Out of
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Ideas, arguments, and musings from inside Harding Loevner.

Does the Equity Market Know Something the Fixed Income Market Doesn’t?

By Edmund Bellord, Portfolio Manager and Asset Allocation Strategist | April 12, 2022

Despite recent volatility the bond market has yet to lose its composure over the multi-decade high in inflation. In the US, ten-year Treasury yields have risen, but only to levels they reached prior to the pandemic, and, while ten-year real yields have been a little perkier, they are still below zero. As a result, the longer-term inflation expectations baked into today’s bond prices remain bunched up around 2% despite headline inflation running at over three times that rate. Short-term yields anticipate a series of hikes in the federal funds rate, the central bank’s standard response to persistent inflation, but even forward curves expect short-term yields to top out at only around 2.5%, within spitting distance of where they peaked back in 2018 when inflation was slumbering at 2%.

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

What are we to make of such an acquiescent yield curve in the face of the highest inflation in a generation? Are investors so convinced of central banks’ inflation-fighting credibility that they are willing to forego any compensation for the risk that things might not turn out exactly as planned? Or have successive efforts by central banks to prop up asset prices at the first sign of trouble by generously spraying markets with liquidity scrubbed away any vestigial memories of inflation and left investors in a state of learned passivity? Or perhaps there’s a simpler explanation: the information contained in bond prices must be taken with a large pinch of salt.

There are plenty of reasons for not taking bond prices at face value, and they bear repeating, if only to remind ourselves of the profound distortions bedeviling sovereign yield curves. The biggest culprits are the quantitative easing programs undertaken by central banks following the Global Financial Crisis (and extended or revived during the pandemic) to push down long-term interest rates and thereby spur economic growth. Despite plans to wind them down, these asset-purchasing programs continue to hoover up much of the sovereign bond supply in the US, the eurozone, and Japan. The rate-dampening effects of these programs are augmented by the ongoing bond purchases by other central banks, notably in Asia, whose recurrent need to prevent large current account surpluses from sending their currencies spiraling higher compels them to keep adding to their towering foreign reserves.

The increased adoption of risk-parity strategies has cemented the role of bonds as foremost an insurance asset. If instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.

But while central banks, along with other non-profit-maximizing participants, have always been a feature of bond markets, what’s new today is the rise of a class of investor for whom default-free government bonds are a hedge first and a return-seeking investment a distant second. The increased adoption of risk-parity strategies, along with various permutations that fall under the umbrella of volatility-targeting strategies, has cemented the role of bonds as foremost an insurance asset. In these strategies, as equity market volatility rises or falls, exposure to bonds is dialed up or down to equalize the contribution to total portfolio volatility coming from each asset class. The inherent assumption is that bonds will be a hedge when the rest of the portfolio heads south. And that’s a problem because the inflation expectations that are backed out from bond prices assume that investors demand a reward for bearing inflation risk. But if instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.

What this means from a practical perspective is that bond prices are likely to be far less reactive to nascent inflation concerns than in the past, and equity prices may be the better guide for those concerned about what’s brewing with inflation. Moreover, today’s strained equity valuations magnify the markets’ sensitivity to prospective increases in inflation. Ominously, high valuations not only make equities more sensitive but also more vulnerable, as we shall see.

Equities and Inflation

Whenever inflation and equities are mentioned in the same breath there is always someone who will reflexively insist that, because equities are a claim on real assets, holders can safely ignore inflation. There is a kernel of truth to this. Equities are a claim on real assets and so over the very long term should be more resilient than, say, nominal bonds, but that doesn’t mean inflation can be ignored. Far from it. Because inflation has knock-on effects to cash flows and discount rates, the impact of higher inflation on equity valuations can be dramatic. The hit to cash-flow expectations comes from the combined effects of a squeeze on company profits from rising input costs and the demand destruction that typically follows the policy response—an increase in tax levels or interest rates—needed to bring inflation back under control. Moreover, because monetary instability also strikes at the heart of the economic compact between labor and capital, it can have a dramatic effect on equity discount rates beyond its mechanical effect on borrowing costs.

Assuming companies can pass on their costs one-to-one with inflation, they should be able to pay higher dividends and their share prices should go up. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.

A simple model for equity returns can help to elucidate the mechanics. One workhorse model for equity returns is the Gordon Growth model, a variant of the dividend discount model that assumes the current dividend D grows at some constant rate g in perpetuity and that investors discount those future expected cashflows at a fixed rate r. The price P for such an asset is the present value of the entire stream of future cash flows, which can be expressed as follows:

P =	D
	r-g

What’s clear from this simplified model is that, assuming companies can pass on ballooning input costs by raising prices for their goods one-to-one with inflation, the resulting increase in nominal dividends will be matched by a corresponding increase in nominal share prices. If that were the only thing going on, then inflation could indeed be safely ignored. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.

The precise contours of the conflict depend on the source of the inflation shock and the relative bargaining power of the various stakeholders. But the broad outlines tend to follow the same pattern, with a shock to living standards sparking a demand for higher wages that gets passed on through higher prices as businesses try and defend their margins. Because each step is contentious, none of it unfolds smoothly, which lowers productivity and interferes with resource allocation and ultimately is manifested in slower earnings growth.

Eventually, a central coordinator like a central bank or fiscal authority steps in to try and break this dynamic. The standard cure involves them reining in economic activity with some combination of higher interest rates or increased taxation, which does eventually bring the inflationary cycle to a shuddering halt but at the cost of lower profits and wages. These interventions typically produce additional unintended consequences—see the miners’ strike in Great Britain during Margaret Thatcher’s early years—which further increase frictions.

Given that backdrop, it’s hardly surprising that consistently rising prices tend to also push up the required rate of return for risky assets. This reflects the real sense that elevated inflation embodies the unraveling of the social contract in the economic sphere. And that’s because inflation is not so much a rise in the price of goods as it is a decline in the value of money. This erosion in the unit of account ripples through balance sheets, blunting price signals, and makes it harder for businesses and households to plan for the future. The longer inflation persists, the more debilitating the harm.

High Valuations Increase Equity Market Sensitivity

The Gordon Growth model also has a role to play in explaining why the confluence of elevated valuations and inflation is so toxic. To understand how that works, we need to introduce another concept known as modified duration. The notion of modified duration is central to bond analysis, but it’s rarely applied in the context of equities. And that’s a shame because equity market duration has a lot to tell us about the stock market’s current sensitivity to inflation.

Duration is the average maturity of the expected future cash flows for any security. Purely speculative assets that have no expected cash flows, such as gold or Bitcoin, have infinite duration. The duration for a zero-coupon bond with a single known cash flow at expiry is simply the number of years to maturity. If you divide the duration of an asset by its discount rate, you have a measure of its sensitivity to changes in that discount rate, which is called modified duration. For bonds, modified duration is the sensitivity of its price to changes in its yield to maturity, or, said otherwise, the percent change in price for a given percent change in yield. For equities, modified duration tells you how much of a share price change you should anticipate for a given small change in the discount rate, r.

Although in the case of equities the cash flows are uncertain, we can still use the Gordon Growth model to approximate a measure of modified duration for the broad market. I’ll leave the tedious math for the footnote¹ but suffice to say that a few manipulations reveal that the modified duration of the equity market is simply the inverse of the market’s dividend yield. With a dividend yield of 1.43%, the S&P 500 is currently sporting a modified duration of around 70 years (100/1.43 = ~70).

It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations.

Over the past 20 years, already a period of elevated valuations relative to long-term history, the average modified duration for the S&P 500 has been 50 years. A current modified duration of 70 implies a 40% increase over the historical average in the sensitivity of share prices to small changes in the discount rate. In practice, at a modified duration of 50 years, a 50 bps increase in the discount rate would translate to roughly a 20% decline in prices. This decline is somewhat less than the 25% we would expect from modified duration alone (.05% x -50 = -25%) because, for larger changes in the discount rate, we need to also account for a bit of arcana known as convexity. Even so, today, with a modified duration of 70, the effect of a 50 bps increase in the discount rate at a modified duration of 70 years is a 27% drop.

It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations. Meanwhile, the resilience of the broader market might indicate that so far, at the aggregate level at least, this rise in the discount rate has been partly offset by rude economic health and no indications of an unravelling of the social fabric caused by inflation. If only such an assessment wasn’t directly at odds with the recent inversion of the US yield curve pregnant with recessionary portents. Let us hope that the bond market’s distortions that scramble its inflation signaling are also adding to its inutility as a predictor of economic slowdowns.

Endnotes

¹By taking the first derivative of the Gordon Growth model with respect for r gives us

∆P

(r-g)²

. Then simplifying and dividing each side by

gives us an expression for duration,

∆P

r-g

, that can also be expressed as

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Meme Stocks and Market Structure

By Edmund Bellord, Asset Allocation Strategist | June 08, 2021

Unless your investment horizon is measured in milliseconds, it’s usually best to ignore what everyone else is doing. But, occasionally, the market throws up something so peculiar that you have no choice but to sit up and pay attention.

The GameStop debacle, and the meme stock phenomenon more broadly, certainly fit that category. The story bears all the hallmarks of a Hollywood script: how a ragtag group of mostly retail investors, armed with commission-free trading apps and loosely coordinated across online message boards, executed a colossal short squeeze on the hedge funds betting against a down-at-its-heels brick-and-mortar video game retailer while inflicting bloody noses on some of Wall Street’s supposedly most-sophisticated operators. Predictably, several films are already in the works. But beyond the thrill of extravagant market pyrotechnics served up with a generous side of schadenfreude at seeing the odd master of the universe brought low by the great unwashed, why should we care?

Market manipulation is hardly new, and short sellers have always been a vulnerable target. The algebra of short selling, where the size of a losing position balloons ever higher as losses accumulate, is such that short sellers are forever in danger of being squeezed. Wait too long to cover or, worse yet, fail to rebalance at all, and you risk being wiped out. No surprise then that short selling for profit (as opposed to for hedging) is the province of dedicated specialists.

Despite their somewhat louche reputation, attested to by the prevalence of short-selling bans that reflexively blossom every time the market wilts, short sellers are nonetheless a key part of a healthy market ecosystem. A healthy market, one that allocates capital to its most productive use at the lowest possible cost, is predicated on many financial species with different time horizons, preferences, and liquidity needs co-existing in symbiosis. Despite what the textbooks might say, liquidity and price discovery are not created in a vacuum; they spring from the unceasing dance between three types of market inhabitants: long-term investors, arbitrageurs, and liquidity providers. Long-term investors attempt to steer capital towards its most productive use, arbitrageurs improve price discovery by correcting the occasional mis-pricings that emerge between assets with similar payoffs, and liquidity providers lubricate transactions, which helps to shrink transaction costs. If any one of these groups grows too dominant, the dance can quickly turn into a scrum.

It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.

Dedicated short sellers are a rare breed of arbitrageur whose relatively small number and modest asset base belie their importance. Much like value investors, whose tendency to buy when others are selling has a stabilizing effect on falling markets, short selling has a similar calming effect in the opposite direction. By leaning against unwarranted price increases, short sellers are a counterweight to market excess, one that makes for a more hospitable environment for beta grazers and alpha hunters alike. In helping to expose flimsy business models, ferret out accounting malfeasance, and unearth cases of outright fraud, short sellers are natural predators that benefit the market’s ecology. Enron, Lehman Brothers, Valeant, and, more recently, Wirecard and Luckin Coffee all owe their comeuppance in large part due to the sleuthing of dedicated short sellers.

Although short sellers are at the center of the GameStop saga, most of the ink spilled has focused on the more conspicuous elements of the story: the evident power of massed retail investors, their copious use of derivatives to magnify leverage, and the populist tendencies that seemingly motivated many of the squeeze’s participants. What has received less coverage is the potential impact of meme stock manias on market structure.

On the face of it, the debacle mirrors many previous episodes of market manipulation, no different, say, than the Hunt brothers ill-fated attempt to corner the silver market in 1980. But there is a crucial difference. A conspiracy to manipulate markets pre-supposes a central origin, a mastermind to hatch the plot before putting it into action. But on this occasion the conspiracy, such as it was, emerged spontaneously. It began with local, seemingly random interactions online that began to feed on themselves in an accelerating feedback loop.

There was no syndicate head, no directives whispered into disposable cell phones, no encrypted texts, none of the subterfuges typically associated with a conspiracy. Quite the contrary, discussions were held in the open, within freely accessible (albeit anonymous) web forums, where anyone was able to proffer their views about the fundamental value of the business, comment on the high short interest, or add an opinion about the implications of the tight float of underlying shares outstanding.

Decentralized and self-organizing short squeezes that materialize spontaneously represent a new type of concern for regulators because it’s unclear which rules, if any, are being violated. Moreover, it’s far from clear what mechanisms can be put in place to prevent it from happening again. But while this may be a headache for regulators, it represents an existential threat to short sellers. It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.

The impact of this new regimen on short sellers is impossible to gauge with any precision. They are a secretive bunch, after all. But we can guess at their travails by looking at the performance of the most shorted stocks as represented by the Citibank US Short Interest Equity Index. The index is akin to a long/short portfolio constructed according to the level of short activity for each stock in the Russell 3000, measured as the ratio of the amount of stock on loan relative to its overall trading volume. After ranking stocks according to this ratio and removing stocks with the most extreme metrics such as high borrow cost, the index simply shorts the 10 percent of stocks with the highest short ratio and goes long the 10 percent of stocks with the lowest short ratio. Historically, simulating short sellers in this way has been a profitable strategy: from its inception in June 2015 through the end of 2019 the index generated a cumulative return of 35%, with a highly respectable return to risk (Sharpe ratio) of close to one. At the onset of the pandemic in early 2020, which coincided with a jump in retail trading reminiscent of the tech bubble, the index collapsed. Over the following months it gave up almost its entire accumulated historical performance before reaching its nadir in January of this year, just as the GameStop episode reached its crescendo. Given the index’s long exposure to the least-shorted stocks, it likely understates the actual damage inflicted on many actual short sellers.

Source: Bloomberg

It’s a truism that no one enjoys losing money, ever. And if the performance of the index is indicative of the damage inflicted on short sellers, we can expect an imminent thinning of their ranks and with it a weakening of their stabilizing influence.

There is a small town in Thailand whose large population of macaque monkeys draws a steady stream of tourists. The locals sell bananas to the tourists who feed them to the monkeys. When the flow of tourists dried up during the pandemic, this balance was thrown into turmoil. Within weeks, the town was overrun by gangs of starving monkeys. Whole neighborhoods were declared no-go areas by authorities after videos of rampaging monkeys went viral.

It’s probably a stretch to claim that having fewer short sellers would have quite such a dramatic impact on market structure as the loss of tourists had on this Thai town, or that the monkeys are now calling the shots, but markets are notoriously susceptible to unforeseen events. A seemingly inconsequential disturbance in one area can ripple out, propagating and growing until it ultimately leads to systemwide effects. While our attention is often drawn to conspicuous price movements, it’s easy to overlook the veiled institutional or structural changes that sometimes precede and may even precipitate them. Bananas, anyone?

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Getting Real About Inflation … and Gold

By Edmund Bellord, Asset Allocation Strategist | January 08, 2021

As favorable vaccine news piles up, the winds of reflation are stirring. Early signs of an equity market style rotation in favor of cyclical value stocks, a weakening of the safe-haven US dollar, and a run-up in market-derived measures of inflation expectations all point to a resurgence of animal spirits despite a gloomy outlook for the economy. With our monetary maestros promising easy money into the distant future come what may, it is time to spare a thought for what the possible return of higher inflation might do to your portfolio. Inflation is viewed as the bane of fixed income investments, and rightfully so. But inflation can also wreak havoc on stocks. In theory, inflation should have no impact on equities provided companies are able to pass along higher input costs to their customers. In practice, equity valuations are highly sensitive to changes in the price level, tending to plummet when prices jump. No wonder investors are already casting about for inflation protection.

For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?

Gold as Currency

Gold, having shed its function as a means of exchange and unit of account, is still used as a store of value. Its inflation-hedging bona fides spring from the notion that, unlike other stores of value, it cannot be debased. Central bankers have the power to conjure fiat money at the stroke of a keyboard, but they are powerless when it comes to the quantity of gold. The price of gold may vary from day to day, but with a fixed supply on the order of 250,000 tons, of which one fifth remains lodged in the earth’s crust waiting to be mined, scarcity ensures that over long time spans its purchasing power remains intact. In 1934 an ounce of gold would have set you back US$26; had you buried it in the ground only to dig it up today, 86 years later, it would be worth almost US$2,000. Not a bad return when you consider that a paper dollar lost approximately 99% of its purchasing power in the interim.

But, of course, this simple illustration is dreadfully misleading. It is true that, had you let slip a dollar bill down the back of the couch while resting after burying your gold some 86 years ago, that dollar bill would buy you far fewer goods at the cash register today. Most dollars, however, are not left lying around to gather dust; they are deposited for safekeeping and, until recently, they earned interest. Fairer would be to evaluate gold relative to what you would have earned holding cash on deposit. According to Barro and Misra¹, the long-term compounded return on cash (T-Bills), after accounting for inflation, has been 1% per year, just shy of gold’s 1.1% real return. Gold may have won by a nose, but that extra 10 basis points came at the expense of frequent eye-watering price fluctuations and the occasional sleepless decade.

Echoes of the Gold Standard

It turns out that gold’s reputation as an inflation hedge is really founded on just two episodes: the end of the gold standard and the oil shock of 1979. Between 1971 and 1975 the price of gold quadrupled as the US severed the official link between the US dollar and gold. Again between 1977 and 1980 the price of gold tripled as the inflationary impact of the second oil shock rippled through the entire energy-dependent supply chain. Outside of these two peculiar instances, the relationship between gold and inflation largely falls apart. Remove just the years of 1974, 1979, and 1980, and as we can see the positive correlation between inflation and gold disappears entirely.

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

If inflation isn’t driving the gold price, what is? The evidence suggests that a big part of what’s moving gold prices are real interest rates—or the difference between 10-year treasury yields and inflation—whose movements up or down are an important indicator of the underlying state of an economy and its expected growth. This inverse relationship between gold and real rates is born out in the next figure, which shows yearly changes in the price of gold and real interest rates from 1971 to 2020. The large increases in the gold price in 1974, 1979, and 1980, in addition to the price spikes of 2011 and 2020, all occurred against a backdrop of negative real rates. Correspondingly, the gold price declines of the early ’80s coincided with soaring real rates, a consequence of the tight monetary policy enacted during Paul Volker’s chairmanship of the US Federal Reserve.

This relationship between real rates and gold echoes the historical linkages between gold and the US dollar. Under a gold standard, because currency values in terms of gold were fixed, trade imbalances between countries were routinely resolved by a physical flow of gold. Gold would flow into countries that exported more than they imported and had high real exchange and interest rates, and out of countries where the opposite conditions held. But under a fiat system, where currency values in terms of gold are no longer fixed, real interest rates continue to exercise their pull, except now rebalancing occurs with a change in the price of gold instead of a flow. Perhaps because of its ongoing role as a central bank reserve asset and store of value, gold behaves like a shadow currency. A currency where, absent the prospect of a future cashflow, assessing how much to own comes down to what else you could be doing with that fraying dollar bill.

Hedging Inflation: It Depends

Just because gold has kept pace with the price of goods and services does not make it an effective inflation hedge in every scenario. And that’s because the alternate sources of expected inflation—diminished supply versus excess demand—have drastically different implications for real rates and hence for hedging strategies. If you think the world is in the thick of a deflationary or stagflationary bust that will depress real interest rates, then by all means buy gold. The current pandemic, like natural disasters more broadly, can certainly fit the pattern and to the extent it continues to depress consumption could still prove to be one of those kinds of periods. But if you are concerned about monetary excess, adding gold to a portfolio may turn out to be futile and may even magnify risks. If central bankers succeed in reviving inflation by stimulating demand growth, then we should also expect real rates to increase and the gold price to weaken. In that scenario, to hedge inflation you are better off buying TIPS and selling conventional bonds.

It’s only fair to point out that any notional horse race between gold and other assets assumes a functioning financial system nested in a stable society—not an unreasonable assumption for an optimist. But you don’t have to peer too far back in history to find examples of conflict, dispossession and collapse. Beyond keeping up with the price level, part of gold’s appeal lies in its tantalizing potential to ward off financial devastation. Although, if society deteriorates and its ability to function looks dicey, the risk of confiscation also shoots up and your chances of avoiding devastation by holding onto your lump of gold decline precipitously. This makes gold a bit like owning an out-of-the-money put option on social collapse underwritten by an ultimately insolvent counterparty. There is no chance of collecting, but at least its value should rise when people are fearful.

Endnotes

¹Robert Basra and Sanjay Misra, National Bureau of Economic Research, “Gold Returns,” NBER Working Paper Series (February 2013).

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Disclosures

“Out of Our Minds” presents the individual viewpoints of members of Harding Loevner on a range of investment topics. For more detailed information regarding particular investment strategies, please visit our website, www.hardingloevner.com. Any views expressed by employees of Harding Loevner are solely their own.

Any discussion of specific securities is not a recommendation to purchase or sell a particular security. Non-performance based criteria have been used to select the securities discussed. It should not be assumed that investment in the securities discussed has been or will be profitable. To request a complete list of holdings for the past year, please contact Harding Loevner.

There is no guarantee that any investment strategy will meet its objective. Past performance does not guarantee future results.

Out of Our Minds

Does the Equity Market Know Something the Fixed Income Market Doesn’t?

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

Equities and Inflation

High Valuations Increase Equity Market Sensitivity

Endnotes

Meme Stocks and Market Structure

Source: Bloomberg

Getting Real About Inflation … and Gold

Gold as Currency

Echoes of the Gold Standard

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

Hedging Inflation: It Depends

Endnotes

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Disclosures

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