With the Fed's taper imminent, rates were on the move again last week, both in nominal and real terms. The TIPS break-even spread continues to test its upper bound of the past five years or so. Are inflation expectations ready to break out? (THREAD)
TIPS break-evens have rebounded from the depths of the pandemic. History shows a tendency to mean-revert around 2%, with the top of the range around 2.3% in recent years. But further back, break-evens spent a fair amount of time near 3%. /2
Given that the CPI is north of 5%, a breakout to 3% would not surprise me. /3
If inflation expectations do accelerate from here, it could very well happen without an acceleration in growth. That may stoke some fears of stagflation. You can see in the chart below that inflation breaks are clearly diverging from economic momentum. /4
It’s interesting that both nominal yields and TIPS break-evens are rallying here, leaving real rates firmly in negative territory. /5
This final chart highlights the divergence between nominal and real rates. One would be forgiven for expecting real rates to be above zero, considering where we are in the market cycle. /END
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After the 6% drawdown since March 28, the forward P/E ratio on the S&P 500 has declined from 21.2x to 19.9x. Valuations were high, so this is good to see. Price should decline less than valuations during this correction since earnings estimates are rising 12%. Pass the baton.🧵
Trailing earnings are now growing at 4% year-over-year, after falling 2.6% in 2023. /2
For the US market, the consensus forward EPS estimate is now growing at a robust 12%. This is considerably more than non-US earnings estimates. /3
If the secular regime has transitioned from the Great Moderation of the past few decades to one of fiscal dominance, perhaps the most seismic change to the investing paradigm that most of us grew up in is the changing influence of bonds in a 60/40 portfolio.🧵
During the Great Moderation era (defined as disinflation and low volatility of inflation), the correlation between stocks and bonds was negative. That meant that if there was a shock to the 60 side of the portfolio, the 40 side would offer a counterbalance. /2
You can see in the chart below that the two lines tended to squiggle together from the mid-1960’s to late 1990’s, but have been squiggling in the opposite direction from the late 1990’s until 2022. /3
If the fiscal picture in the US is deteriorating per the new era of fiscal dominance, and gold is rallying sharply as a result, wouldn’t it make sense for the dollar to be declining? That’s what the chart below suggests.🧵
Why is the dollar holding up so well? I think the answer is the Fed. While fiscal dominance should be pressuring the dollar, the Fed’s restrictive policy is providing a counterbalance. /2
The US budget balance in purple and the Fed’s policy stance in orange. They are exactly offsetting each other, which is something that doesn’t usually happen. The last time the Fed was getting tighter and the fiscal side was getting looser was the first half of the 1980’s. /3
Several unusual things are happening in the markets, which in my view are most likely explained through the lens of fiscal dominance. 🧵
We are all painfully aware of the $11 trillion increase in the Federal debt since the pandemic in 2020, and we also know that the Fed has been shrinking its balance sheet (and therefore stopped being the buyer of first or last resort). /2
That has opened a large gap between the issuance of paper and the demand for paper. Yet, the term premium (the risk premium on long-term Treasuries) continues to meander around zero. /3
What time is it in the cycle? Now that we are 17 months into a bull market cycle, it’s worth asking how much life there is left. How long can this broadening bull continue?🧵
As the chart illustrates, cyclical bull markets can be as modest as 48% (1966-1968) or as grand as 200% or more (1982-1987, 1994-1998). /2
And this chart lines them all up. Over the past 100 years, the median bull market has produced a gain of 90% spanning around 30 months. By that measure there should be some life left for this cycle. /3
Based on the 1949-1968 and 1982-2000 super-cycles, we might be later in the cycle. Adding some support to that thesis is the CAPE model. The CAPE (or cyclically adjusted P/E) model holds that the prevailing 10-yr P/E ratio is a good predictor of the 10-yr forward annualized return (CAGR).🧵
By that measure, the 10-year CAGR should moderate from its peak of 16.5% in 2019 to a mere 2.6% in 2034. Those returns are not consistent with a secular bull market (quite the opposite) and therefore suggests that we are late in the game. /2
I prefer to use the 5-year CAPE ratio, as five years is more in line with a typical business cycle. I also prefer to use the price-to-total-cash ratio instead of price-to-earnings, given that the share buyback machine in the US stock market has been a powerful driver of valuation and performance. /3