Implications Of Weak Growth For Financial Assets And Monetary Policy

My economic forecasting prowess has been vindicated by the awful first quarter GDP growth data, which show that the economy is on the brink of recession. I have been saying since October that the economy is at risk of both deflation and recession. I have based my pessimistic outlook on the decline in money growth and inflation over the past two years, and on the Fed’s perverse decision to further reduce monetary stimulus in the face of subpar growth and inflation.

What does this depressing growth scenario mean for financial assets? It is bullish for both stocks and bonds, and bearish for inflation hedges like precious metals.

Implications for Bonds: Bullish

Low growth is bullish for bonds because it removes the risk of accelerating growth,  delays further the possibility of higher short-term interest rates, and anchors inflation expectations at their current low level. The big bond selloff has already occurred, during 2013, when the 10-year yield doubled from 1.5% to 3%. This year, bond yields have fallen back to 2.65%. I don’t like bonds because they yield nothing, but I don’t see the  “inevitable bursting of the bond bubble” happening any time soon.

Implications for Stocks: Bullish

Low bond yields are bullish for equities. Stated differently, high bond PE ratios support high stock PE ratios. (Today, the bond PE is 38x and the stock PE is 19x.) This relationship is captured by the equity risk premium, which compares the demanded return premium for stocks over bonds. On Friday, Aswath Damodaran at NYU will publish his calculation of the ERP for the first of the month. For April 1st, he calculated the ERP at 5.15%, which is on the high end of the range since 1961 (the range is roughly 2% to 6.5%). This means that you are being paid a historically high premium for owning equities.

The ERP is elevated despite high PE multiples because bond yields are so low. Skeptics say that the ERP depends upon strong earnings growth and abnormally low interest rates. The are wrong about earnings growth: the ERP does not reflect or depend upon strong forward earnings growth. They are right about interest rates, but rates are abnormally low because inflation is at a 50-year low. The 1Q14 growth data suggest that rates will remain abnormally low for some time.

Implications for Metals: Bearish

Precious metal prices should move in accordance with inflation expectations, and indeed both inflation expectations and metals prices have been declining since 2012. The current growth and inflation outlook suggests that metals prices will continue to decline until the Fed can get a grip on money growth.

Implications For Monetary Policy: Nothing

The 1Q14 growth numbers represent a victory for the doves and a defeat for the hawks. Once again, the hawks have been shown to have a complete misunderstanding of the Fed’s current monetary stance, which is contractionary, not stimulative. Once again, the doves have been proven correct: tapering at this point in the cycle is insane. This might give Yellen the ammunition she needs to reverse the decline in money growth, but history suggests that she, like Bernanke, will fail. For the Fed to do a complete 360 will require negative growth and higher unemployment, both of which are likely. Then we might see a policy rethink.

Knocking Down Jim Cramer's Bear Case

Jim Cramer just published “The Bear Case in 10 Easy Lessons”, which lays out the arguments for lower stock prices.  He throws these “lessons” out not as an argument but as discussion items, a sort of straw man. Here is his case and my observations:

1. Something is very wrong with the market when we get strong news out of the economy and interest rates plummet. That's a fear of an unknown unknown. What's the point of buying when there is something lurking?

Interest rates are falling because inflation is falling while the Fed is tapering. Low bond yields support low earnings yields (high PE ratios).

2. When interest rates plummet, the banks plummet, particularly now that the short rates aren't going higher. Banks are the linchpin of all big rallies, and we have lost them.

There is no doubt that banks are hurt by a low and flat yield curve which makes retail deposits expensive and compresses margins. Bank earnings are under pressure. But the current ERP is a result of low interest rates, and doesn’t depend on robust earnings by banks or corporates. And also, low interest rates may hurt banks but they help corporates.

3. There is no price where the insiders won't sell these extended techs with no dividends or earnings.

Tech goes its own way and is always hard to value using conventional tools. The valuation of blue chips is not so hard, and is poorly correlated with tech. If a tech selloff pushes down blue chips, buy them.

4. We have had a big run from the bottom, almost a triple, so it has to be out of gas and extended. It was just high-multiple stocks. Now it is every stock.

Distance from the bottom is not a useful index of valuation. Stocks were severely undervalued in 2009, when earnings were cyclically depressed. The fact that they are higher today contains no information about value.

5. We've seen this movie before in 2000. In fact, it was this week to the week that we were really beginning to thrash with the really awful dot-coms crashing daily and the insiders still selling no matter what the case.

The 2000 movie was of a classic equity valuation bubble, when the broad market equity risk premium was at an all-time low. That is not the case today; the ERP is at the high side of its normal range suggesting value.

6. Japan's a disaster.

Japan has been a disaster since 1991 and it has never had any impact on the US equity market. As a result of Shinzo Abe’s reflationary policies, Japan is finally beginning to recover, and now has higher inflation than the US.

7. China's a disaster.

China is not anything like a disaster. China remains the best performing economy in the world, although it slowing a bit as the PBoC reins in credit growth (which is a good thing). China prints its own money and has $3.5 trillion in external reserves.

8. The world's being kept afloat by central bank fiddling.

Global inflation is lower than it has been in 50 years. Global money growth is in the single-digits (almost zero in Europe). The IMF is warning about deflation. The world is kept afloat despite central bank incompetence.

9. The initial public offering flow doesn't stop.

IPO volume is suggestive of frothy sentiment and is a warning light. However, other measures suggest that we are not in an equity bubble comparable to prior episodes such as 1999. If equity prices fall from their current levels, market valuations will become more compelling.

10. Earnings will be terrible.

Future top-line and bottom-line growth are limited by anemic nominal GDP growth and by potential capacity constraints. However, from a valuation perspective, weak earnings growth is fully offset by low bond yields (i.e., a low discount rate for future cashflows). The current price-earnings ratio for 10-year governments is 38x with zero potential earnings growth, while the S&P ratio is half of that at 18x with potential (albeit weak) earnings growth.

Implications Of Deflation Risk For The Equity Market

• Deflation poses a risk to current stock market valuation.
• Inflation is falling and the risk of a deflationary episode is growing.
• Deflation is a monetary phenomenon caused by inadequate money growth.
• The Fed appears to be unable or unwilling  to raise the rate of inflation to its targeted level.

In a recent post I argued that the stock market is not overvalued, and that the equity risk premium is historically high, or at least within a normal range (depending on your calculations).  I cited a study by Duarte and Rosa at the NY Fed which found that:

“The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.”

In other words, the market is not overvalued in the context of bond yields. I further argued that I don’t expect bond yields to rise because of the subdued inflation outlook. Today I will discuss the other side of the inflation equation: deflation risk.

Research suggests that the stock market sweet-spot for inflation is between 1% and 6%. The market reacts negatively (i.e., it demands a higher risk premium) to inflation levels that are above or below this range. The stock market doesn’t like high inflation because it raises the discount rate for future cash flows, and it  doesn’t like low inflation/deflation because it reduces corporate earnings and magnifies debt.  You will recall that the market performed badly during the 1929-33 deflation, the very low inflation in 2002, and the deflation of 2009.

Deflation poses a risk to today’s market outlook. Consumer price inflation has fallen to low levels, producer price inflation has been bouncing around zero, commodity prices have been falling for three years, while the price of oil has been flat.

As we know from Friedman and Bernanke, deflation is a monetary phenomenon. Today’s low inflation is a result of low velocity-adjusted money growth (M x V). Strong growth in the monetary base (QE) has not translated into money growth, and the current moderate money growth has not translated into equivalent  nominal growth (P x T) due to falling velocity. Hence, we have  subpar nominal growth and deflationary pressures.

It is at this deflationary brink that the FOMC has chosen to taper monetary stimulus. The rationale for tapering in the face of below-target inflation is that the current sub-target level is temporary and inflation will rise (as monetary stimulus falls). Not every member of the FOMC buys this logic, according to the minutes of the latest meeting:“A couple of participants expressed concern that inflation might not return to 2 percent in the next few years.” What these two dissidents got was a meaningless promise: “members agreed that inflation developments should be monitored carefully.” In other words: ignore the numbers, the taper will continue.

When Ben Bernanke gave his famous helicopter speech in 2002, he listed five reasons why “the chance of significant deflation in the United States in the foreseeable future is extremely small”. These reasons were:

1. The stability of the US economy.

2. The strength of the financial system.

3. Stable inflation.

4. Anchored inflation expectations at a non-deflationary 3%.

5. The willingness and ability of the Fed to take whatever means necessary to prevent significant deflation.

Let’s look at these five factors in today’s context:

1. Economic stability: Check; the economy is stable.

2. Strong financial system: Check; we are not having a financial crisis.

3. Stable inflation: No; inflation has been falling since 2011.

4. Anchored inflation expectations at a noninflationary 3%: No;  inflation expectations have been falling since 2010 and are now below 2%.

5. The ability and willingness of the Fed to meet its inflation target: No, current inflation is running at half of target, and the Fed is withdrawing stimulus.

So today’s economy currently meets three of Bernanke’s five deflation risk criteria. Hence the recent concerns being expressed by the two dovish committee members. In his speech, Bernanke listed steps that the Fed could take to counteract deflationary pressures:  

1. Cap the entire yield curve;

2. Offer zero interest loans to banks;

3. Buy foreign government debt;

4. Monetize Treasury purchases of private assets.

Twelve years later, despite the clear risk of deflation, all of these tools remain unused--not even during the 2008 deflation.

Conclusion:

Current market valuations are merited as long as inflation remains within the moderate range (1-6%). Given that current inflation is at the bottom of that range, and that the Fed is reducing monetary stimulus, the principal risk to today’s  market valuation appears to be lower inflation or outright deflation.

Bond Yields And The Equity Risk Premium

Summary

• High PE ratios do not signal an overvalued equity market.

• Multiples are high because bond yields are low.
• Bond yields are not artificially depressed by the Fed’s bond-buying.
• Bond yields are likely to remain low, given the inflation outlook.

Duarte and Rosa at the NY Fed say that the equity risk premium is elevated at all horizons because the term structure of interest rates is depressed at all horizons. They say that the only thing that could reduce the ERP would be higher bond yields, and that earnings and dividend growth rates only play a minor role. That means that an equity investor cannot have an informed opinion about the stock market without also having an informed opinion about the bond market.

Stock market bears say that bond yields have been artificially depressed by the Fed's purchase of $3T of Treasury bonds, which represents a material proportion of the total float (about the same as the PBoC's portion). But I don't believe that QE is the reason why yields have fallen. If QE had been effective and had stimulated money growth, it would have raised bond yields. The idea that printing money depresses inflation expectations and bond yields is upside-down.

Bond yields are low because QE has failed. QE has had no impact on money growth or inflation or inflation expectations. Money growth since the crash has been anemic (~6%) and inflation and inflation expectations have trended steadily downward. We have gone from a disinflationary economy to a borderline deflationary economy. This is not good for workers (or earnings growth), but it justifies high PE ratios.

Inflation has not been this low since before the Vietnam war, and inflation expectations are very near their all-time low. Bond yields are at Eisenhower levels because inflation and inflation expectations are at Eisenhower levels. When you couple this with the FOMC's decision to reduce monetary stimulus in the face of declining inflation and inflation expectations, it's hard to build a case for higher bond yields. Since bond yields are unlikely to rise, then the outlook for stock prices remains bullish.