GMO 3Q17 – What Happened to Inflation? And What Happens If It Comes Back?


GMO 3Q17 Quarterly Letter – What Happened to Inflation? And What Happens If It Comes Back?

What have we learned about Purgatory and Hell?

  • US economy was around full employment, inflation was at the Fed’s preferred level, and the Fed was preparing to embark on a significant tightening cycle for the first time in over a decade
  • When the economy was stumbling through its slow recovery from the crisis, it was hard to really get a good feel for how close the economy was to its potential and how quickly inflation would return once spare capacity had been used up
  • But with unemployment rate below 5% and inflation creeping up, it seemed we had worked our way through the lingering effects of the crisis
  • After a long period of lower than target inflation, we seemed to be getting back on track. GDP growth seemed to be in line with target levels
  • Once you threw in the election and promises by the Trump administration for a large fiscal stimulus, it really did seem like a lot was going to become clearly pretty quickly
  • Fed did indeed go ahead with its expected rate increases in December, March and June. GDP growth mildly strengthened. On the other hand, we would have expected inflation to either stay the same or rise, given GDP growth of around potential or better
    • The fall from 2.2% to 1.7% instead is somewhat mysterious
  • When the economy was in recovery mode from the financial crisis, the secular stagnation versus gradual healing scenarios for the economy was a slightly academic argument, as it was hard to determine which was more accurate from the evidence we had
    • From now on, the role of inflation seems utterly crucial to determining if we are in Purgatory or Hell
  • Higher real interest rates would give central banks more ammunition to fight future recessions, but we’ve seen from recent events that the zero bound, which economists assumed put a limit on how easy monetary policy could get, is more porous than we thought
  • A central bank primarily concerned with keeping inflation on an even keel, let alone one that desires to encourage maximum employment given tame inflation, will tend to keep rates very low as long as it believes that inflation is not a threat
    • So whether inflation starts to rise again is extremely important for helping us determine whether short-term interest rates ever come back up to the good old days of perhaps 1% to 1.5% above inflation
  • Rising inflation does not have to mean an inflation problem
    • If inflation were up to 2.5% to 3.0% in response to an economy continuing to grow steadily with low unemployment, this would not come back as a shock to economists or the Fed
    • However, it would mean that after a number of years of sub-normal inflation, the traditional rules of the economy still seem to hold and the Fed would have to raise rates at least in line with their current forecasts
    • This would push up bond rates and push down the general level of P/Es for stocks as well as valuations for real estate, infrastructure, PE deals
  • Historically, there have not been a strong relationship between interest rates and valuations for real assets and while inflation has impacted stock market P/Es, impact has been modest for smaller changes in inflation
    • An increase in inflation by 2.5% actually caused the valuation of the stock market to increase
    • Any deviation from that level caused the market to trade at a lower valuation
  • Apart from the FAANGs, there appears to be a sense that we all have to be invested in something and bonds and cash at current yields are more or less unownable
  • Low volatility stocks look relatively expensive to us – significantly pricier versus the market than they were on average during the decades before low volatility became fashionable

What happens if there’s an inflation problem?

  • If inflation were to actually become a problem and head to, say, 4-6%, the Fed would have to raise rates more aggressively
  • While such an event would be devastating to bonds under any circumstances and would be normally expected to hit stocks moderately as well, the potential pain today seems significantly greater
  • Combination of bonds and cash suddenly yielding quite a bit in both nominal and real terms as well as much higher uncertainty about the future path of the economy seems likely to be utterly devastating to today’s high valuations
  • We will look at Hussman P/E instead of Shiller P/E since Shiller P/E is biased high because earnings tend to grow over time and a 10-year average earnings figure will be, on average, lower than last year’s earnings. Hussman P/E is biased low: since it is always comparing the market to the highest earnings figure we’ve ever seen. But versus their long-term medians, both are telling precisely the same story – S&P 500 is trading at about a 93% premium to the long-run median
    • Falling to median P/E therefore involves a 48% fall
  • Historically, the 3 things that have dragged the market lower than median have been major wars, economic crises, and inflation spikes
    • Holding aside the major war category, that leaves us with 2 categories of events that might blow a hole in your portfolio
    • Ordinarily, I would consider that the economic crisis is the worse by a significant margin among the remaining 2 categories
  • Imagine first that the economic value of the stock market falls by a full 15% – that knocks the S&P down from 2600 to 2080. Let us further assume that the crisis disabuses investors of any notion that stocks aren’t risky and therefore investors demand a full 4% equity risk premium over cash to compensate
    • Given that in the past 18 years since the end of 1999, T-Bills have averaged a real yield of -0.6%, let’s be conservative and say that long-term cash estimates would be 0% real
    • That means the required return to stocks would be 4% real and the Shiller P/E of the market that would be consistent with that is around 23
    • If we combine the 15% loss of value with the required fall in valuations, we are talking about a market drop to a little over 1600
    • Let’s say profits really do go back to their old relationship with GDP – this would knock another 15% off the market, dropping us to 1360
    • A very nasty shock to investors but this is exactly the kind of scenario that bonds are in your portfolio for
    • If the yield on US bonds went to the yields we see today in the Eurozone, a bond portfolio with equivalent duration to the US Aggregate would experience a windfall of 14%
  • Let’s imagine instead that rather than a depression, we found ourselves with a moderate inflation problem with expected real cash rates moving to 2% real
    • From a corporate cash flow perspective, the real cost of debt will be significantly higher so earnings accruing to shareholders will likely drop
    • Given the pretty high leverage of the market and very low current interest costs, let’s conservatively imagine that sustainable earnings for shareholders fall by 7.5%
    • This takes the market from 2600 to 2340
    • The much bigger issue is that if the stock market has to deliver 6% real to give an adequate risk premium over the healthy cash rate, the fair Shiller P/E is probably about 16
    • Combination of falling earnings and valuations takes the market down to about 1200
    • At the same time, bonds would be taking it on the chin as well – if the yield on US Aggregate rose to 7%, a bond portfolio would be expected to lose around 25%
    • If we imagined something that caused inflation expectations to rise to 5% and real rates to rise to 3%, the fall for the 60/40 portfolio goes to 52%

Could other assets save you?

  • Unfortunately, it’s not entirely clear what other assets would save your portfolio in this event
  • Real estate and infrastructure form a big chunk of investors’ “inflation hedging” portfolios, but it’s hard to see how they help a lot here
    • While real cash flows from the underlying assets would be expected to keep up with inflation, these assets are usually held in a levered form
    • Rising real rates would hurt cash flows for holders similarly to what we modeled for equities. The big driver of the losses in equities was not cash flow problems but falling valuations, and the same logic applies for these assets as well
  • Natural resources have a possibly better claim as protectors, as they have the potential for an increase in real cash flows. However, this is really only true in a particular kind of inflation – one that is driven by a spike in resource prices that is greater than that of prices in the rest of the economy
    • Should such a commodity spike happen, resource stocks would certainly hold up much better than other equities

Okay, but can it happen?

  • Hypothetical inflation case is a scary one, but inflation is far from people’s minds as a big risk
  • In the past decade we’ve actually seen two different commodity price spikes that didn’t lead to any significant inflation, and the relationship between unemployment and inflation seems to have gone completely flat
  • Prior to the financial crisis, the relationship between unemployment and wage growth was what economists expect – when unemployment gets low, wages heat up
    • Since then, the relationship has been much more muted, with 80% less slope than the older relationship
    • On the other hand, 2008 wasn’t all that long ago. Maybe the current situation is temporary and we will go back to the old rules
    • And maybe the Fed will slow to catch on to the shift and wind up behind the curve, allowing inflation expectations to rise significantly
  • Is it my base case? No. But it doesn’t seem like an entirely implausible one, either

So what can we do?

  • Basic trouble with the rising inflation environment on investor portfolios is that it hits every asset class with significant duration
    • Stocks, bonds, real estate, private equity, infrastructure, all should take a hit
  • There are few, if any, assets that reliably do well in the event of unanticipated inflation
    • TIPS outperform traditional bonds, but certainly would lose money
    • Resource stocks should beat traditional stocks by a large margin if there is a meaningful commodity component to the inflation; whether they would make money in absolute terms is less clear
  • There is one security that is more or less guaranteed to pay off in the event of unanticipated inflation – an inflation swap
    • If inflation is higher than expected, such a contract will give a windfall gain, exactly what we’d want to cushion a portfolio
  • The trouble with buying an inflation swap is that if we imagine a scenario in which inflation surprises significantly to the downside, it is the depression scenario – the other way portfolios get hit really hard
    • So we can reliably protect against the inflation scenario at the cost of almost certainly worsening the depression scenario. That might be the right trade but it is hardly a lay-up
  • In our benchmark-free portfolios, our primary defense against the inflation threat has been shortening the duration of our assets
    • This is straightforward in fixed income. We own some duration in the form of TIPS, which are at least less acutely vulnerable to inflation than traditional bonds, but most of our fixed income portfolio has a duration of 2 years or less
    • In the risky part of our portfolio, we have moved significant amounts of money to liquid alternatives – we believe liquid alternatives are a significantly shorter-duration way of taking depression risk than equities
  • Somewhat speculative piece of comfort I take in our equity portfolios – significant inflation would certainly come as a nasty shock to equity investors in general; but if there is one group of equities that deals with inflation on a pretty much continuous basis, it is emerging equities
    • Emerging markets usually have a decently high beta in down markets
    • But it is not so far-fetched to imagine that if the catalyst for the fall were rising inflation, the stock markets where inflation was never absent in the first place might be better able to shrug it off
    • To be clear, our fondness for emerging equities today is driven overwhelmingly by their cheaper valuations, not a speculative belief in their resilience against an event that has not occurred since emerging became an institutionally buyable asset class

Image Source: Federal Reserve, GMO