Friday, September 14, 2012

Equities rise with inflation expectations

As a follow up to my post yesterday, the chart below provides strong support for my belief that equities are responding more to inflation expectations than they are to real growth expectations. That is consistent with the monetarist view that the Fed has very little control over real growth—you can't print your way to prosperity.


The chart compares the S&P 500 to the market's forward-looking inflation expectations, the 5-yr, 5-yr forward implied inflation rate embedded in TIPS and Treasury prices.

Equities benefit from QE3 because it is likely to boost nominal GDP growth, but not necessarily real growth. Inflation is now much more likely than deflation, and future cash flows are likely to be better than expected.

This is all good news for now, but lurking in the shadows is the issue of how the Fed is going to reverse its quantitative easing in the future, and whether they can do it in a timely fashion to avoid inflation going too high.

Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook.

20 comments:

Bill said...

Do you believe that based on historical p/e ratios, the S&P500 in 2013 should be about 1800?

Mark Gerber said...

"Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook."

Huh? You just pointed out that yields and stock are rising due to increased inflation expectations. So how is that an "improved outlook?"

Dr William J McKibbin said...

I concur with Scott -- inflation expectations are abounding in equity prices -- this is normal following monetary expansion announcements -- the effect of monetary expansion on growth will take time, assuming they happens at all -- however, if monetary expansion and inflation are to be the future, then a positive side effect of inflation will be to rout government spending and entitlements in detail, especially if inflation exceeds 3% annually -- recall that the US experienced 85% aggregate inflation between 1973 and 1982 (!) -- a ten-year run of 85% aggregate inflation would be hard on savers, generally good for real estate, but devastating for those who live on the government -- said another way, a 10-year run of 85% aggregate inflation would rout the government spending that most needs cut, which is fine with me by the way -- the other benefit would to reduce the national debt by very meaningful amounts -- a 10-year run of 85% aggregate inflation would essentially reduce the existing national debt by 85% (!) -- inflation has lots of bad effects, but some of the effects would hit directly at those parts of the US economy that need hit anyway -- oh, and a Congressional or public mandate is not required for the Fed to create that inflation -- I prefer to live in the world as it is -- and I can definitely see some advantages to monetary expansion and a period of double-digit inflation.

Dr William J McKibbin said...

PS: More at:

http://wjmc.blogspot.com/2010/05/student-recently-remarked-to-me-that.html

Mark Gerber said...

Dr. McKibbin,
I must be having a tough day understanding people because I don't get how inflation will "route the government spending that most needs cut." The two biggest government spending progams by far are SS and Medicare, and their payouts are both effectively indexed to inflation.

Scott Grannis said...

Mark: Treasury yields have been extremely low because the market has been extremely concerned about the risk of an extended period of very slow growth and/or a recession and/or deflation. The Fed's QE3 suggests an increased likelihood of faster nominal GDP growth, and the market has been very concerned that nominal GDP growth would be dismal.

Dr William J McKibbin said...

@Mark, cost of living adjustments (COLA) did not keep up with inflation for most of the past 60 years -- as a result, inflation resulted in lower entitlement spending after COLA adjustments -- COLA adjustments are unlikely to keep up with inflation in the future as well assuming inflation exceeds 3% -- watch and see...

PS: A Romney administration would no doubt block matching COLA adjustments to inflation...

Benjamin said...

i am flabbergasted at Grannis' take on this smart, if too small, Fed decision to go to a sustained QE3.

Inflation? Dr. Perry (Carpe Diem) has just intoned that "inflation is dead," and I am inclined to agree with him.

If inflation is dead, and the economy soft, and yields near zero bound---jeez, this is a situation tailor-made for QE. If we don't go to QE now, when would we? Do we have to wait for depression to go to QE, or is it good policy to thwart that in advance?

We had two rounds of QE, and inflation has been trending south since the completion of QE2.

In Japan, they had a sustained QE program from 2001 to 2006, which coincided with their longest postwar expansion. When they stopped QE, they went right back to deflation (John Taylor posted a gushing paper about the successor Japan's QE program, on his website. Taylor will support QE once Romney becomes president, I highly suspect).

I only wish the Fed had said it would do $100 billion a month, and that it was targeting 7 percent annual growth in nominal GDP.

William said...
This comment has been removed by the author.
Benjamin said...

Hey, our problems are over!

Romney will cut federal outlays by $500 billion in first term in office!

While leaving Defense spending (that is, the bulk of agency spending) untouched!

Some Romney Proposals Await Fuller Detail
New York Times - ‎6 hours ago‎
Mitt Romney says he will cut government spending by some $500 billion a year by the end of his first term, while protecting military spending.

I know what some of you are thinking. That Reagan, then Bush, and then Bush jr. all said something similar, and instead federal agency spending and entitlement spending just kept growing and in fact exploded on their watches.

You are cynics!

Lucy will not pull the ball away from Charlie Brown this time!

William said...
This comment has been removed by the author.
Dr William J McKibbin said...

@Benjamin, I am not confident that either the big government Democrats or military-industrial Republicans will cut Federal spending...

Dr William J McKibbin said...

PS: @Benjamin, you said, "our problems are over" -our- the problems are never "over" -- my experience is that problems are normal -- my advice to all is to view every set of problems and situation as just another opportunity to make money and build your estate -- however, I can think of no time in the history of the US or the world when everyone's problems were "over" -- to quote one of my professors of past, "...act from an instantaneous apprehension of the totality..." (R G H Siu) -- that's not cynicism, but good advice for all times...

Dr William J McKibbin said...

PPS: No doubt, Scott is going to be providing some useful reporting on bond activities in the coming months -- QE3 will be hard to gauge in terms of effects -- Scott's methodology is where we should all seek grounding -- we desperately need more information (vice data) right now about bond activities -- Scott, I'm eager to read what you can share with us in the coming months...

randy said...

Pimco says QE buying us a little more time, but cannot effect the underlying problems. Sounds right to me. As long as we continue to think sugar water will fix our ills, and avoid doing the hard things that need to be done, real and sustainable growth will be harder to achieve.


http://investments.pimco.com/insights/External%20Documents/PIMCO_Cyclical_Outlook_Building_Rickety_Bridges_to_Uncertain_Outcomes_PCCO005_32757.pdf


While monetary policy is arguably doing all it can to sustain the rickety bridge of nominal growth in the New Normal, fiscal policy coordination and planning have been disappointing on a global basis. Without structural change aided by well-planned fiscal policy, we are afraid the nominal bridges of monetary policy will fail to reach their desired outcomes, whatever and wherever they may be in this uncertain global environment.

randy said...

dang... I hate it when people misuse effect and affect...

William said...

ECRI has been sig-saging its way higher since early June with a sharp rise the past three weeks to 24.9. It peaked in April at 27.

The 2012 Recession: Are We There Yet?
"In other words, nine months ago we knew that, sitting here today, most people probably would not realize that we are in recession – and we do believe we are in recession.

"Think back to four years ago in 2008, a couple of days before the Lehman failure. Looking at the data in hand, you would see GDP growth at about 1% in Q1 and 3% in Q2. More specifically, Q2 GDP growth had just been revised up on August 28 from 1.9% to 3.3%, sparking a 212-point Dow rally that day.

"In March 2001, 95% of economists thought there would not be a recession, but one had already begun. And we do not recall anyone outside our shop predicting the 1990-91 recession beforehand. Hardly any economists recognized the severe 1973-75 recession until almost a year after it started. Indeed, that recession began with the ISM at 68.1, and payroll jobs growth did not turn negative for eight months.

http://www.businesscycle.com/ecri-news-events/news-details/economic-cycle-research-the-2012-recession-are-we-there-yet

William said...

OECD composite leading indicators point to a continued loss of momentum in most major economies

"13/09/2012 - Composite leading indicators (CLIs), designed to anticipate turning points in economic activity relative to trend, show that the loss of momentum is likely to persist in the coming quarters in most major OECD and non-OECD economies.

"In Italy, China, India and Russia the CLIs continue to point to a slowdown. For the Euro Area, France, and Germany the CLIs point to continued weak growth.

"The CLIs for Japan and the United States show signs of moderating growth above trend, while in Canada the CLI continues to point to growth moderating below trend.

"The CLIs for the United Kingdom and Brazil tentatively point to a pick-up in growth, but remain below trend.

http://www.oecd.org/std/leadingindicatorsandtendencysurveys/compositeleadingindicatorsclisoecdseptember2012.htm

Dr William J McKibbin said...

I just did a deep dive into QE3 and its design -- my conclusion is that QE3 will definitely be expansive monetarily, with all the ills that accompany monetary expansion -- however, have also concluded that this expansion will flow into Main Street USA deal-making in ways that were impossible under QE1 and QE3 -- more at:

http://wjmc.blogspot.com/2012/09/main-street-usa-primary-beneficiary-of.html

The news is good for Main Street real estate investors, especially for new real estate deal-making.

Bob said...

@ Dr. McKibbin. I have been following your comments on QE3 and realestate.

What about the potential for a Romney victory, the replacement of Bernanke as Fed Chairman and a change in QE3, even it's cancellation? I

Is this not a potential game changer right as you start building your realestate empire?

I'm not doing any thing until the outcome of the general election.

Bob