Inflation, Real Interest Rates, and Market Turbulence: What Investors Need to Know

On Friday, January 20^th, 2023, with investor pessimism rampant, calls for a market retest of 3500 or lower throughout strategist land and S&P500 trading at 3900, I released a video titled “two things that really matter”.  Here’s the link to that video.

Our investment team had been talking positively about our expectations for 2023, but few people seemed to be listening. We had already published our 2023 outlook and a follow-on stock talk titled, “What could go right”?  We gave a few reasons for our optimism during a time of uncertainty backing it up with historical statistics combined with real-time data series. I felt uneasy releasing this video and I’ve been doing this investment management gig for almost 30 years.

As it turns out, our outlook for 2023 turned out pretty close to spot on in both price and time throughout the year including the summer selloff and calling for the 4^th quarter lows and pivot higher almost to the day of our October 26^th livestream.  Here’s the link to that video with myself, Troy and Charles discussing the likely strength of the coming November through year end period.

In this week’s video I’m returning to the EXACT same topic I addressed on Friday, January 20^th a year ago.  It’s title back then, What “really” matters. This week, the two things that matter, revisited.

So, what really matters here?  What two things above all else matter to investors? The same two things that most often do as far as I see it and they are intertwined of course.  First, is inflation and both its level, whether it’s absolutely high or low, and sometimes more importantly, its trend. Is it rising or falling.  From a high or low level?

And secondly, the level and trend in the “Real” interest rate component within nominal yields. This is also called the TIPs interest rate.  This is the one that many market strategists finally discovered and started discussing as “critical”, almost universally in a negative manner, right at the market’s lows in late October 2023, right in front of the rip-roaring late 4^th quarter rally.  Remember all of those CNBC and Bloomberg interviews with strategists spouting the Feds “higher for longer” message? Or discussing some academic notion of “R-Star” right at the market lows in stocks and yield highs in bonds? Unlike many others, we’ve spoken about real interest rates and real time inflation a lot over the last 2 years.  We will cover them again here.  Real time inflation and real time “real interest rates”, and unfortunately, opposite January 20^th, 2023, they are currently saying to seasonally curb your enthusiasm here and there’s a pullback, that’s likely fast and furious forthcoming.

Inflation. Let’s cover it again. Overall goods inflation peaked in the late first half of 2022.  Commodity pricing slumped. Used car pricing collapsed.  Container shipping rates collapsed. Most industrial metals roundtripped.  The price of lumber dropped 75%. Fertilizer, oil and natural gas prices plummeted even with the war in Ukraine and the energy shortages in Europe throughout 2h22 and the 1h2023. Back in January, 2023 we shared with you the data about “peak inflation”.  Here’s the great chart from Barry Bannister at Stifel Financial showing the lead affect of peak CPI versus the lows and pivot up in the S&P500 since World War 2.  The average length of the lag was about 7 months after peak CPI print.  The CPI peaked at +9.1% in June 2022.

That would put the timing of the average pivot up in stocks starting in? Yes, January 2023.  Which of course happened, spot on cue.

The problem now currently lies in that 1- investor inflation expectations of the symmetrical drop in inflation that our team has discussed for 18 months, have now caught up to market reality, 2- inflation is seasonal with it usually picking up in the 1^st quarter, and 3 – inflation is set to rise throughout the rest of January into February on the back of many of the EXACT same reasons the repeat of the “1970’s inflation hysteria zealots” were discussing 18 months ago.

Here are a few of the current reasons for a likely seasonal upturn in inflation.  Yes, as we film, shipping rates are “skyrocketing on the back of the middle east Red Sea military exercise AND the low water levels in the Panama Canal.  Secondly, energy prices are troughing.  Whether it’s the cold weather in the US pushing natural gas prices higher the last 2 weeks, or Middle East turmoil turning the oil markets higher, higher energy prices are bad for inflation data and consumer sentiment.

Here’s a chart of real time 2-year breakeven inflation rates.  These are real time.  This isn’t government data that takes months to compile and disseminate and is revised.

One can clearly see that historically 1- a lower level is good, 2 – a stable level is good, 3 a lower trend from a high level is good but 4- a low level, but trend high is BAD! For the markets.  Case in point from a recent example of point 4 – low inflation but trending higher? We don’t have to go back far.  In fact, just last year, mid-January 2023 through late February. Inflation expectation rose for 6 weeks, and the S&P 500 cash markets dropped 300 points or about 9% back then, from 4195 to 3808 in 6 weeks from early February through mid-March. I’ve highlighted that period in the chart of the S&P500.

The second thing we’ve discussed multiple times the last few years that “really” matters to investors is “real” interest rates. Investors, remember the Treasury yield you get paid by the bank is the nominal interest rate.  It is the sum of an inflation component and a real yield premium, also called the TIPs yield.  The real interest yield component of Treasuries goes a long way to determining the risk premium investors pay for equities.

When the Fed and other central banks ran a world of zero and negative interest rates, this enabled or forced investors into a world of holding larger equity positions because money was nearly free.  It created the notion of “TINA”, or there is no alternative.  There has been a very strong, and inverse correlation, between the multiple on the S&P500 investors are willing to pay and the direction of the 2-year real yield.

Here’s a 18 month chart of the 2 year real yield.  It troughed in late November of 2021 and pivoted up as many Fed committee members began talking more hawkishly behind the scenes even though Chairmen Powell was out publicly worrying about employment still.

This interest rate peaked of course peaked in mid-October 2023, just as virtually every strategist on TV was out mirroring and messaging the Fed’s phrase “higher for longer” and talking academic nonsense around theoretical R-star levels. This piece of data and this chart is almost entirely behind the November and December stock market rallies around the world.

But Chris, why are you not more optimistic about the markets this year?  Your team only have 5000 as a 1h24 target on the S&P 500 you might ask?  Why are you so cautious if a lower trending “real interest rate” is generally good for stocks and their multiples?  It’s the reason TINA existed for so long. That’s what you told us a year ago when most everyone was negative, but your team was optimistic.

Because history also says that there is a tipping point between positive investor sentiment and lower real interest rates too.  There is a point where lower real interest rates become a symptom of an economy that is not just slowing, but stalling, and potentially heading into negative growth territory.  And that’s where investor optimism for the so called “soft landing” flips from hopeful and optimistic, to worried, doubtful and pessimistic.

What does this mean to you the investor?  Investors, this is set up for seasonally higher trending inflation in the 1^st quarter, coupled with lower and or faulting real growth expectations that completely aligns with our team’s messaging for 1h24.  Expect a period of higher volatility in the markets over the coming 4-6 weeks as other investors see these trends and worry about a “soft landing” scenario. A completely normal outcome would be at best 1- a continued stall for January and February in the overall markets or 2- a sharp pullback post January option expiration into month end February, much as what transpired in 2023.  What ever the case, the 2 things that have “really” mattered for your stock and bond portfolios the last 2 years are saying the same thing, it’s not time to get “FOMO” and a better entry in both price and time will likely show itself from lower levels in February.

Have a blessed week and a fantastic new year.

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