The Bond Market Is Screaming Stagflation
March 14, 2022 | Tags: ZEROHEDGEThe Bond Market Is Screaming Stagflation
Topic #1: Market-based expectations for future US inflation have broken out to new highs in the last 10 days. Using data from the TIPS (Treasury Inflation Protected Securities) market back to its start in 2003:
- At present, TIPS are pricing 3.52 percent annual inflation for the next 5 years and 2.94 percent for the next 10 years.
- Before 2021, the highs for expected inflation were back in March 2005, at 2.94 percent (5 year) and 2.76 pct (10-year).
- In November 2021, expectations spiked to 3.17 percent (new record for 5 years) and 2.76 (tying the 2005 record for 10 years).
The chart below shows this history/recent breakout and also compares the 2003 – present timeseries to the Federal Reserve’s 2 percent inflation target. In the middle of the chart, we have highlighted the 2011 – mid 2014 period. Recall the crude oil prices were high back then, as they are now, ranging around $100/barrel for over 3 years. Even still, inflation expectations remained around 2 percent because the US economy was recovering only slowly from the Great Recession.
Takeaway: the TIPS market’s inflation expectations are no longer as well anchored around the Fed’s 2 percent level as they have been since 2003. This trend is recent and not only tied to energy prices. Moreover, this month’s breakout is happening as the US economy is near stall speed (Atlanta Fed GDPNow Q1 estimate at 0.5 percent) and geopolitical tensions threaten domestic/global growth. All that makes for an awkward setup going into the FOMC meeting this week. Chair Powell has often cited TIPS inflation expectations being close to 2 percent as a proof point that structural inflation is not a threat to the US economy. For the moment, at least, that is no longer true.
Topic #2: The latest revisions to Wall Street analysts’ Q1 and Q2 2022 earnings expectations. The data here is courtesy of FactSet’s weekly Earnings Insight report (link below).
Good news (1): Street estimates for Q1 2022 rose last week for the first time in 5 weeks:
- The aggregate S&P 500 earnings per share estimate, based on consensus analyst forecasts for the companies in the index, rose to $51.79/share from $51.64/share last week.
- Estimates had been declining for Q1 since February 4th, when they peaked at $52.06.
- That may only be a 0.3 percent increase over the last week, but it comes with US stocks under pressure and growing macroeconomic uncertainty. Against that backdrop, seeing estimates rise is reassuring.
Good news (2): Q2 estimates rose last week and are now at their highs for 2022:
- Analysts’ estimates for Q2 rose to $55.59/share from $55.44 last week.
- Q2 estimates are up 0.7 percent since the start of Q4 2021’s earnings reporting season, when they were $55.18/share.
Bad news (1): both Q1 and Q2 2022 Wall Street earnings estimates imply the companies of the S&P 500 are close to peak earnings power or (perhaps) already past their peak.
- The S&P earned an actual $55.44/share in Q4 2021.
- The Street’s current Q1 estimate of $51.79/share is 6.6 percent below that most recent quarter actual.
- The Q2 2022 estimate of $55.59 within a rounding error (0.3 percent) of Q4 2021.
Takeaway: without a clear path to sequential earnings growth, which we’ve had since Q3 2020, markets are left to wonder if Q4 2021 really was the peak for US corporate cash flows. That is the fundamental reason the combination of Fed rate policy and geopolitical uncertainty have hit US stocks so hard in 2022. Wall Street analysts are tweaking their models at the margin and printing slightly higher estimates, which is reassuring. But … We’re still a month away from Q1 2022 earnings season, which is a long time to wait given everything else going on at the moment.
Topic #3: A history of 10-year US Treasury yields and Consumer Price Index inflation. 10-years yield 2.0 percent today. Thursday’s CPI report showed 7.9 percent inflation. That 5.9-point difference between long-term risk-free rates and inflation got us to wondering if such a gap has every occurred before and, if so, when.
This chart of 10-year yields minus CPI inflation from 1962 to the present gives the answer. The highlights:
- The only precedents for very wide differences in contemporaneous 10-year yields and inflation readings were after the 1973 and 1979 oil shocks. December 1974 showed a 4.7-point gap (Treasuries at 7.4 percent, CPI +12.1 pct), and June 1980 a 4.5-point gap (Treasuries at 10.0 percent, CPI at 14.5).
- There were smaller but still noticeable negative readings in July 2008 (-1.5 points) and September 2011 (-1.8 points).
- The current 5.9-point difference is wider than even those of the 1970s/early 1980s.
Takeaway: very wide gaps between Treasury yields and inflation occur when geopolitical events such as the 1973 Saudi oil embargo or the 1979 Iranian Revolution cause both a spike in energy prices/inflation and a sharp decline in investor confidence. That pushes capital into Treasuries, regardless of their inability to keep pace with potentially high inflation for years into the future. The same situation is occurring now, of course, and in a manner broadly consistent with the 1974/1980 periods.
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Meanwhile, here is Goldman looking at the risk that stagflation brings to "balances" or 60/40 portfolios. The outlook is not good.
In the last cycle US 60/40 portfolios benefited from a structural ‘Goldilocks’ scenario, with falling inflation/real rates boosting valuations and strong profit growth despite relatively weak economic growth. With a less favourable structural growth/inflation mix and less of a tailwind from valuations and profit margins, real returns are likely to be lower in the Post-Pandemic Cycle.
The risk of a ‘lost decade’ for 60/40 portfolios, i.e., a prolonged period of poor real returns, increases with stagflation. Markets have further repriced risk of stagflation, boosted by the commodities rally due to the Russia/Ukraine crisis – US 10-year breakeven inflation has reached the highest level since the 1990s, while real yields remain near all-time lows, resulting in a similar gap to that in the 1970s (Exhibit 1). This points to little optimism on LT real growth and material concerns on inflation risk.