Vol. 2, No. 21
Vol. 2, No. 21
America's overheating economy threatens to scald us all; Global equity markets still aren't cheap; Disinflationary shoots are appearing; Value in an online marketplace
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Housekeeping
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In today’s issue
Global stocktake (3 minutes)—Paid subscribers only
Rank and file (2 minutes)—Paid subscribers only
Credit creation, cause & effects (5 minutes)—Paid subscribers only
Debt cycle monitor (2 minutes)—Paid subscribers only
Investment ideas (19 minutes)—Paid subscribers only
"The most contrarian thing of all is not to oppose the crowd but to think for yourself." — Peter Thiel
Cartoon: Overheard in the Threadneedle thinktank
Boiling point
America’s overheating economy threatens to scald us all
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America is teetering on the edge of an inflationary event horizon. Like an inflamed appendix, the jobs market is bursting at the seams. Bosses and the government must fix the problem before it goes boom. Workers, irked by microscopic raises and plummeting living standards, will demand higher wages. Unless companies accept lower profits, a wage-price spiral will burrow itself into the economy. And ripping it out will be excruciating.
In a tragic irony, the labour market is strong, too strong. The unemployment rate was lower last month than economists and pundits expected. Just 3.5% of Americans looking for a job didn't have one. Businesses also created 263,000 new jobs, 5% more than forecast. More jobs and low unemployment are usually desirable, but not when inflation is high and rising. Mixing these two ingredients is a recipe for much tighter economic conditions and higher interest rates.
The Federal Reserve, America's central bank, wants to get inflation down but can only do it by forcing up interest rates. The Taylor rule—a prescription for rates based on price and productivity levels—suggests the federal funds rate, the central bank’s main interest rate lever, should be closer to 10%. The current rate is just 3%, a distance from the double-digit remedy. The exact Taylor number is unimportant. Instead, the gaping chasm between current and suggested rates reveals how high rates could get if the situation isn’t improved.
Ongoing labour market strength combined with sustained price hikes give employees the bargaining power to demand raises. Unless companies accept lower profit margins, they will raise prices to offset the growing wage bill. In turn, workers paying newly higher prices will demand fatter paycheques. Unless one side of this tug-o’-war surrenders, inflation will take off, dragging interest rates up. Households and businesses, already grappling with higher financing costs and straining under enormous debt burdens, will struggle to pay higher rates. Defaults, deleveraging, and depression are likely results.
Profit prophets
The silver lining is that businesses are doing better than ever. Net after-tax operating profit margins have increased from 18% pre-covid to over 23% this year.
But despite being able to afford it, companies are unlikely to take one for the team. Bosses, under pressure from investors annoyed by lacklustre stock performance, will be unlikely to dish out higher wages. Nor will they willingly dip into their own overflowing compensation packages. Labour and capital are once again at odds with one another. Something has to give. And the longer the standoff, the worse it will be.
Cost of capital
Interest rates are finance’s most consequential yet misunderstood prices. Here’s what happened to the price of money in the past fortnight
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The price of money has risen dramatically in the past year. We shouldn’t think about valuations falling; instead, we should think about capital costs rising.
The transition from a low to moderate cost of capital has shaken investors and traders. Companies relying on a spigot of cheap external money are struggling to survive. Bosses, who chalked rising valuations up to their own brilliance, don’t know how to reconcile their self-image with market realities. They go on television and lash out at central bankers, journalists, and investors. Not a good look.
Money markets
Stock prices fell last fortnight. The S&P 500, an American index of companies, dropped 3.8% to 3,577. Investors knocked $1.9trn off global market capitalisations (see: Global stocktake) as real interest rates rose. The market is down 18% in the past year and is the lowest it’s been since 2020.
Government bond prices fell too. Yields, which move inversely to prices, rose again despite the expected inflation rate falling. The yield on a ten-year US government bond, a critical variable analysts use to value financial assets, rose 21 basis points (bp) to 3.9%. Analysts expect inflation to average 2.3% over the next decade, down 4bp from last fortnight and 20bp from last year. Consequently, the real interest rate, the difference between yields and expected inflation, rose 25bp to 1.6%. These inflation-adjusted rates have risen 2.5 percentage points in the past year and are the highest since 2010.
Equity investors think stocks are slightly riskier than they were two weeks ago. The equity risk premium (ERP), the extra return traders demand to buy stocks instead of risk-free bonds, climbed 24bp to 5.4%. They’ve risen 48bp in the past year. Similarly, the cost of equity, the total yearly return these investors expect, rose 45bp to 9.3%. This rate is up 2.8 percentage points in the past year—a steep rise and the factor explaining much of the market’s decline in that time.
Expected equity returns are the highest they’ve been since 2012.
Corporate bond prices fell less than government ones. Credit spreads, the extra return creditors demand to lend to businesses instead of the government, dropped a single basis point last fortnight to 2%. But spreads are still 93bp higher than they were a year ago. The cost of debt, the annual return these lenders expect to make, rose 20bp to 6%. These interest rate costs have more than doubled, up an astonishing 3.3 percentage points, in the past year. And lenders are charging companies their highest rates since 2009. Many companies relying on cheap debt won’t survive.
Using the average ERP of the past five years, the current ten-year Treasury bond yield, bottom-up analysts’ consensus earnings estimates for each company in the index, and a stable payout ratio based on the S&P 500’s average return on equity over the last decade, I value the index at 3,720 compared to its level of 3,577.
Money talks—it just needs an interpreter
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Global stocktake
Valuing regional and global stock markets to help us find the best ponds to fish for value
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