Derek Chen, CFA, MBA is a sophisticated portfolio manager who digs deep into financial markets. He focuses on analyzing data, patterns and technical structure of different markets to give investors a better timing of entries and exits.
As investors have seen in the recent CPI data, one forgotten risk is arising. For the past eight years, US inflation is low and stable. However, despite with declining oil prices, inflation starts to tick up, and it may make a major impact to portfolio allocation.
The economic environment today is similar to the environment of the Reagan Presidency from 1981 to 1989. In 1986, after implementing a historic tax reform, the U.S economy surprisingly headed into a period of stagflation. Will history repeat itself?
According to Investopedia, the definition of stagflation is: “A condition of slow economic growth and relatively high unemployment and economic stagnation, accompanied by rising prices, or inflation and a decline in GDP.” In summary, four economic phenomena may happen:
- High inflation
- High unemployment rate
- Stagnant or decline in GDP growth
- Slow growth in corporate earnings
During the past decade, we had an extremely easy financial environment as the “Big Three” global banks: ECB, Federal Reserve and Bank of Japan implemented quantitative easing (QE) to help the economy recover, which tripled their total assets.
*Source: Federal Reserve, Bloomberg
Velocity of M2 Money Stock – Another Look At inflation
By definition, M2 includes the amount of currency circulating and all forms of deposits. Velocity of M2 Money Stock, however, is not necessarily the frequency of money exchanging hands via transactions. Instead, an increasing velocity of M2 Stocks is the willingness or incentive to spend at a faster speed. Economist Irving Fisher introduced the equation in 1911:
M: Money supply in financial system;
V: Velocity of money stocks
P: Price of goods and services;
Q: Productions, or the quantity of goods and services.
The Fed started to trim down its balance sheet and gradually increase its Fed Fund Rate. Banks are motivated by higher interest rates and consumers are motivated by the passage of the tax bill. The willingness of lending and spending bounced from historical lows, which fueled the velocity of money stock. Steadily rising money supply (M), higher velocity of money stocks (V) (Shown in Exhibit 1), plus stagnant productivity (Q) (Shown in Exhibit 2) are pushing prices higher (higher inflation).
The natural unemployment rate occurs when the economy is at “full employment” which is the optimal scenario that will sustain stable GDP growth and inflation, according to Federal Reserve. Historically speaking, the unemployment rate tends to act mean reverting around the natural unemployment rate. Especially after a recession, the real unemployment rate is unlikely to stay below the natural unemployment rate for long.
Currently, the real unemployment rate is 3.7%, while the natural unemployment rate is 4.7%. After the 1981 recession, the real unemployment first fell below the natural unemployment rate and quickly reversed above it, causing the 1989 recession. We are now in a similar situation.
Since the 2008 financial crisis, companies have been taking advantage of historically low interest rates. Earnings per share (EPS) were boosted by reducing shares outstanding, which was funded by issuing debt with low cost of debt.
- This action not only inflated financial performance, but also increased balance sheet risk. S&P 500 EPS has benefited from share buybacks. When rates rises, this practice will be more expensive.
- Companies that have high leverage will have higher cost of debt, which results in lower valuation. For example, if cost of debt reaches 10%, Amazon’s share price in 2019 will be $1,008 while maintaining a median growth rate.
*Source: S&P Dow Jones Indices, U.S Bureau of Labor Statistics, Federal Reserve, author’s calculation
Short-term yields (2 Year) have trended upward over the past five years, while long-term yields (10 Year and 30 Year) are flat. U.S yield curve is near inversion. Reasons:
- 2-Year Treasury yield reflects the high expectation for a Fed rate hike. The Fed is the first central bank to exit a QE program. Its gradual rate hikes and balance sheet reduction (Treasuries & MBS) directly affect short-term yield.
- Long-term Treasury (10 Year and 30 Year) yields reflect the expectation for future economic growth.
Yield spread between long term and short term is declining over time. Indications are:
- Short-term monetary supply is tighter than long term’s, which makes business borrowing more expensive. As a result, economic expansion is likely to slow down.
- Long term economic condition may be worse off.
- Long term GDP growth may be slow, which may signal a recession.
Conclusion: Yield curve will invert as short end rates continue to be lifted by Fed and long end rates continue to adjust to slower growth.
*Source: Federal Reserve
Given the current economic conditions, the four elements that may cause stagflation are met:
Higher Inflation: Stagnant productivity and rising M2 money stock velocity
Higher Unemployment: Real unemployment rate is currently below natural unemployment rate. Unemployment rate normally rises after the recovery of a post-recession period.
Lower Corporate Earnings:
- Rising interest rates will
- Mitigate the incentives for company to repurchase its shares and issue debt.
- Lower companies’ valuation with higher cost of debt and weighted discount rate
Slower GDP Growth:
- Narrower yield spread and flattening yield curve indicates an economic slowdown, possibly even a recession in the future.
- Higher interest rates, especially fast rising short-term interest rates makes business borrowing more expensive.
Looking back to the period from 1981 to 1989, we believe we are now in a similar situation and that history may repeat itself. While enjoying this nine-year long bull market, investors need to be aware of the potential stagflation risk that is surfacing and be prepared for the unforeseeable headwind in the future.