do anything. If it agreed with me, we wouldn’t be seeing these frightening numbers.
Nonetheless, it is quite likely that, at some point this year, the FOMC will wake up and notice that things are slipping out of control, and will be forced to take decisive action to raise expected inflation. For example, it could eliminate interest on excess reserves and launch an open-ended QE. If such a policy proved successful, bond prices would fall substantially (and deflation risk would be banished).
The do-nothing option is not really viable, because we are already seeing signs of deflation. Commodity and producer prices are falling, as is headline inflation (both CPI and PCE). How much of this is the transitory effect of falling oil prices and how much is a deeper phenomenon is not yet clear. But the fact that hourly wage rates are falling suggests that this problem may go deeper than the oil situation. The price of oil has declined many times before without causing general deflation (aside from the Crash which was about a lot more than oil prices).
When bond yields are below the Fed’s inflation target, I think bond prices have entered risky terrain. The current low yields make stocks a better investment alternative (with expected total return around 7-8%), but stock prices are also vulnerable to higher bond yields, because higher yields compress the equity premium. Nonetheless, I feel safer being overweight equities and underweight longer-dated bonds. Stocks are an investment which will over time reward you with cashflow irrespective of subsequent price movements. Don’t buy for appreciation, buy for total return. Note that the market’s current dividend yield is higher than the 5-year bond yield, and about the same as the 10-year.
Tuesday, January 6, 2015
- The markets are signalling deflation risk.
- The Fed’s 2% inflation target is no longer credible.
- The Fed must reverse course and resume effective monetary stimulus.
- The outlook for stocks and bonds remain bullish, with stocks being particularly attractive.
The ongoing decline in inflation, expected inflation and bond yields provides clear evidence of the failure of Janet Yellen’s chairmanship of the Federal Reserve. When she became chairman one year ago, the 10 year yield was 3%; today it is 1.9%, a decline of 37%. Ten year expected inflation was 2.3% (above the Fed’s 2% target); today it is 1.6%, far below the Fed’s inflation target. Under Yellen’s leadership the Fed’s inflation target has lost credibility in the bond market, which now believes that the rate of inflation will remain below target for the next decade.
A brief glance at prices:
- The CRB index is down by 30% since June.
- The PPI is in negative territory.
- Headline PCE is negative.
- Core PCE is about to go negative.
I don’t care what Yellen thinks about economics, just as I didn’t care what Bernanke thought. I care about the seriousness of the FOMC’s commitment to meeting its 2% inflation target, and to anchor expected inflation at 2% or above as stated in its Policy Statement of January 2014: “The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored.” Clearly this target is not being met, at great danger to the economy’s long-term growth trajectory.
As I have written before, the problem with the leadership of Bernanke and Yellen is their excessive emphasis on consensus with a minimum level of dissenters. By reaching for consensus, they have given the Austrians an effective veto over unconventional policy. And conventional policy hasn’t worked.
There are two ways to fix this problem. One is to be like Greenspan and be autocratic. The other is to be like the Chief Justice and go for a simple majority, allowing the dissenters to dissent. Yes, there are drawbacks to both approaches, but the job of Fed chair is not popularity but policy success, which Yellen is not achieving. She is risking the Japanification of the US economy: a permanently stalled economy operating far below its potential growth rate.
The FOMC blathers on about its data-dependency, which is not true. In fact, the FOMC is path-dependent, because path stability supposedly lends to greater credibility. It is time that the committee wakes up and becomes data-dependent, which will require a 180 degree change in course. When the dashboard is flashing “DEFLATION”, it is not the time to tighten policy or to threaten to tighten it. Admit the truth: QE was ended prematurely, and the talk of a rate rise in 2015 was reckless.
To reverse the steady decline in inflation expectations will require a program of shock-and-awe that would convince the market that the Fed will do whatever it takes to restore inflation expectations to a level above 2%. Such a policy should include:
- An inflation target of 3% to be maintained until inflation expectations rise to the desired level.
- A statement by the committee that until inflation expectations return to the desired level, below-target unemployment and “overheating” will not be a concern (just as above-target unemployment is not a concern when inflation is too high).
- A zero remuneration rate on excess reserves, and the explicit possibility of a negative rate.
- A resumption of asset purchases at a monthly rate of $100 billion to be continued until expected inflation exceeds 2% at both the 5 and 10 year horizons. (Five year expected inflation is now 1.4%.)
- A wider range of policy instruments to include a trade-weighted basket of foreign government bonds, gold, silver and ETFs.
- A personal commitment from the chairman to raise inflation expectations, with the implicit threat of resignation if outvoted.
- Continuation of the ZIRP until the above goals are achieved.
I think that such a program of shock-and-awe would raise inflation, expected inflation and bond yields. If it proved insufficient, more should be done with respect to both the scale of asset purchases and the variety of policy instruments. The point is to do what it takes, not just to “do something” and then throw up your hands as Draghi has done.
Unfortunately, the likelihood of the FOMC adopting a policy along the lines suggested above is very low. As the Fed’s credibility continues to fall, the reversibility of the decline in expectations becomes increasingly difficult, as Japan has shown since the introduction of QE, and as Bernanke warned in his famous Helicopter Speech. I am worried about the US following Japan and Europe down the road of a Fisherian problem.
Bonds: Deflation is bullish for bonds, as we have seen, with bonds having outperformed every asset class in 2014. Given my outlook for inflation, and given bond yields in Japan and Europe, US bond yields still have a long way to fall.
Stocks: The decline in the risk-free rate, ceteris paribus, widens the equity risk premium and makes stocks more attractive than alternative investments (bonds, cash, metals). It is undeniable that falling commodity prices will hurt the reported earnings of commodity producers such as oil & gas. I expect to see a lot of noncash impairment charges in the 4th quarter due to the writedown of intangibles, which may depress reported earnings (but not cashflow).
However, I don’t see the risk of a material decline in the long-term expected return from US equities which should remain where it has been for the past fifteen years at around 8% (even during the Crash). Thus, the risk free rate will decline while the expected equity return should not. A decline into an uncontrolled deflationary spiral would be devastating for stock prices, as we saw in the early thirties, in Japan and soon in Europe, but even this do-nothing Fed would step in to prevent that. There are no Germans on the FOMC.
While I expect bond yields to fall further, I feel safer being in an instrument with an 8% expected return rather than one with a fixed coupon of a negligible amount. It is worth noting that the current dividend yield of the S&P 500 exceeds the yield for both the five and ten year T-bonds. We saw this briefly post-Crash, but the last time prior to that was 1956, a very good time to buy stocks assuming a long investment-horizon.