Beware the dead-cat-bounce

Acquire everything! It’s a bull market! Equities are cheap! The buy-the-dip-reflex will prevail! Central banks will slash rates and lift their inflation targets! Residential and commercial investment properties paying net yields that are half the return on risk-free cash are still a bargain! Cryptocurrencies with zero intrinsic value and no government guarantees will go to the moon!

One hears these arguments from those loaded to the gills with stocks, property, tech, crypto, venture capital and risky debt. To believe this BS, you have to close your eyes and pretend to occupy a parallel universe.

You must ignore the biggest interest rate increases in history and the fact that they are deliberately designed to destroy demand, kill businesses, create job losses and slash the highest core inflation central banks have faced in 40 years back to their legislated 2 per cent targets.

You have to ignore the US Federal Reserve’s advice that the world’s largest economy will probably experience a recession, which this column has been warning about since the start of last year.

You have to turn a blind eye to the waves of defaults and business bankruptcies that are starting to materialise, and the fact that 15 per cent of all listed companies cannot service the interest bill on their debts (let alone principal repayments).

If that number sounds high, it just happens to be the same proportion of borrowers the Reserve Bank of Australia believes do not have enough income to meet their mortgage repayments and essential living expenses.

Finally, you have to ignore the harsh reality that perfectly liquid, government-guaranteed and risk-free cash deposits are paying interest rates of 4 to 5 per cent annually. To even contemplate allocating capital to something that is illiquid and/or carries high risks of substantial loss, you would want to be banking near-certain risk premia of three to five percentage points above that 4 to 5 per cent risk-free hurdle rate. And because most asset classes have yet to fully adjust to the new normal of structurally elevated interest rates, it is awfully hard to find anything that satisfies this test.

Central bank pressure

The concern is that central banks have yet to get close to dealing with their inflation woes, notwithstanding that headline rates peaked last year.

Global unemployment rates remain way below estimates of full employment, which means labour markets are still far too tight, fuelling buoyant wage growth despite poor productivity.

The nub of this challenge is revealed by a decomposition of the headline inflation data into its “goods” and “services” components.

Goods inflation was massively boosted by the closing of supply chains during the pandemic, peaking in double-digit territory. If we annualise goods inflation over the past six months, it has slumped from 12 per cent in the US last year to effectively zero in the first quarter of this year. In Australia, the story is similar: goods inflation dropped from a peak of 12 per cent last year to 5.5 per cent in the March quarter.

This is why headline inflation rates have rolled over.

Yet excessively strong demand continues to power incredibly strong services inflation. In the US, annualised services inflation over the past six months has accelerated to 6 per cent, which is the highest rate since the early 1980s. In Australia, services inflation is loftier still at almost 8 per cent.

Even allowing for the dampening influence of the one-off reduction in goods inflation, overall core inflation in Australia and the US was expanding at a 4.8 per cent and 4.9 per cent pace, respectively, on a three-month annualised basis in the first quarter of this year.

This was the highest quarterly inflation the US has suffered since 1988 (excluding the post-pandemic period). In Australia, it is the worst quarterly inflation outcome since 2008 when a 7.25 per cent RBA cash rate and the global financial crisis conspired to eviscerate demand (again excising the post-pandemic data).

The central banks’ battle with high inflation is, therefore, far from over. We are much more likely to be living in a world where interest rates remain high for a number of years. And it is entirely plausible that central banks will be forced to embark on a second phase of interest rate increases after this pause expires, which has been a common feature of past cycles.

Valuation puzzle

Given this challenge, let’s consider valuations in one of the most important markets on the planet, US equities, which tends to be the tail that wags many dogs. The cyclically adjusted price/earnings ratio (or CAPE) for the US sharemarket peaked at 39 times in late 2021. This was, amazingly, the second-highest level on record, surpassed only by the tech bubble mark of 44 times in 1999. (It also exceeded the third-highest recording of 29 times touched in 1929, just before the Great Depression.)

Since 1880, the average CAPE has been 16 to 17 times. It is currently 29.5 times. In the exuberance immediately before the 2008 crisis, the CAPE traded a bit above 25 times. After that shock, it climbed from a low of 15 times to north of 30 times just before the pandemic. This was powered by the belief that we were living in a world in which inflation was dead and interest rates would remain low for a long time, combined with the central bank response of spending trillions of dollars buying bonds and equities to bid up the value of all assets.

The pandemic pushed these policies to new extremes with zero or negative interest rates and the biggest central bank buying programs in history coupled with unprecedented fiscal stimulus. The CAPE subsequently soared to 39 times in 2021.

Since the Fed launched its existential battle against inflation, and jacked up its policy rate by a stunning 475 basis points, the US equities CAPE has started to normalise, falling from 39 to 29 times.

History shows that high inflation is bad for share prices because the rise in discount rates crushes valuations. Coolabah’s chief macro strategist, Kieran Davies, finds that “based on more than 70 years’ worth of data, the current US core inflation rate around 5.6 per cent is consistent with a CAPE of 10-15 times”.

“This implies that even though the CAPE has fallen, there is still significant downside risk to share prices, particularly if inflation remains elevated.”

Those who are long risk argue that central banks will simply lift their legislated commitments to price stability from 2 per cent to, say, 3 to 4 per cent, avoiding the need for further aggressive interest rate increases. Davies counters that “this solution would still lead to higher interest rates that would challenge the valuation of current asset prices”.

A recession may be precisely the jolt lackadaisical Millennials require to lift their game.

“This is because interest rates equal the real or inflation-adjusted rate plus expected inflation – and a higher inflation target would lead to higher expected inflation,” he says.

“If markets thought that central banks could credibly hit their new higher inflation target, the increase in expected inflation would be 1:1. And if a higher inflation target caused markets to doubt whether central banks were serious about containing inflation, expected inflation could rise by much more, leading to higher ongoing inflation in an echo of the disastrous experience of the 1970s.”

Another argument is the inflation problem is being propelled by companies expanding profit margins, particularly as wages have lagged the rise in consumer prices.

Australian analysts have replicated work by the European Central Bank that uses an accounting identity to explain economy-wide inflation through labour costs, profits and net taxes. At face value, this work is alarming because it found that profits have been fuelling inflation.

This is not, however, that surprising given economy-wide inflation includes export prices, where the surge in commodity prices has resulted in a near-doubling of mining profits since the start of the pandemic.

Coolabah has adopted a different approach, replicating the ECB’s analysis by approximating consumer prices using industry statistics on household services and retail trade. Preliminary analysis suggests that higher consumer prices mainly reflect higher unit labour costs rather than profits.

“We find that unit labour costs added 6 percentage points to inflation over the last year, with unit net taxes contributing 3 percentage points and unit profits adding another 2 percentage points,” Davies says.

“This would not come as a surprise to the RBA since it has recently started highlighting strong growth in unit labour costs, which reflects stronger wages growth combined with poor productivity.”

The RBA has stressed that for current wage growth to be consistent with low inflation, workers will need to improve their productivity. A recession may be precisely the jolt lackadaisical Millennials require to lift their game.

First published in the AFR here.