The firing shot went out in August, as detailed in a speech for the history books when the move to ‘average inflation targeting’ became enshrined in official policy. In subsequent press conferences Powell has doubled down stating ongoing easy monetary policy is mandated given the real unemployment rate is likely around 10%. This is more than the latest official statistic, at 6.3%, which Powell stressed ‘didn’t capture the full extent of labour market stress’. Further, within the employment objective Powell is increasingly focused on social policy. In a Bloomberg article written by Craig Torres, Powell cites the unemployment rate for Black Americans is 9.2% versus a White rate of 5.7% and that it could take ‘many years’ to overcome the scars from long-term unemployment. All this points towards a Fed that will remain highly accommodative for the foreseeable future.  

Over the last few years we’ve seen a notable rise in political instability. Whether its Brexit or the recent riots on Capitol Hill, examples lie abundant. Whilst the underlying causes are multitudinous and deeply complex, top of the list is deep and growing inequality. Globalisation has worked for some but not all and feeding into this narrative is the rise of technology and social media which provides a voice to those that previously had none. This has contributed to the polarisation of politics, evident from a hollowing-out of the middle ground and the rise of right and left-wing parties. What is interesting about the GameStop story is this same narrative seems to have spilled over into the world of finance. Enabling this transition are a host of commission-free stock trading and investing apps, like RobinHood.com. Most readers will be familiar with Robin Hood who famously stole from the rich and gave to the poor. It’s an apt name and shrewd move for an app which has sought to tap into this growing political undercurrent via its stated intention to democratise finance. But the democratisation story is not new as demonstrated by this e-trade commercial from 1999. Nor is that feeling of missing-out that typically accompanies the kind of market mania we see today. If anything, GameStop represents the democratisation of risk, to the detriment of less sophisticated retail investors.

Responsibility for said mania, and growing inequality are largely attributable to the Fed. It is admirable of Powell to seek to redress social inequality in the US but arguable such an endeavour goes beyond his monetary remit. By prioritising employment objectives, Powell may have become blind-sighted to financial stability risk. Many markets have ‘gone vertical’ and there has never been a greater disconnect between the underlying fundamentals and the stock market and yet that gap may continue to grow even as Powell maintains that financial stability across markets is ‘moderate’.

Another key risk which might have been overlooked is inflation. In a recent article in the Washington Post, Larry Summers, who served as US Treasury Secretary for Bill Clinton, argued that Biden’s economic stimulus package risked unleashing the worst inflation in a generation. The article drew forth a rigorous response, as detailed in the FT, from an unnamed Biden administration official who suggested ‘worrying about ‘overheating’ when the job market recovery has stalled out is foolish in the extreme’ and Jared Bernstein, a long-standing economic adviser to Biden, stated Summers was ‘flat out wrong’. Summers response to these criticisms can be found here.

We have no greater insight or knowledge of this subject area than the experts, but we do see a rising risk of inflation relative to policy makers expectations. The key tenets of this argument are best addressed another time and I won’t go into them here, except to re-iterate that both Biden and Powell are laser focused on employment whilst Janet Yellen, Treasury Secretary, has been urging Congress to ‘act forcefully’. In just 3 months last year the US increased its deficit by a greater magnitude than the last five recessions combined. This debt will need to be funded yet overseas investors are quite rightly starting to question the merits of doing so. Thus, in 6 weeks, the Fed bought more Treasuries than it did in 10 years under Ben Bernanke and Janet Yellen, which at the time had been considered extreme.

The stage is thus set, politically and economically, for Modern Monetary Theory. In simple terms, MMT states governments should use fiscal policy to achieve full employment and do so by creating new money to fund purchases. To quote Stephanie Kelton, author of the ‘Deficit Myth’ and one of the most influential advocates of MMT: ‘to the extent the United States has an unemployment problem, there’s too little money in the world; to the extent it has an inflation problem; there’s too much money in the world’. With the focus very much on the unemployment problem, expect a lot more money to come. That’s somewhat breath-taking when you consider the US M2 money supply has already grown 25% in 2020 alone. All we need is a pick-up in the velocity of money, as lock-downs end and consumers spend their replenished coffers, for inflation to finally take hold.

This risk, of a notable and dramatic rise in inflation, is best summarised by former NY Fed President Bill Dudley in his Bloomberg opinion piece “Four More Reasons to Worry About US Inflation”. The article concludes by stating:

“All this suggest that the Fed, despite its desire to be accommodative and boost employment, might have to pull back on stimulus sooner and with greater force than anticipated to keep inflation in check. Such a move would be a significant surprise, given that in the Fed’s most recent Summary of Economic Projections, the median projection foresees no rate hikes through 2023. This, in turn, would further increase the chances of a volatile market reaction, along the lines of the taper tantrum that the US experienced in 2013.”

Early-stage inflation is typically positive for the stock market but beyond a certain level it becomes prohibitive. This got us thinking. At what point might inflation, or higher interest rates, become a problem?

One way to answer this question is to look at inflation expectations. As shown in the chart below, US equities and 10-year inflation break-evens tend to move in tandem, demonstrating a positive correlation over time, although this relationship seems to break down during those periods when inflation expectations, in white, reaches 2.5% in yellow. Whilst average inflation targeting means investors may now allow expectations to overshoot, historically speaking, 2.5% could prove a key hurdle.

What about actual inflation? The magic number, according to financial historian and macro strategist Russell Napier is 4%. We’ve reached that level several times before, in 1996, 2000, 2005, 2007 and 2011 and on each occasion, inflation has reversed course quite precipitously, typically alongside a fall in equities.

But before we get to 4% inflation, there is a strong argument for some kind of yield cap. With inflation at 4% you might ordinarily expect a similar, if not higher, nominal yield on long-dated government bonds, yet this is extremely unlikely in today’s environment given elevated debt levels and lingering solvency concerns. To keep the show-on-the-road the Fed needs to keep rates lower for longer. One way to achieve that is yield curve control. But in the inflationary scenario I am describing, it’s unlikely the Fed would continue its prior policy of bond purchases and balance sheet expansion as that would be like adding liquidity fuel to the inflationary fire. Rather, the yield cap would be imposed by alternative means, most likely via the regulator by forcing savings institutions to buy and hold more bonds whilst selling equities to pay for them. This method of financial repression, or subterfuge by a thousand cuts, allows governments to reduce their debt burden by imposing real losses on, typically mature, savers.

Once again, the question to ask is how high can nominal yields rise before they cause a problem, at which point some form of yield control is deemed appropriate? The chart below tries to answer this question. It shows the correlation between the S&P 500 and the 10-year US Treasury yield since 1963. What is immediately apparent is there is a transition point, between positive and negative correlation, and this level seems to have changed over time, falling from around 5% during the period 1963 to 2012 (in grey), to around 3% during the period 2012 to 2019 (in orange). That is to say, US equities could continue to benefit from the reflationary narrative, and higher nominal yields, up until the point the 10-year Treasury yield reaches 3%. More recent data, in blue, suggests the actual number could be nearer 2%.   

Interestingly, this is consistent with the range within which 10-year US Treasury yields have operated for the last three decades.

Let’s wrap things up by looking at real yields, which combine inflation expectations and nominal yields. Putting it all together, we think real yields would have to increase (right hand axis is inverted) by about 35bps before equities start to come under pressure. On the flip side, if real yields stay where they are now, the 12-month forward P/E ratio could rise further still.

That was the conclusion we reached from the following chart which shows the cyclically adjusted price/earnings multiple, or CAPE, for the S&P 500 going back to 1881. Multiples are clearly stretched but we think there is still room to run toward the polynomial adjusted trendline, in grey, which would match prior market tops in 1901, 1936 and 1966.

To summarise, it’ll take some doing (and that’s an understatement) to overcome the significant disinflationary headwinds of the last few decades. But the risks are increasingly skewed in that direction and if inflation does print higher than current expectations suggest, we have a roadmap in place to navigate the ever-evolving macroeconomic climate.