inflation

What Moves Interest Rates?

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Quiz!

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal.
  4. A slight increase in unemployment.
  5. A severe recession in the US.
  6. Very high unemployment.

What Moves Interest Rates?

For a long time, some experts predicted a decline in interest rates. How could they be so wrong for so long? What really drives the Fed’s decisions?

Topic

Expectation

Reality

What are normal interest rates?

Very low, after 0% for years

Closer to the current 5.5%

What inflation is needed?

Declining inflation

An absolute level of 2%

What is the target inflation?

Higher than 2%, maybe 3%

2%

How does inflation change?

Linearly

The decline typically slows down as it approaches 2%

How are employment & inflation balanced?

Employment isn’t a big factor.

As long as inflation isn’t very high, we deserve low interest rates.

With unemployment so low, the main goal is to lower inflation

What are the Fed’s biases?

They want low interest rates

They don’t want to repeat the 1970’s where prematurely lowered rates let inflation spike again

What is good?

Low interest rates

Maximum employment with 2% inflation

Explanations: It seems that some people are driven by wishful thinking more than reality. Investors used the extremely low interest rates of the 2010s to justify extreme large US stock valuations, and they are eager to see interest rates go down. They hope to see very low interest rates as both the norm and the target. The Fed thinks very differently. They have two goals in mind (based on their job description): maximum employment and 2% inflation. With the employment goal in place, their focus is on getting inflation down. They saw inflation spike out of control in the 1970’s, and they are trying to avoid a repeat. The Fed said clearly that they will go as far as needed to reach their inflation goal.

What should we expect? Inflation is still nearly double its target: 3.5% vs. 2%. With inflation declines typically slowing down as we head towards the target 2%, we may have a long period with high interest rates. It is reasonable to expect the Fed to space out the rate increases further and further apart, as long as inflation keeps moderating. It may keep the interest rates the same for an extended period until inflation gets close to its target 2%.

Are there other scenarios? Yes. If the economy slows down and unemployment surges, the Fed will go back to a balancing act between employment and inflation, and could lower interest rates for a while. In that case, stock prices could do the opposite of mainstream expectations – they may decline. This could be most pronounced for stocks with the highest valuations (as measured by Price/Book).

Should we welcome lower interest rates? At first thought, lower interest rates are compelling, making it easier to fuel growth with cheap borrowing for companies & individuals. When considering the drivers of the Fed’s actions, lower interest rates without much lower inflation may be bad news – reflecting a response to a recession.

What can you do? You can structure your investments to benefit from high interest rates, and welcome the reality. Value stocks (with low price/book) tend to do unusually well with sustained high interest rates (not every month and not guaranteed). Note that your ideal investment allocation depends on your overall risk profile and goals.

Quiz Answer:

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal. [Correct Answer]
  4. A slight increase in unemployment.
  5. A severe recession in the US. [Correct Answer]
  6. Very high unemployment. [Correct Answer]

Explanations:

  1. The Fed seeks 2% inflation, not just a decline in inflation. Declines can moderate interest rate increases and space them out more, but less likely to lead to a reversal long before approaching the target 2%.
  2. The Fed said repeatedly that it will accept a mild recession if needed to control inflation.
  3. When Core PCE Inflation reaches its 2% goal, interest rates don’t need to stay elevated and would likely move down.
  4. Slightly higher unemployment would still be low historically, and wouldn’t justify lower interest rates without much lower inflation.
  5. A severe recession would likely lead to lower interest rates, though not guaranteed if inflation spikes very high.
  6. Very high unemployment would likely lead to lower interest rates, especially if inflation isn’t very high.
Disclosures Including Backtested Performance Data

What are Some Pitfalls of Bonds Today, and When will they Subside?

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Quiz!

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility.
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long -term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

  1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.
  1. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility. [Correct Answer]
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long-term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

Explanations:

  1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
  2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
  3. Correct: Short-term bonds indeed enjoy low volatility.
  4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
  5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
  6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.
Disclosures Including Backtested Performance Data

What is the Impact of High Inflation on Stock Returns?

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Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data

A Great Diversifier to Hi-Tech

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Quiz!

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks
  6. Bitcoin

A Great Diversifier to Hi-Tech

If you work in hi-tech, your financial position could be greatly influenced by the hi-tech cycle. Your income comes from hi-tech. In addition, If you have any stock options, stock grants or actual stocks of your company, they all depend on hi-tech. Even if you do not work in hi-tech, but most of your clients do, you are very dependent on this sector. When constructing your investment portfolio, it is worth being aware of this. It may be tough to diversify, if you believe that the strong run of hi-tech in recent years will never stop. To understand how a reversal is possible, note that valuations (price/book) of tech stocks surged in the past 10 years. This means that people are paying substantially more (price) for company values (book). This is in contrast to company values (book values) improving as much as the price gains, leading the price/book to stay flat over these years.

You may be discouraged by the fact that interest rates are low and expected to go up, and inflation has spiked. Commonly discussed candidates for moderating the risk of expensive tech stocks, including bonds and cash, can get hurt by rising interest rates and inflation.

There is a solution that doesn’t require accepting the typical low returns of bonds and cash, and without giving up the liquidity of stocks. This solution is especially helpful when interest rates and inflation go up. The solution is Value stocks, especially in other countries. When US tech stocks declined for over 10 years starting in 2000, Emerging Markets Value stocks grew substantially. This occurred at a time of extreme valuations for tech stocks, just like we are experiencing today. So, while any investor should be cautious of a concentration in high-tech stocks today, if your income is tied to hi-tech, you have a good diversifier available now.

Note that diversified Emerging Markets Value funds already have an allocation to high-tech stocks (while emphasizing lower valuations than typical), so they don’t require a separate allocation to high-tech.

Quiz Answer:

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks [Correct Answer]
  6. Bitcoin

Explanations:

  1. Cash offers zero volatility, and seems perfectly safe. The issue is that it loses money to inflation. With a modest 3% inflation rate, you lose 50% every 24 years.
  2. Bonds offer low volatility, at a price of low returns. While they may seem compelling, they can decline when interest rates go up, and they can lose value relative to inflation.
  3. US Value Stocks are a good diversifier given that they are helped by rising interest rates and inflation, while tech stocks tend to get hurt by those. They are still subject to US-specific country risks, so are not the best.
  4. Emerging Markets Stocks diversify the US-specific country risk, but there is still better!
  5. Emerging Markets Value Stocks diversify the US-specific country risk, and are also typically helped by rising interest rates and inflation, while tech stocks tend to get hurt by those.
  6. Bitcoin is a currency, with no expected positive returns. But, it is far worse than cash, because it is extremely volatile. In addition, people were drawn to it in recent years given the high past returns, similar to tech-stocks. As seen recently, they can experience declines together with tech stocks. This is opposite of what some speculated, thinking that it may be a good inflation hedge.
Disclosures Including Backtested Performance Data

Tipping Point for Value?

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Quiz!

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment.
  2. Rising bond interest rates.
  3. Expectation for inflation.
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks.
  6. Economic recovery from the pandemic.
  7. The best option out there.

Tipping Point for Value?

Last year will go into the history books given the pandemic. But another, less noticed, rare thing happened. Growth stocks, those with a high price relative to the company’s book value (P/B), or intrinsic value, went from very expensive to extremely expensive – a level barely second to the late 1990’s. While they’ve become more expensive for a while, there was a big spike in unprofitable small growth stocks. Last time we had a spike even close to this magnitude was around 1999. This is very reassuring for Value stocks, because often a long-lasting trend ends in a big spike in the direction of the trend, followed by a sharp reversal. For value stocks in the US, last time the reversal meant a 50% outperformance in a mere 2 years.

There are a number of logical reasons to see a reversal at this point:

  1. A change in sentiment: The reversal already started a few months ago, long enough for people to take note, and start treating it more like a new trend than noise.
  2. Expectation for inflation: Two forces are leading to an expectation for higher inflation: (1) Dramatic government stimulus; (2) The Fed planning to hold interest rates low until after inflation overshoots the typical target. Bond prices already started declining reflecting this expectation.
  3. Very low valuations relative to growth (high Price/Book) stocks: With the valuations of growth stocks going so much higher relative to value stocks, growth stocks became much more dangerous. People took note and started shifting towards value stocks.
  4. Economic recovery from the pandemic: Value stocks tend to outperform at times of economic recovery.

Note that value stocks outside the US have much lower valuations than US stocks – near record difference, making them even more appealing. As always, there could be surprises, and it is important to structure your financial picture to account for them.

Quiz Answer:

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment. [Correct Answer]
  2. Rising bond interest rates. [Correct Answer]
  3. Expectation for inflation. [Correct Answer]
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks. [Correct Answer]
  6. Economic recovery from the pandemic. [Correct Answer]
  7. The best option out there. [Correct Answer]

Explanations: #4 is only partly correct. In the US value stocks are not low relative to their historic average, though they are very low relative to growth stocks. Outside the US, valuations are clearly low.

See article for more explanations about the correct answers.

Disclosures Including Backtested Performance Data

What Happens When Interest Rates & Inflation Rise?

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Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

Look for the answer below and read this month’s article for a discussion.

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data