The 2022 experience has so far been rather dismal for US stock markets. Following 21 months of nearly uninterrupted rise since April 2020, YTD losses are now approaching the 20% mark! While this is certainly no good omen for equity investors, the recent commentaries putting an obsessive blame on inflation (and by misconstrued extrapolation, central banks) are not helpful either. Worse, they do not serve investors, corporate nor policy decision makers well. By contrast, our models point to the rise in real (inflation-adjusted) interest rates as the likely culprit. In turn, our models indicate that the increase in real rates has been driven by a relative decline in uncertainty (i.e. increased certainty) about sluggish long-term real economic growth - not an increase in inflation!
Exhibit 1 portrays the performance of the S&P 500 Index since January 2019. It stands out from the Exhibit that US stock markets experienced a spectacular and almost uninterrupted rise from March 23rd, 2020 through December 2021 - a 114% cumulative increase. A remarkable recovery given the dramatic -34% fall experienced at the start of the pandemic (from February 19th to March 23rd 2020). Since January 2022 however, the performance has been rather bleak, with a nearly continuous decline of -18%, year-to-date.
Market commentaries, for the most part, have been quick to attribute losses in equity markets to the rise in inflation, and by (inappropriate) extension, to central banks. Inflation led to the increase in nominal interest rates, so the argument goes, and thus the decline in the stock market price. Central banks are being blamed for not taking appropriate preventive action and underestimating the rise in inflation. However, our previous note showed that according to bond markets, the rise in inflation expectations (long-term, demand driven) has been relatively muted. In other words, while nominal interest rates rose, real (inflation-adjusted) rates, as measured by the 10-year TIPS yield, also rose, by a nearly equal amount. We also argued that much of the observed rise in inflation is likely to be linked to shorter-term supply related frictions, due to the pandemic and more recently, the war in Ukraine. In this case, monetary policies operated by central banks are of little help. In addition, historically, it is well known that equities act as a good hedge against long-term inflation.
So if not inflation, what drove stock prices down? To grapple with this issue, our models suggest going back to the fundamental principles of asset valuation. This principle states that the real (inflation-adjusted) equity share price reflects future expectations of real (inflation-adjusted) discounted dividends. Thus fluctuations in the share price, even in the short-term, reflect markets' perceptions of future changes in real dividend per share and real interest rates. In turn, according to our models, real dividend growth and real interest rates are driven by markets' perceptions of long-term real economic growth trend and uncertainty about the growth trend.
Let's examine these two principal factors (dividend per share and real interest rates) and their fundamental macro drivers in turn. Exhibit 2 portrays the evolution of the year-on-year change in dividend per share (dividends accruing to the S&P 500 index) and our model projections for US long-term real economic growth from January 2019 to present. According to the Exhibit, US equities real dividend growth has been on a continued and strengthened recovery path over the past year and since its fallout from the pandemic. Likewise, US long-term real economic growth implied by our models has also been steadily recovering, although still at lower rates compared to pre-pandemic rates and the pre-2008 GFC average rate of 2.8%. In the long run, real growth in the equity market dividend per share is primarily driven by real economic growth, according to our models. Thus, Exhibit 2 suggests that in the past year, long-term prospects for real dividend growth have not been deteriorating.
The next issue then, for investors, is to further understand the fundamental macro trends supporting our models' long-term real GDP growth projection (and by extension, long-term real dividend growth). Exhibit 3 depicts the recent evolution (since 2019) of the drivers of long-term real GDP growth in our models. These are the long-term (real) growth in the labor force and total factor productivity (TFP) . According to the Exhibit, labor force growth has been recovering on trend on a continuous basis since January 2021. While long-term TFP growth has remained sluggish, on average at about 0.8% (slightly above pre-pandemic trend but well below its 1.5% pre-2008 GFC average), there were no signs of relative deterioration.
Taken together, Exhibits 2 and 3 suggest that the decline in US equity markets is likely not due to expectations of lower long-term (nor short-term) dividend growth. The next step then, for investors, is to examine the possible changes in (real) discount rates. Exhibit 4 shows the evolution of 10-year TIPS yields - our measure of real discount rates. As discussed in our previous paper, the spectacular rise in equity market value from April 2020 through 2021 could be primarily attributed to the prevailing ultra low, negative real interest rates. After entering negative territory at the start of the pandemic, the 10-year TIPS yield bottomed at -100bps from August 2020 through December 2021. Since January 2022, real yields have been continuously and steeply increasing, averaging 50bps over the last month - a 150bps increase, YTD. Thus, given the stable prospects for long-term real dividend growth, it stands to reason that the dismal YTD performance of the US equity market has been primarily driven by the sheer increase in real yields.
Moreover, our macro-based models help understand the fundamental long-term drivers of this increase in real yields. According to our models, increases (declines) in real yields on trend are driven by the combination of increases (declines) in expectations of long-term growth and declines (increases) in growth uncertainty. The intuition is that investors demand insurance against shocks to real economic growth in the form of government bonds. Assuming no change in long-term growth prospects (according to Exhibits 2 and 3), Exhibit 4 shows that this increase in real yields is indeed consistent with markets' pricing of a decline in uncertainty about long-term real GDP growth, from its acutely high level induced by the pandemic. More precisely, our (monthly updated) macro uncertainty index decreased from 263 to 129, a nearly 50% decline. This decline in macro uncertainty (and the corresponding increase in real yields) is also consistent with the continuation of anaemic real GDP growth, driven by sluggish TFP growth and shy improvements in labor force growth, as portrayed by Exhibit 3.
In summary, inflation did not (most likely) lead the decline in stock market valuations. On the contrary, historically, equities have rather been an effective long-term inflation hedge. Nor should central banks be taking the blame. Going back to the fundamental principles of asset valuation, our models point to the rise in real interest rates as the likely driver. And in turn, the rise in real interest rates was primarily driven by a decline in uncertainty about a sluggish long-term real economic growth trend. Investors should avoid getting distracted by these misconstrued explanations read in most commentaries. Rather, our advice is to remain focused on the long-term, fundamental drivers of equity returns, and their exposures to macro risk. Going forward though, one key question remains whether there are any potential downside risks to future growth that are yet to be priced into (equity and bond) markets? We will explore this issue in a follow-up note.
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