getting our post-Fed meeting bearings

What strikes me the most about the current economic situation in the US is how complex the inflation situation is:

–the Russian invasion of Ukraine has caused inflation-inducing oil/gas, metals and grain shortages around the world. This is partly boycott, partly interruption of production

–covid-related lockdowns in China are slowing production/shipping of consumer products destined for the US and Europe

–in hindsight at the very least, the anti-pandemic fiscal and monetary stimulation in the US was much larger than needed and therefore requires a greater effort to return to non-emergency levels of government policy.

I see the first two as being external shocks. The orthodox prescription is to let economies make the sometimes painful adjustment to the new reality. (Washington was unique among major country governments in not doing so during the 1970s oil shocks, with long-lasting negative results for the US in general and the auto industry in particular). Recent announcements by Target, Walmart–and most recently by Samsung–that they have excessive inventories suggest that the non-Russia problems are beginning to solve themselves.

Oil is a headline-grabbing issue. Unlike the 1970s, however, we’re seeing higher prices rather than shortages (due mostly to congressional attempts to legislate a “fix” to potential problems). And, putting political hysteria aside, my guess is that in two years prices will be considerably lower than they are now. How we get there is another question. My point, though, is that I don’t think we should think of oil price increases as a chronic issue. In any event, any reasonable Fed action won’t affect prices that much.

This leaves the issue of reversing the pandemic stimulus.

Assume that the Fed’s inflation target is, say, 2.5% (the Fed is still saying 2%; I think FOMC is thinking 3%). If we think the real yield on the 10-year Treasury should be 1.5%, then the nominal yield should be 4.0%. We’re now at 3.5%–up from 0.93% at the start of 2021 and 1.63% this January. So rates are up by 187bp this year and 260 bp in the past 18 months, with another 50bp to go.

If we look at the same numbers in PE terms, the 10-year-implied multiple on stock market eps was 107x on 1/1/21, was 61x this January …and is 28x now. If 4% on the 10-year is the final goal, 25x is the implied multiple (20x if the final goal is 5%). Brokerage house analysts, who are always too optimistic, say that eps for the S&P 500 will grow by 10% this year to about 250/share. The S&P is now trading at about 15x that number as I’m writing this.

If stock market investors were to be looking forward–the essence of a bear market is that they don’t, and discount and rediscount today’s woes over and over instead–stocks would seem to be on relatively sound footing.

Historically, however, the emotional charge of the fear of continuing loss needs a considerable time to work itself out. The Financial Times, however, suggests that this time around AI trading strategies are making the pain more severe that it might otherwise be.

more tomorrow

One response

  1. Hi thanks for the insights, really interesting.
    Could you share why did you assume a 1.5% real interest rate? And why are you sharing a 2.5% cpi when inflation is at 8% high? Is that because you are looking at the long run? Other whise the total nominal multiplier is almost 10x

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