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Inflation Mispricing. Risks And Opportunities.

Whenever the S&P 500 earnings yield has fallen below the Treasury yield the long term outcome has been a worst case set up for equities over the last 100 years.

Q4 2022 earnings growth is declining so far in the current earnings season, and is set for further declines in Q1 2023.

“With interest rates now well above zero, the primary causes and conditions of the recent speculative bubble are no longer in place. The persistence of rich valuations here are, in my view, largely the result of psychological anchoring.”
John Hussman

The recent rally in stocks has been driven by the idea that inflation will rapidly come down back to the Fed’s 2% target, without an economic recession as catalyst, allowing the Fed to end and even reverse its rate hike campaign later this year.
Jesse Felder

a decline in inflation that rapid has only ever happened during steep economic recessions. Still, the market appears to be content to ignore the possibility of recession and discount strong earnings gains this year and next.
Wall Street Journal

The positive real Fed funds interest rate policy imperative, shown in the previous Weekly Insight, is still some 250 basis points and several months away at best. The Fed would lose credibility if they tried to short cut that metric. The decision by the Bank Of Canada to signal a pause in rate rises this week, in a similar situation, suggests central banks may be overconfident about their long term inflation fighting credibility.

If Central Banks end tightening too soon this raises the risks of higher inflation for longer. There are also some other key additional risks that could get in the way of a successful return to low inflation. Discounting a return to the 2% inflation objective is premature, yet here we are, according to the chart below!

Two Major Factors Against Falling Inflation

First, oil and commodity prices. China’s economic recovery is welcome news for a weak global economy, but it also comes with increased demand for commodities. There were multiple measures put in place to dampen oil prices in 2022, from fiscal subsidies, to releases from the US Special Petroleum Reserve, which still needs to be replenished. Yet all these measures achieved was a test of the long term breakout line of WTI oil prices. There is a clearly a possibility that the oil price could rally from here, along with other commodities.

Secondly, a weak dollar leads to higher import prices. The chart below shows that the recent decline in the dollar has immediately led to the highest rise in import prices in two decades, and this is already likely to slow the recent rapid decline in the CPI.

Three Further Issues that Could Lead to a Declining US Dollar

Relative speed of rate hikes.
The US lead the way last year with interest rate hikes both in timing and extent of the rate rises. Now the rate hikes are slowing and only 2 further 25 basis point rate hikes are being discounted. This comes at a time when Europe is finally accelerating its rate hikes and planning quantitive tightening as well.

Currencies consistently respond to changes in relative interest rate expectations and monetary tightening measures and the Euro had already rallied against the dollar.

A Treasury funding crisis is building as international investors retreat.
The chart below shows the explosion of oustanding Treasury issues in the last few years. It also shows that the percentage of foreign ownership has been in decline to the tune of around 30% from the 2008 peak.

As just the interest on debt becomes the the biggest item in government expenditure, the refinancing requirement soars to new highs, and there is little sign that budget deficits, Treasury issuance continues to accelerate to extraordinary levels. This is coinciding with overseas investors losing their appetite for Treasuires.

Asset reallocation away from western centers. Reasserting focus on gold.
Jim Rickards explains:

There is also a growing movement to move away from dollar reserves because the U.S. has abused financial sanctions to freeze assets including central bank reserves of Russia, Syria, Iran, North Korea, Venezuela, and others. Countries like China, Brazil, and India are moving away from dollars for fear that they will be next on the sanctions list. Physical gold in secure custody cannot be frozen or seized or digitally banned. This will create demand for perhaps 100 metric tonnes over the coming year. If China continues to add 30 metric tonnes or so to its reserves at the same time that Russia is out to buy 100 metric tonnes, it will put a de facto floor under the gold price while supporting the 20% rally in gold prices we’ve seen over the past few months. Russia and China could be acting in concert to send a message to the world that dollars are yesterday’s news, and gold is the new foundational reserve asset (as it was for centuries prior to 1971). We could be witnessing a critical turning point in the international monetary system.

New competing Asian currency in South East Asia

Bloomberg reports that at a recent meeting of Southeast Asian officials and experts hosted by a think tank in Singapore participants were just as fearful as the major countries that the U.S. has gone too far in weaponizing the dollar to apply pressure in geopolitical disputes. George Yeo, the former foreign minister of Singapore, went so far as to say that “the US dollar is a hex on all of us.” He went on to say, “If you weaponize the international financial system, alternatives will grow to replace it.” The former trade minister of Indonesia, Thomas Lembong, praised Southeast Asia central banks that have developed digital payments systems using local currencies. He also urged government officials to find new ways to avoid relying extensively on the U.S. dollar. “I have believed for a very long time that reserve currency diversification is absolutely critical,” said Lembong. What’s amazing about this report is that the criticism of U.S. dollar policies is coming from reliable allies and countries that have traditionally favored dollars.

Higher government bond yields are challenging US equity valuations

A key ratio for the S&P 500 is the earnings yield comparison with Treasury bond yields. The chart below shows the 100 year record. Every time the earnings yield has fallen below the Treasury bond yield it has been a long term disaster for the S&P 500.

Markets are not discounting the recession needed for the current expected decline in inflation.

Credit spreads are nowhere near the levels that would suggest they are discounting a recession.

Wall Street is not even expecting a dip in earnings in either 2023 or 2024.


An immaculate disinflation and recovery is now being discounted as a likely outcome by the markets and Wall Street. The biggest inflation for over 40 years can come and go, apparently, without much in the way of adverse earnings, unemployment, or widening credit spreads, despite the worst corporate debt market for many decades. If so why does the Fed need to cut interest rates?

There is no record of a market and economic free pass on this scale that I can find. Investors will have to consider the probabilities of a durable upturn very carefully. The outlook for a weak Q1 2023 is compelling, not just from the data, but also from the yield curve and other indicators.

In the mean time short dated TIPS look very attractive on a yield basis currently. Gold remains in a strong uptrend which could challenge new highs even in the current year, and commodities may be a better growth allocation than US growth equities.

Transform Your Investment Experience

The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs Best Investor metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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Chris Belchamber is an IRMAA Certified Planner

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