It’s funny in investing – even when you’ve been expecting something to happen for months, it can be hard to say for sure that it is indeed what’s happening.
Stretching back well into 2020, we have had a few core beliefs here at UK Uncensored.
Firstly, that inflation is coming, in one form or another.
Secondly, that inflation fears will cause the bond market to crash (and bond yields to rise).
Thirdly, that stocks, especially US growth and tech stocks, are in a bubble which will burst once the bond market has started falling (and yields have pushed higher).
So, how’s that going?
Part 1 – “Inflation is coming”
A combination of the supply shock of Covid-19 (economies which are shut down are less able to produce, manufacture, deliver, dig up stuff) and the gargantuan monetary and fiscal response are expected to lead to some unnaturally high inflation figures in the short term, and potentially some sustained inflation in the mid to longer term too.
This has begun – last Wednesday saw US inflation reach 4.2% on an annualised basis. That’s the main figure (there are a ton of adjustments and modifications and alternatives) but for simplicity, that is the number we’ll go with.
4.2% is… a lot? By the back-of-the-envelope Rule of 72 for estimating compounding, a 4.2% inflation rate means your savings get cut in half in a bit under 18 years.
This takes the form of £12 pints in 2040 – your bank account might still show the same number, but it’s worth half as much.
You can also look at the breakevens on US ten-year government bonds (the difference calculated between two ten-year bonds – one inflation protected and one not).
The premium for buying the inflation-protected bond instead of the regular one shows what the market expects the US inflation rate to be for the next ten years.
Currently, it’s at 2.51%. That’s a five-fold increase from a year ago when it was at 0.5%.
The highest reading in the last 20 years is 2.74% in 2004.
The breakevens have been steadily rising, and you can follow their progress on the St. Louis Federal Reserve’s data page here.
So the market’s inflation expectations have been rising steadily for a year, commodity prices have been soaring too, while CEOs have been warning of price rises from suppliers being passed along to consumers.
Then last week, we finally got some official data which confirmed the first effects on the consumer price index, as CPI inflation surged to 4.2% in the US.
My belief is that we will see some pretty wild inflation data before the year is out, and that while it may not rise in a straight line from here, that a Rubicon has been crossed.
Unless governments change tone dramatically and revert to austerity, government spending and central bank printing will work together to build a new, inflationary period in our lives.
Part 2 – Inflation fears cause the end of the great 40-year bull market in bonds
Since the early 1980s, inflation has fallen, and interest rates have fallen in tandem.
That makes sense. The lower inflation is, the more attractive a bond becomes, as the fixed payments and the redemption capital will have more value in the future if inflation is lower.
Inflation rising has done the opposite.
Here’s a chart of the iShares 20+ Year Treasury Bond ETF (TLT), one of the largest US bond exchange-traded funds (ETFs):
People have sold bonds, causing interest rates (yields on those bonds) to rise.
I have marked 4 January 2021, as the moment when bonds really began to sell off, causing yields to rise swiftly.
Below is the US Government 10 Year Bond Yield.
It’s essentially the reverse chart, but it is helpful to visualise the cost of debt going up.
It is also helpful to see the risk-free return investors can get from bonds going up – which is what makes equities relatively less attractive.
So in short, yes, bonds have sold off as investors flee inflation.
Part 3 – US tech and growth suffer…
Here is Tesla:
Here is bitcoin:
Here is Cathie Wood’s ARK Innovation ETF – a basket of the most speculative tech stocks out there.
The human brain has wired to see patterns since the days of cavemen and tigers. And hey presto, mine’s no different.
The correlation between these three seems apparent to me.
As inflation fears started to rise, they grabbed a hold of bond yields, and from January 2021, they started pushing higher and higher as bond holders sold in fear of rising inflation.
I have helpfully marked a line on 4 January 2021 in each case, just as I did with the US Government 10 Year Bond Yield.
Once interest rates began accelerating higher, such speculative long-term plays like bitcoin and Tesla become riskier, as the return you could get this year from owning government bonds rises.
The cash flow of the bond is immediate, you get your 1.5% this year, guaranteed by the US government.
The cash flow of Tesla is much more uncertain. Much more.
So yes, inflation rising has caused people to sell bonds, making interest rates (and/or bond yields) go up, which has put a pin in the speculative bubble in US tech and growth stocks.
Just as we would expect.
Parts 1, 2, and 3 have played out much as we thought they might.
Part IV – speculating on what comes next
The final belief of your editor and analyst is this.
Because low rates and tech which have, in combination, spurred the entire global stock market to superior heights…
… I can see very few scenarios in which once the US/tech/growth part of the market rolls over, it doesn’t start dragging the rest of the US’s (and then the world’s) stock market down with it.
However, I tell myself never to be more than 60% confident about anything in these crazy markets of ours, so don’t be taking this as gospel. And for good measure, here’s my second-best guess:
It’s also possible that prices range for a long time – a decade or more of mediocre ups and downs – while inflation renders those prices less and less valuable in real terms. Look at the 1970s to see what I mean:
There’s a heck of a lot going on there, so here are the headlines.
- The S&P 500 (blue line) suffered a 35% drop and a 50% drop between 1968 and 1982, between which years the prices went absolutely nowhere (105 to 100).
- In that time, the US Consumer Price Index (CPI) rose at between 4% and 14%.
- For pure simplicity’s sake, even just imagining that the CPI rose at 8% annually for 14 years, the CPI would rise from 100 to 293.
- This means your $100 dollars’ worth of shares stayed at the same price, but they fell in value by 2/3rds in just 14 years.
- You can imagine this in two ways – either by 1982 you’d need to have roughly three times as many dollars ($293) to buy the same amount of stuff, or your $100 from 1968 could only buy 1/3rd as much stuff (100/293 = 0.34 or 34%).
- I also find it noteworthy how clear the correlation is between the annual inflation rate rising and stocks falling.
I think that valuations are too high at this point, sentiment too extreme, and market structures too fragile for such a decade-long range to occur – a clear-out of epic proportions feels necessary. But heck, what do I know about the future.
All I know is that higher prices are simply lower future returns in disguise.
After a 12-year bull market, with global stocks at record valuations relative to the size of our economies, the meagre long-term future returns are all but guaranteed, no matter what happens in the short term.
A crash, or inflation. One or the other is the boogie man under the bed.
It’s quite tiring, to be honest, being so bearish while so many investors out there think everything’s just dandy. It’s a psychologically draining way to invest – not participating in crazy bull markets because of elevated risks.
But I saw a nice explanation recently, though sadly I can’t remember where.
Over seven years, a 10% gain every year with a 40% decline in the fifth year does this:
100 –> 110, 121, 133.1, 146.4, 87.8, 96.6, 106.3.
Over the same seven years, a 5% gain every year with only a 10% decline in the fifth year does this:
100 –> 105, 110.25, 115.8, 121.5, 109.3, 114.8, 120.6.
Avoiding big losses is the best path to long-term wealth.
That’s why I’m so consistently concerned by what I see, and so desperate to keep all of us on the same path to safety, protecting out wealth, while taking the opportunities where I see them along the way.
It’s not for everyone but if it helps, some people avoid the catastrophic losses that could well be coming our way soon, then it will certainly have been worth it.
My very best wishes,
Editor, UK Uncensored