We have had many good discussions around Macro lately, so I requested another guest post, enjoy!
It’s well known that one of the biggest drivers of strong performance for global equities since the bottom in March is lower real yields, which has driven Price/Earnings ratios to historically high levels. Real yields, which effectively is nominal yields minus inflation (or inflation expectations), latest peaked in the end of 2018 and has since moved far into negative territory. You remember the volatile Q4 for equities in 2018 which was finally saved by the FED’s U-turn in its hawkish communication.
Chart 1. MSCI World P/E vs US 10y Real yield
Nominal US yields have barely moved since end of March this year despite inflation expectations coming up, reflecting money printing and potentially better growth ahead. Some strategists argue the low nominal yields reflect weak growth expectations but given FED’s new inflation target US Treasury traders are most likely expecting FED to introduce a yield cap in case nominal yields move higher, which gives them a positive risk/reward to own US Treasury.
Chart 2. US 10y Nominal Yield vs 10y Inflation expectations
So, if we assume nominal yields will remain low for the long-term driven by either expectations of a yield cap or if it’s officially introduced, what can drive inflation expectations further?
I believe it’s important to understand the current QE, which merge monetary and fiscal policy (aka for instance MMT), should have significant higher impact on inflation compared to QE 1, 2 and 3. Previous QE programmes have boosted the cash position for US Treasury holders, such has banks, mutual funds, insurance companies as well as foreign investors. However, when a US bank sell a US Treasury bond to FED, it doesn’t necessarily mean they will lend more to Retail, SMEs or large corporates as that would depend on a lot of other factors such as credit standards. The US banks’ cash position has correlated well with FED’s total balance sheet (see chart 3) over the past decade. I.e. you could argue this sort of QE is an inefficient way to stimulate the real economy.
The newly introduced QE is different. It gives the US government access to the freshly printed money, and will eventually end up with consumers through different stimulus packages, indirectly or directly. Even though the chart below doesn’t illustrate the full picture of the new QE it shows this difference between the QE programes where US banks’ cash position has increased significantly less than FED’s balance sheet and instead US Treasury’s cash position has increased, leaving room for fiscal stimulus.
Chart 3. FED’s Balance sheet vs US Banks’ cash position and US Treasury cash position
Combining fiscal stimulus packages, funded by freshly printed cash, with supply chain interruptions is highly likely to increase inflation. This we are already seeing signs of. Truck transport costs, lumber and milk prices are just examples of products that have rallied in a short period. The Food factor in the US CPI basket (14% weight) was up more than 4% y-o-y in August, while products that are of less interest to consume in a recession such as Apparel (2.7% weight) and Transport (5.2% weight), which include flights, is down more than -4% y-o-y. Both those factors are included in Services Excluding Energy Services n the chart below.
Chart 4. US CPI Basket. (Size of bar represents weight per 31st July 2020)
Chart 5. US CPI Basket – Excluding the two Energy factors.
Potentially FED introduced an average inflation target as they see inflation on the horizon and want to avoid a situation where they are forced to hike. Introduction of a nominal yield cap would be necessary for real yields to continue further into negative territory, but looks highly likely given FED’s communication over the past few months. The recovery in consumption, falling savings ratio, increasing US trade deficit and net borrowing is likely to lead to a depreciation of the USD, which will drive inflation expectations even higher – positive for equities. It’s not until FED feel a need to protect the value of the USD, they will have to let yields catch up with inflation. This is when real yields turn and equity loses its shine. Until then there is a positive scenario for equities.