In this post, I’ll talk about how, based on past experience, it takes quite a long time for high inflation to revert. By the time it gets to 2% your hair can already start to turn gray. Then we’ll take a look at speculation about the stock market hitting the bottom. The sentiment is morbid, but especially US stocks don’t look cheap.
The COVID pandemic led to a reactionary over-stimulus because there was little alternative. The over-stimulus led to inflation, which in turn led to panic at central banks. Ultimately, this can lead to a global recession if interest rate hikes go too far. And there we have the real pandemic dip, albeit a couple of years later.
As usual, let's start with relevant observations from the last few days.
The global stock index, in which the US equities have the most weight, has already come down by a quarter. In practice, equities are hovering around their pre-COVID peak.
The US 10-year bond rate, which can be seen as the ultimate risk-free rate for the global economy and a gravitational force for shares and all kinds of capital investments, briefly touched 4%.
Strange explosions have occurred at the Nord Stream pipeline near Denmark and gas is gushing out. There's not much gas coming from Russia to Europe anymore except—ironically—via Ukraine. However, further explosions at the Norwegian gas pipelines, where a quarter of Europe's gas comes from, would be very problematic. The people behind sabotage are not known, but unless those tubes are into small cap investing and blow themselves up out of sheer misery, it’s reasonable to assume that there is a person behind the blasts. These pipelines are pretty sturdy structures after all.
In Europe, natural gas prices rose immediately. Additional sabotage would add significant risk to an already cold winter and would certainly not stimulate the market.
We might be stuck with high inflation for a while
A slowing economy, collapsing raw materials and falling asset prices (as you may have noticed in your own portfolio) argue for a calming of future price rises, maybe even deflation. The Bloomberg raw material index, where crude oil has a major weight, has already fallen 20% from its peak. On an annual basis, raw materials are only up by 10%. Measured over a 12-month radius, this inflationary pressure is thus quietly turning into a deflationary stench.
Freight costs have also plummeted in maritime transport and now US trucking, the booming logistics vein of the world's largest economy, is showing signs of cooling.
There is also growing evidence of an economic slowdown as the yield curve is inverting in the world's economic powerhouse, the United States. The interest rate difference between the two-year and ten-year bond has turned negative, meaning that an investor earns more interest by borrowing short than long to the federal government. The yield curve inversion is rapidly making the banks' business bubbly, as they borrow short and lend out long. But, the interest rate differential between a 3-month and a 10-year bond has yet to invert. In general, it has taken an inversion of both to give a recession signal. A recession should reverse inflation quite effectively.
Although I myself have been consciously guilty of spreading early inflation-busting talk and thus exposing my transitory cards on the table, this statistical observation from Bloomberg put things into perspective.
This Bank of America graph shows how long it has taken different countries to tackle inflation, if inflation has run above 5% annually. On average it takes 10 years to take inflation back to 2%. The data covers the period 1980-2020 and includes different developed economies such as Finland, the United States, Portugal or the Netherlands. History never quite repeats itself and economic circumstances change. However, the 1980s were marked by tight financial policies in several economies, including the United States and the United Kingdom.
In addition, this period has been marked by the loosening of economic regulation, globalization and the erosion of trade union power in developed economies, which could be seen as very deflationary elements. By contrast, today production is more likely to come back from China and labor shortages are shifting bargaining power back from capital to workers. In the 1980s, combating inflation was made easier by improvements in productivity, and investment. At the moment, productivity is actually falling.
Thus, at least at the macro level, the central banks' deadly inflation hunt is made more difficult rather than easier by such external factors.
At present, inflation is expected to fall back to 2% in a couple of years. That’s not impossible, but without a decisive financial tightening it seems even less likely on the basis of this historical data. A prolonged environment of high inflation and higher interest rates would hardly be comfortable for equities. On the other hand, this evidence confirms the market's view that inflation succumb without a deep recession. So, for equities, the options look slim over the next few years. The Fed, having learned from history, is not so quick to turn the tables. It has past experience of how easing financial policy too quickly only exacerbates long-term inflation.
The Bank of England is grappling with an even bigger inflation problem, and the new government's generous economic policies have not helped. Sterling has weakened sharply, while interest rates on the country's bonds have risen.
Yesterday, the situation escalated to the point where the central bank was forced to rush to the rescue and buy long bonds. Otherwise, the collateral requirements of certain pension funds would have been triggered and at worst could have started a financial crisis in the market last afternoon. Bank of England signals that this problem will be fixed, even if it takes an unlimited bond-buying program. At the same time, the central bank reiterated that it is committed to pushing inflation down to 2% by tightening interest rates.
It will be interesting to see whether the program remains a temporary band-aid for a specific market problem, or whether this is the start of a central bank about-face if the financial system can’t withstand high interest rates.
On the other hand, this case is a good example of how even the central bank's power is limited. If the market breaks down, the only thing to do is to put financial tightening aside for a while and begin stimulus measures. More broadly, central banks have little they can do with demographics, productivity growth, economic policy or the economic policy choices of other countries. Eventually, they too will have to adapt their financial policies to the realities of the world around them. The central banks don’t control the economy or the market, the economy controls them.
Trying to guess the bottoms
As the bloody tide of the bear market sweeps investors along like driftwood, investors try to cling to every straw in search of the bottom. A classic way of guessing bottoms is going to the opposite direction when the crowd is ultra bearish. “Buy when there’s blood in the streets”, as the old saying goes. And I’m not talking about a drunken 2 am kebab queue. A sentiment survey of American investors gave the most bearish reading since the financial crisis. 60% of respondents believe equities will fall within the next six months. This graph shows in parallel the number of bears in the survey and the evolution of the S&P 500 index. As you can see, the previous bear peaks were excellent places to buy at the index level.
However, I would like to point out that, unlike with the previous bearish results, the valuation of the shares is not as cheap. This graph shows the forward-looking P/E ratio of the S&P 500 index, as well as the spots where the AAII survey has been as bearish as it is now (green bars). In simple terms, the valuation of shares is about a third higher than in previous times.
Of course, year-ahead pricing based on EPS guesswork doesn’t tell the whole story. For example, after the bubble burst in the early 2000s, the P/E ratio of the S&P 500 hit a low of 14, which is not far from today's levels. So not every rough bear market ends up with ultra-low earnings multiples, but in most cases you can buy shares cheaper from the bottom.
The European stock market is priced for only ten times the forward-looking earnings. I’m starting to sound like a broken record, but I would take the earnings forecasts with a pinch of salt, but indeed a contrarian should find something to buy. Of course, Europe is also sadly next to the flash point of the war in Ukraine and our companies are not growing as briskly as in the US, but there are certainly already opportunities for us local stock pickers.
At the same time, I would like to remind that while it may be easier to look at and talk about things at the level of the market as a whole, individual stocks are driven more by their own earnings growth and the profitability of that growth. The earnings period starting next week will give an indication of the sustainability of the earnings growth.
Thank you for reading the post! Read analysis and make good stock picks!
What's up with Stonks is a biweekly report that delves into the complex and often confusing world of the stonk market. Community Manager Verneri Pulkkinen helps you navigate the troubled waters of market movements and macroeconomic phenomena. Stay tuned for the hottest investment scene news, moderate amount of stock populism and understandable information about the stock market.