How Are Earnings of Emerging Markets Companies Holding Up?

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:

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

The Beauty Contest

To its advocates, the virtues of indexing are beyond reproach. With low fees and high transparency, index funds offer a cheap and straightforward way for an investor to earn average returns. This perspective is buttressed by mounds of academic research that have characterized passive investing as a stable equilibrium, meaning that even were everyone to index their investments, it would make no difference to either prices or the cost of capital.

Underlying this claim is an assumption that markets are populated by rational beings, whose collective behavior delivers market prices that always perfectly reflect all available information. But markets don’t work that way, and grubby reality is a world away from this frictionless ideal.

“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
—John Maynard Keynes

The early 20th-century British economist John Maynard Keynes understood this only too well, famously comparing investors to participants in newspaper beauty contests. A popular feature in the London press of his time, these contests asked readers to choose the six prettiest faces out of a collection of a hundred photographs. The winner was the entry that came closest to the average selection. Although nominally about personal aesthetics, winning the contest meant successfully anticipating the anticipations of others. “It is not a case of choosing those which…are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

Investors tasked with choosing which stocks to own face the same quandary as players in the beauty contest. Should they expend time and energy to understand companies’ long-term business prospects and to project cashflows decades out? Or, given limited resources, is it wiser to try and figure out which stocks are likely to be popular six months hence? Writing seven years after the great crash of ’29 and attempting to make sense of the devastation left in its wake, it was clear to Keynes that only the former had any merit, but that most investors favored the latter, trying to “beat the gun, […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” A slight shift in mood is enough to set off cascading price changes as investors react en masse. The inherent instability spawned by this recursive guessing game is why prices are far more volatile than what is known of underlying fundamentals, and why life for investors struggling to get a purchase on cash flows and discount rates, in Keynes’s view, can be so forbidding.

But what happens when most investors opt out of selecting individual stocks? When beauty contestant judges pick the same pretty faces week after week?

The question is relevant because the answer would go some ways toward explaining today’s higher-than-average valuations. An end to the beauty contest would equate to a permanent decline in undiversifiable risk, which all else being equal, would justify paying a higher multiple for uncertain future cash flows. It might even make life a little less unpleasant for those relying on their projections of long-term fundamentals. After all, with fewer active traders whacking prices around, shouldn’t the signal be a little easier to unscramble from the noise?

The evidence on the ground, however, suggests a more complicated picture. The beauty contest hasn’t ended so much as shifted its locus of speculation from individual securities to trading vehicles that clump together groups of securities based on mechanical trading rules.

One indication that this is happening is the puzzling reversal in the positive serial dependence of short-term index returns. Serial dependence, or autocorrelation, refers to the degree of correlation between two observations of the same variable at different points in time. A random variable, the flip of a coin say, has an autocorrelation of zero, each flip independent of the one before. Historically, short-term index returns have had a small (but consistent) positive serial dependence, meaning that, on average, a positive return one day will be followed by a return in the same direction the next day and vice versa. One possible explanation for this phenomenon held that stocks reacted with a lag to non-fundamental shocks.²

But in 2000, this relationship turned negative, and it has remained so ever since. The chart below shows correlation between daily returns for the S&P 500 averaged over a ten-year window going back to 1949. Positive serial dependence increased steadily throughout the 1960s and ’70s, peaked shortly before the introduction of index futures in the ’80s, then declined steadily for two decades before falling consistently below zero at the start of this century.

Source: Bloomberg, Harding Loevner

According to a new study³ by researchers at Erasmus University and the University of Notre Dame, the explanation for this reversal can be laid squarely at the feet of indexing and the seismograph-like movements of mechanical trading rules amplifying the daily response to new information. The research considered 20 equity indices across 15 countries and found an identical change in the behavior of short-term returns. Moreover, they found a direct causal relationship between these patterns and the combined increase in index products including futures, ETFs, and mutual funds. According to the authors, “introducing indexing products seems to change the behavior of the underlying stock market across indexes and over time,” and more critically a higher level of indexing leads to “a more negative serial dependence.” It is unclear what the full consequences of the new pattern will be, but we may be seeing it on display at the far right of the graph above, in the sharply negative one-day autocorrelation in March 2020 at the onset of the pandemic. In plain language, it used to be that uncertainty about the future flowed from individual stock prices into indices; now, the tide has been reversed and uncertainty propagates from indices to individual stocks.

Vol of Vol

Another unsettling sign of change is the rise in the level of implied volatility of volatility (vol of vol), a measure of the market’s capacity for registering unexpected shocks. Roughly speaking, implied volatility—the volatility that is backed out from the price of options—reflects the market’s expectation for the range of potential outcomes for an asset over a specific period. When implied volatility is high, markets expect larger price moves (in either direction), or when it’s low, smaller moves. The most well-known measure of these signals is the VIX, which is calculated from the price of short-dated index options on the S&P 500 and is frequently referred to as the “investor fear gauge.”

Despite its notoriety, the VIX is a measure of disorder and quite distinct from a measure of potential disorder. For that we need to consider volatility of volatility, the true measure of market entropy. To measure that entropy, we use VVIX. Just as the VIX is calculated from the price of options on the S&P 500, the VVIX is based on the price of options on the VIX. Future returns are unknown, but the VIX tells us something about the range of returns we should expect. The VVIX, on the other hand, indicates how uncertain we are about the variability of that range.

Intuitively there are strong reasons to believe that while this vol of vol itself should vary day-to-day as the market digests unexpected shocks, like the VIX it should be stable around some long-term average. But, as can be seen in the chart below, since 2006, a period coinciding with the boom in passive investing, volatility of volatility has shown a consistent upward trend—a sign that the range of potential disorder is expanding.

Source: Bloomberg, Harding Loevner

Doubtless there is more than one culprit behind the increase in vol of vol. Low real interest rates driving down risk premiums probably figure in, as does the growth in systemwide leverage which magnifies fragility by accelerating the interdependence of financial flows. But we would be remiss to ignore the effects of ballooning index flows. Index replication relies on a well-behaved and liquid market for the underlying securities, a presupposition that is paradoxically undermined by the expanding share of index flows. Keynes’s insight was understanding the role of psychology in fueling the tussle between long-term investors and short-term speculators. But things are different at the asset class level. Strategic allocations are typically set in stone, which leaves precious little capital to take the other side of the trade and lean against speculative flows, and a tussle can turn into a rout.

“When you invent the ship, you invent the shipwreck.”
—Paul Virilio

The cultural theorist Paul Virilio asserted that every new technology embeds the potential for new unanticipated accidents. As he put it: “When you invent the ship, you also invent the shipwreck.” Indexing is an invaluable new vessel, which has ushered in a new era for many types of investors. And yet, as indexing has mushroomed over the past two decades, the switch in serial dependence to an amplification as opposed to dampening of short-term shocks and the increased probability of tail-risk events with the rise in vol of vol are ominous signs that we’ve yet to reckon with the consequences of a market swamped by passive flows. Shoals may await just over the horizon.