By Roman Chuyan, CFA

  • The Fed has shifted to an average 2% inflation target, which has already increased inflation expectations and will likely turn real interest rates more negative.
  • This has important implications for all major asset classes: bonds, equities, and gold.

In my previous article, I wrote that this market is the most expensive ever, while the economy is one of the worst ever. Today’s market is betting on an immediate and rapid V-shaped economic recovery. It is true that the economy has improved from its March-May debacle, especially income and spending (driven by the federal stimulus). But history teaches us that the market is “bipolar” – periods of euphoria give way to periods of depression. Today’s market is full of optimism, pricing-in the best-case scenario of a rapid V-shaped recovery with certainty. At the top, looking up.

Many argue that this market is all about the Fed and its liquidity creation. However, as I have written, the correlation between the market and the Fed’s assets is low at best – above is that chart once again.

Today, I focus on the Fed’s change in its targeting of inflation, announced by Chairman Powell last week. The Fed will now target inflation that “averages 2% over time,” rather than a simple 2% target as previously. If inflation runs below 2% for a while, the Fed will then “aim to achieve inflation moderately above 2% for some time.”

To me and to many observers, this means that the Fed will allow higher inflation. Note that the Fed’s statement says that it would allow above-2% inflation after below-2%, but not the other way around. Next year’s inflation expectations have already jumped above 3% (see chart above) – the highest in six years. Core CPI inflation, while still low because it’s always depressed during recessions, already started to rebound, at 1.6% in July. This means that real (net of inflation) rates will grow more negative, unless the Fed lets interest rates rise. Rising interest rates would be devastating based on our enormous debt loads – but it’s a separate topic.

Implications For Bonds And Stocks

Higher future inflation (more negative real rates) will have important implications for fixed-income investors and strategies (and tactical strategies that are currently defensive, as we are). Most bonds are not compensating investors even for current inflation of 1.6%. By investing in the 10-year Treasury, for example, investors commit to around a 1% loss in real terms (0.6%-1.6%, see chart above). Corporate bond investors are barely making up for inflation at this level. If inflation rises, then all bond investors will lose in real terms. This loss will come over time (if bonds are held to maturity) or sooner on a market-value basis, if interest rates rise.

 

Inflation-indexed Treasuries (TIPS) are also a poor investment: their prices are already so high that their real yield is around -1% (see chart above) – that is to say, you will earn inflation rate minus 1%.

 

The recent rally has brought stocks to extremely overvalued levels. The S&P 500 ended the month of August at a new all-time high of 3500. At the same time, corporate earnings declined by 32% in Q2 from the same quarter last year. These trends have brought valuation ratios to historical highs. The valuation measure that we use in our equity model, the price-to-book ratio, at 3.96 is at its highest since Jan-2001 (which preceded the 2001-02 bear market) and well above its 2007 and 2019 levels. The gap between the S&P 500 and its earnings per share (EPS) widened to an extreme:

A popular argument for higher stock valuation has been that interest rates are lower. So, a hint of rising inflation and interest rates might be just the pin that pricks the stock bubble. Recall that as the Fed was normalizing interest rates in 2018, the 10-year yield crossing above 3% in October-2018 was what initially triggered the market selloff. This time, the threshold is likely much lower because of larger debt and near-zero (or negative) global interest rates.

A Case For Gold

If not stocks or bonds, then what? Some authors have written extensively about the attractiveness of gold as a store of value – I don’t have much to add to that. We’re not gold bugs – the attractiveness of gold as any asset class depends on the environment. More investors are beginning to recognize the attractiveness of precious metals in this environment of trillions of added liquidity and zero interest rates. And the Fed’s most recent shift to potentially higher inflation makes gold even more attractive now.

 

Gold price rallied this year to a new all-time high in early August, along with most precious and industrial metals. But if we take a longer-term view, its 10-year total return, at 48%, is similar to bonds and well below the S&P 500’s 286% run. I wouldn’t be surprised if they converge somewhere in the middle in the coming years. In the short term, our Gold model remains positive, and the moderate price correction since early August trimmed the year-to-date gain to 26% and makes an attractive entry point, in my view.

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