April 10, 2022

Inflation, interest rates  and the  Equity risk premium : A critical evaluation of the consensus views. 

The first quarter of 2022 reinforced the view that a diversified portfolio should strategically include most asset classes and can prove beneficial during hard times. Cash and gold justified during this period  their presence in portfolios despite not providing any yields !  Evidently, as always the portfolio asset allocation is instrumental.

At the end of 2021 we had expressed the view that the investment environment  was not particularly promising for stocks but  that stocks would probably outperform bonds. The war in Ukraine exacerbated the dark clouds. The quarterly bond performance was the worst since the mid nineties and the stock market had the worst quarterly performance since Q1 2020.

We will try to evaluate critically the future course of the key variables on the investment landscape. It is always very difficult to challenge the wisdom of the consensus but we will express our views on a tactical level.

Α)The perception that the FED was behind the curve  and that we had a non-friendly environment for the markets  materialized. In addition, the debate of whether inflation is temporary or permanent continues. At this moment, Supply bottlenecks continue to persist as Covid issues are resurfacing. 

Moreover, the war in Ukraine exacerbated the supply bottlenecks leading to a further rise in commodity prices and inflationary pressures. The  consensus thinks that the inflation rate will  subside from a temporary level of over 7.5 % in the USA to about 3 % in the next five years. Hopefully this view will not prove to be rather optimistic  leading to eventual disappointments.

B) Interest  rate projections and the pace of their increase swing from optimism to pessimism. At this point, the number of necessary increases  for the fed funds rate according to the consensus view appears extremely aggressive. The market appeared recently to have  discounted  2.25 percent of total increases in the FED rate. However, the latest most likely  fed fund rate path through  March 2023, based on the future market, is three 50 bps hikes and then five 25 bps hikes at next eight meetings through 3/23 . Hawkish FED officials have already been discussing 3 pct of total hikes.

This is a rather pessimistic consensus view in our opinion  leaving some room for a pleasant surprise.

C) A study of the equity risk premium (earnings yield minus nominal or real interest rates)  continues to lead to the conclusion that  despite increases in interest rates equities  are still attractive from a static point of view. A more dynamic view involves forecasts about earnings, the shape and the position of the yield curve. The optimists think that the basic scenario is not altered : on the basis of relative valuation the equity market still  looks reasonably attractive.

Let´s apply some recent market numbers : 

With 2022 forecasted earnings of usd 240 for the S and P at 4480, the earnings yield is 5.35%. It still  higher than the 10y TB rate of  2.70 % and the 5y of 2.76% but the positive gap has been narrowing. 

The pessimists believe that headwinds will appear for stocks in a low growth-high inflation environment characterized by lower earnings and higher 5y/ 10y rates. Finally,  they also note that the Sand P dividend yield , now at 1.30% , is about half the level of bond yields and provides  another negative metric. 

D) Τhe shift of the aggregate supply curve of the economy can lead to a textbook case  new equilibrium of higher  inflation and lower growth. Would it imply a recession ? How stubborn will inflation be ? The sensitive human reaction in consumption and especially in investment will be of major importance in determining the outcome. However, human reactions are difficult to forecast. Geopolitical issues, connected with the war in Ukraine, and politics can provide shocks exogenous to the economic system leading to disequilibrium and overshooting. As a result , a serious additional risk premium has to be priced by investors in valuations leading to a more risk-off tactic.

E) The curse indicator of inversions in the yield curve has already appeared at various maturities. This implies that due to weak future aggregate demand, short term interest rates will likely be lower in the future and indicates  the possibility of a recession. The  negative indicator  has unfortunately exhibited some successful predictions in the past. However, according to the eminent economist P. Samuelson it had forecasted nine out of the last five recessions by the 1960s ! A false alarm signal can indeed take place  but inversions constitute a reason for concern for an economic slowdown or a recession.

Conclusion : 

Nobody knows yet the exact final net outcome of all the above mentioned factors. We are not convinced that the market has fully discounted a pessimistic scenario and that we will be pleasantly surprised on all issues. However, based on the prospects of the excess equity premium (Earnings to price of stocks versus 5/10 year yields) we continue to believe that stocks will outperform fixed income in the medium term.

Good luck to all of us !

N.Ritsonis 

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