After falling in early trade, it took just a few soothing words from Fed Reserve boss Jay Powell to push the main US indices higher overnight. The Dow was up around 0.2%, while gold and oil were modestly higher too.
But inflation, it seems, is nowhere to be seen. From The Wall Street Journal…
‘U.S. government-bond prices climbed Wednesday after soft inflation data indicated that investors will have to wait longer for the big increase in consumer prices that many have been expecting this year.
‘Overall, the data indicates that “there’s just no real significant underlying inflationary pressure,” said Thomas Simons, senior vice president and money-market economist in the fixed-income group at Jefferies LLC.’
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If you’re expecting an inflation outbreak due to all the ‘Fed money printing’ and the huge fiscal spending, you’re going to be disappointed.
Well, in the short term at least.
Inflation will eventually pick up. And it could get ugly a few years down the track. But there is no real reason why it will just yet.
That’s because the US economy is still weak. There is still high unemployment. And there is just no demand for borrowing in the real economy.
Let me explain…
Everyone thinks the Fed ‘prints money’. It doesn’t. Commercial banks create money when they make loans. When the Fed buys bonds off commercial banks, it credits their accounts with reserves. These reserves must be held at the Fed. They don’t go into the economy.
The Fed’s actions ‘help’ in other ways. They drive interest rates lower, which increases risk taking and creates moral hazard. Pretty cool, huh?
Anyway, I looked up what the real economic money creators are doing, and it’s not particularly good viewing when you break it down.
On the surface, things look pretty strong. In 2020, total bank credit grew a robust 8.4%. This was much stronger than in 2019 and 2018. Funnily enough, second quarter growth of 21% boosted the annual result.
The second quarter was the worst of the downturn, how could banks’ credit growth be so strong? Well, that was the time when access to money markets and repo shutdown. Companies went to their banks and drew on credit lines to access cash. Commercial and industrial loans increased 88%!
But in the third and fourth quarters, these loans contracted 20.3% and 22.4% respectively, as companies accessed cheaper forms of credit again.
That marked a big slowdown in bank credit growth too. In the third and fourth quarters, growth came in at just 2.4%. But here’s the worrying stat…
Nearly all that growth relates to banks buying government debt. US banks increased their holdings of Treasury and Agency securities by 31.7% and 22.6% in the third and fourth quarter, respectively. Meanwhile, credit provided to the real economy (commercial and real estate loans) went backwards by 7.5% and 5.6%.
In other words, US government spending is pretty much the sole prop for the US economy (and company earnings for that matter) right now.
As wasteful and unproductive as government spending is, this is not a situation conducive to inflation.
Don’t despair though, equity bulls. This is a ‘just right’ situation for stock prices.
Don’t get me wrong; there are many overheated parts of the market ripe for a decent correction. But in an environment of zero interest rates and non-existent inflation, don’t expect prices to move materially lower.
Think about it…
If you’re waiting for the good old days of a bear market bottom and a price-to-earnings multiple of five times on the Dow, consider then when that fleeting moment occurred in the early 1980s, Treasury yields were around 15%.
Add on a 5% risk premium and the discount rate used to value companies was 20%.
The higher the discount rate, the lower the valuation. A 20% discount rate is the equivalent to a PE multiple of five (1/20%).
The point I’m making here is that you’re not going to get materially lower stock prices when long bond yields are around 1%. Add a 5% risk premium and the discount rate is 6%, equivalent to a PE multiple of 16.67 times (1/6%).
And I’m probably being generous with the risk-free rate. Some of these Big Tech companies are corporate sovereigns, which the market sees as very low risk. So if I assume a 4% risk premium plus a 1% ‘risk free rate’ on government bonds, the discount rate to value these companies is around 5%, which equates to a PE multiple of 20 times (1/5%).
You don’t have to agree with it, but that’s how the market sees it.
Going back to the start of the essay, the absence of inflation is great for stocks, as it means the discount rate stays low and valuations remains high.
The risk is that the absence of inflation turns into a deflationary scare and a ‘liquidation event’. This is where a lack of growth and falling prices freak investors out. They worry about earnings growth and ‘liquidate’ their holdings. This causes stock prices to fall, despite the discount rate remaining low.
This is something my colleague Jim Rickards worries about. He’s just written a book about it. It’s called The New Great Depression: Winners and Losers in a Post-Pandemic World.
I’m looking forward to getting my hands on a copy. Keep your eyes on this space to find out how you can too.
Editor, The Rum Rebellion
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