Thursday 13 May 2021

Tech, inflation, and the tyranny of the numerator

Over the last three months, market inflation fears have increased - and not without good cause, given the increasing number of companies reporting supply shortages, cost pressures, and price increase, and the recent US CPI print coming in at 4.2% - which has pressured the share prices of tech/growth stocks in particular (and to a lesser degree, the broader market). US 10 year treasury yields have risen from 0.9% to 1.7% this year, in fits and starts, and tech and other narrative-driven growth stocks have come under pressure with sell-offs correlating with higher inflation concerns and rising treasury yields.

This behaviour has confused some investors, who often argue that stocks are real rather than nominal assets, and that tech companies ought to have the ability to pass through inflation into higher prices. The most common explanation you hear for the correlation between rising treasury rates and inflation expectations, and falling tech stock prices, is that high multiple growth stocks have longer duration cash flows, such that when discount rates increase, the valuation consequences are larger than for shorter duration "value" stocks. While this is somewhat true in theory (it would only apply to higher real discount rates, not nominal ones), in my submission this is not the real reason for the financial market behaviour we have been seeing.

Financial market asset pricing is a real world, concrete thing, not an abstract academic one, and greater cash flow durations associated with growth stocks is a theoretical rather than practical construct. In the real world, asset pricing is determined by one thing and one thing alone: the concrete interaction of demand and supply in financial markets. It is therefore factors that change demand and supply that drive prices rather than the fundamentals per se, and consequently, it is how inflation impacts demand and supply that will determine financial market outcomes. 

When people argue that stock prices "shouldn't" theoretically fall due to them being real assets (true but only to some extent - mostly for capital light businesses; see my post here on why inflation leads to lower P/E ratios and increases effective real tax rates), they also make the same mistake as when people argue the economy is weak so share prices shouldn't be going up; or that earnings/growth is strong so stock prices shouldn't be going down. These perspectives all suffer from what can be described as the "tyranny of the numerator" - the idea that the only or primary driver of asset prices is peoples assessment about the level of cash flows. But the denominator - the cost of capital, which is determined by the forces of demand and supply - often has a much larger practical impact on asset pricing than numerator effects in all but the very long term. 

While fundamentals, earnings, growth, the economy, and returns on capital etc of course all matter a great deal to what stocks are "worth" long term, asset prices are highly sensitive to perturbations in the cost of capital, and the cost of capital in turn is highly sensitive to perturbations in the demand and supply for capital, just like the price of oil is highly sensitive to ever-changing demand and supply conditions. Furthermore, core fundamentals tend to change relatively slowly, but the cost of capital can fluctuate wildly in the short term, and it is variations in the latter that is the primary determinate of asset price volatility. 

The cost of capital I'm describing here is also not an academic WACC that goes into investors' DCF valuation models, but rather the outcome of the real world interaction of demand and supply in financial markets. In the aggregate, investors have a certain amount of "liquidity" (cash and readily available liquid investments like bonds and stocks) at their disposal, and they have a certain menu of liquid assets they can invest in (cash, T-Bills, bonds, stocks, etc). The interaction of these two forces of demand and supply is what determines the aggregate level of asset pricing. Numerator effects are still important (what are the cash flows), but denominator effects determine the multiples with which those cash flows are capitalized, which has an outsized role in price fluctuations. 

Investors can and do compare the cash flow numerators amongst different assets, and size up their relative attractiveness. Investors might determine they want to sell a bit of Google and add a bit of Facebook, or sell some bonds to increase their ETF allocations, etc. Consequently, numerator effects have a significant influence on the relative valuations of assets/asset classes. However, this process cannot be extrapolated to the emergent absolute level of asset pricing in general, where denominator effects often play a more decisive role. Individual investors can choose to own less Google and more Facebook, or more/less bonds and more/less ETFs, but they have to hold something

The cost of capital falls and asset prices rise when there is excess liquidity - i.e. a situation where there is too much cash chasing too few financial assets/places to park that capital (this is the financial/asset price equivalent of real economy goods and services inflation, where there is too much money chasing too few goods and services). This can create a bull market which has little to do with investor expectations per se - on either the economy, earnings, growth, or much of anything "fundamental". It can simply reflect the forcing function of the weight of excess liquidity. This reality is often overlooked, leading to sometimes puzzling moves in financial markets to those suffering from the tyranny of the numerator.

Investors like Grantham for instance, look at rising markets and historically-high valuations and conclude that it is because investors are too optimistic on the economy and earnings (numerator effects), or surmise that there is an "everything bubble", when in fact this situation can exist even if everyone is bearish and pessimistic on the outlook for returns, simply because there is too much capital chasing too few assets, and the ever-volatile market clearing cost of capital has fallen. It is strongly arguably that you cannot have an "everything bubble"; the capital market overall simply reflects the market clearing price of available liquidity and the availability of investable assets, and at a system level, investors have to own something. You can therefore have bubbles in certain assets or asset classes, but not in the capital market as a whole. Excess liquidity will drive asset prices up regardless of whether people are bullish, bearish, or believe asset prices are cheap, expensive, or should or should not be going up. 

This is particularly the case when the returns to holding cash are negative in real terms. Sure, you might prefer 10% equity returns. But if the market is only offering you 5%, your choice is to either accept the market-clearing return of 5%, or get nothing (or -2% real in cash). You can wait and hope markets offers you 10% in the future, but if the market clearing cost of capital remains at 5% (or worse, declines to 4%, or 3%, etc), every year you wait loses you 7%+. You have priced your capital out of the market, just like an employee who wants $30 and hour but where the market rate is only $15, is unable to get a job, and so gets nothing. 

Holding cash is "prudent" in some respects, but in other respects, you're simply taking a bet that markets will offer you a better return in the future than they do right now. It's a gamble you may win or lose. Because of this - and the fact that the longer investors wait without the cost of capital rising, the more money they lose - the forcing function of excess liquidity will act to drive asset prices up, because those that wait get penalized/suffer (and may be subject to redemptions, for instance, for underperforming), and so one by one, investors and available liquidity is slowly drawn/forced into the market.

As I have noted in the past, the world does not owe capitalists a high return on capital, and there is no rule of the universe that says the market clearing cost of capital in the future will resemble what happened to be the average market clearing cost of capital in the past, any more than the market clearing price of oil ought to reflect the average demand and supply curves in past eras. It doesn't work that way. Times change, and the demand and supply balance changes with it. The cost of capital is not fixed, but constantly evolving to reflect ever changing real world conditions. It's a volatile, practical concept, not a fixed, academic one. Investors who suffer from the "tyranny of the numerator" often overlook this fact, positing a fixed cost of capital and attempting to attribute all changes in financial market prices to changing assessments of the numerator. But that's not the way real world financial markets work.

Consequently, the real reason rising inflation is a risk to asset pricing - and tech and growth stocks in particular - is because of the fairly dramatic impact it could have on the market clearing cost of capital as compared to the status quo ex ante. It could cause a significant change in the demand and supply balance, and if it does, the level of prevailing asset price equilibrium will significantly change.  

At present, the Fed is printing US$120bn a month to buy treasuries, as it has been doing since the onset of the pandemic. Meanwhile, the US government is running large fiscal deficits, driven by (amongst other things) large stimulus cheques being mailed out to the broader populous. For the first time since the 1970s, this represents the Fed monetizing the fiscal deficit in size, and engaging in de facto "helicopter money" policy via fiscal intermediation. When consumers receive their stimulus checks and go out and spend the funds in the real economy, that is functionally equivalent to helicopter money.

This US$120bn per month expansion in the money supply has flooded financial markets with extra liquidity. In the absence of this QE/deficit monetization, every US$120bn of US government fiscal stimulus injected into the system would need to be offset by US$120bn of liquidity being withdrawn from financial markets by investors/institutions acquiring US$120bn of new primary treasury bond issuance. However, because the Fed is printing and funding the fiscal deficit directly, no such offset exists and US$120bn a month in additional liquidity is being created and pumped into financial markets. If there is not enough newly issued financial assets available to absorb this liquidity creation, asset prices will have a tendency to rise as the demand for financial assets will exceed the available supply. 

This happens by the mechanism of investors competing with each other to get rid of cash. System cash levels increase by US$120bn a month. The money comes from a combination of (1) bond market investors selling bonds to the Fed, and now having cash in their accounts looking for alternative investments; and (2) stimulus checks funded by the Fed, which consumers can spend and/or deposit in their RobinHood or CoinBase accounts and use to participate in financial market speculation.

As this waterfall of cash has cascaded through financial markets looking for a home, it has started to flow into every nook and cranny, pushing up asset prices. Investors desperate for any sort of return on their cash will hunt high and low looking for any reasonable place to put their money, pushing asset prices up across the board. This is the "denominator effect" of an excess supply of liquid capital in action, and the apparent bull market it creates can have little to do with people's view on the economy, earnings, and valuations per se (though rising prices can themselves temporarily improve economic fundamentals and have a favourable psychological effect on markets). And the denominator effect of a precipitously falling cost of capital is amplified because the real return on cash is now negative, so at a system level, the base cost of capital is now in some respects zero or even less than zero.

The financial sector is in the business of manufacturing new financial product to absorb excess financial market liquidity, and once again it has dutifully responded. This is why investment banks are currently generating record earnings. This has manifested of late primarily in the form of a SPAC IPO boom, as well as rampant other tech stock issuance, which has absorbed hundreds of billions in liquidity. This increase in supply is another reason why tech stocks have started to come under a bit of pressure of late - some excess liquidity has being absorbed. However, the SPAC IPO boom has still been inadequate to absorb all of the liquidity being created by the Fed. This is why we have seen spillovers into a new cryptocurrency boom, as well as an NFT boom, etc. There is too much capital chasing too few places to invest, so new assets are being manufactured to absorb the excess - including phantom digital assets.

This dynamic has gone on for some time already and has pushed asset prices in certain parts of financial markets to extremely high levels, with the speculative excesses concentrated in tech/thematic growth areas of the market, as well as crypto. Consequently, from this starting point, any perturbation in the environment that pushes up the cost of capital and tips the system from one of an excess liquidity to one of shortage (at the margin), will lead to a radical decline in asset pricing. Suddenly there will be too many financial assets chasing too little liquidity - the opposite of the prior situation, which will create a tendency for prices to fall rather than rise, as capital starts to be rationed. This will happen regardless of the "fundamentals", like growth rates, profitability, etc.

The decline in aggregate asset prices this would trigger would have little to do with investor expectations, or long term fundamental concepts like cash flow duration, or the ability to raise prices with inflation. These concepts matter long term to value investors, but they don't impact financial market asset pricing over the timeframes that most investors care about. 

So why are tech stocks the most vulnerable? Because in parallel with the above general dynamics in asset markets, the tech/software/thematic growth sector has been the overwhelming recipient of liquidity largess in recent times, which has led to exponential gains and driven prices to extraordinary heights, driven by the liquidity flywheel dynamics I have discussed in past posts. High-profile cheerleaders like Cathie Wood of ARK have contributed to a gush of retail money rushing into speculative growth areas of markets, while other growthy managers have also ridden momentum-driven returns to large inflows. 

The inward rush of liquidity has manufactured giddy headline returns, driving yet more performance-chasing inflows in a world with too much capital and too little available return, pushing prices to the stratosphere. Most of these gains have been attributed to disruptive innovation, growth, and accurate foresight of secular trends, whereas in reality they have been almost entirely driven by liquidity. 

Consequently, if the liquidity balance were to change, the areas of markets that have been the disproportionate recipient of these liquidity excesses would logically be the most vulnerable to a re-equilibriation. All asset prices will suffer, but areas of excess will suffer the worst. This is the real reason why tech/growth share prices have been highly sensitive to developments with respect to inflation and bond yields of late - investors are aware of the degree to which excess liquidity has inflated valuations, and the degree to which prices could fall should we see a liquidity "regime change".

Importantly, system liquidity has not yet meaningfully tightened (the size of the fiscal deficit has increased vs. constant Fed purchases, absorbing some additional liquidity, but overall the Fed is still printing aggressively) but investors are anticipating/fearing it could, which may lead to a catastrophic bust. Volatility has been high, because investors are torn between not wanting to jump off the momentum train too early on the upside, but also not wanting to be caught in a liquidity downdraft, driving heightened sensitivity to new data points. In addition, as noted, the SPAC IPO boom, as well as the manufacturing of alternative speculative assets - crypto, NFTs, etc - has also absorbed some of this excess speculative liquidity, which has contributed somewhat to the recent pull back in pricing as well. 

So how exactly will higher inflation change the market clearing cost of capital? First and most obviously, it will likely force the Fed to change policy course. If inflation were to rise to >5% and start to become entrenched in that range amidst a self-sustaining cost-push spiral, the Fed would need to raise rates, stop printing money, and maybe even begin to shrink its balance sheet. The prior net injections of liquidity would turn to a net withdrawal. Even if it were to simply stop printing and not shrink its balance sheet, financial markets would then need to fully absorb large primary government bond issuance to fund record deficits, which would push up treasury yields and absorb a growing amount of the system's excess liquidity. If the Fed started to shrink its balance sheet - we could see capital markets going from being in an excess liquidity position to a shortage (at the margin), leading to a substantial spike in the market clearing cost of capital. This could have devastating consequences for asset prices in areas of prior speculative excess - even before considering likely second-order consequences.

The issue with inflation is that it is difficult to get started, but once started, it can be equally difficult to stop. This is because there are many prices in the economy that are contractually or regulatorily linked to CPI. If CPI increases, many prices reset to reflect higher inflation (e.g. regulatorily allowable prices/returns on infrastructure assets, etc). This can lead to a cost-push environment where high CPI leads to compensatory price increases that sustain that high CPI. In addition, in an environment of increasing labour shortages, bargaining power can shift to employees who can demand pay rises to compensate for higher inflation. If expectations for 5-10% annual pay increases to offset inflation become entrenched, it can get to the point where breaking the back of inflation can become extremely difficult; companies keep raising prices to offset the higher cost of labour, in a vicious circle. A weakening USD would also increase the cost of imported commodities and manufactured goods. Only a Volcker-esque dramatic tightening and a devastating multi-year recession would break it. 

Is it possible that the Fed would sit by with 0% rates and continuing QE/money printing even with inflation at 5-10%? Anything is possible, but the Fed is currently required to target inflation, and it will be difficult to justify continuing to print money if inflation rises significantly above its 2% target for a sustained period. In addition, at worst, a checkmate situation can develop where rising treasury yields in response to higher inflation leads to an increase in the fiscal deficit, as financing costs rise. If the Fed tries to buy even more bonds to control the increase in rates, it can lead to even higher inflation by monetizing an even higher fiscal deficit. This is how hyperinflation happens in emerging and frontier economies - a lack of fiscal restraint and rising financing costs lead to accelerating fiscal deficit monetization by the central bank to avoid default. I am not that pessimistic, but I do believe the Fed will not be able to ignore inflation printing at 5% or more and will be forced to take at least some action. 

However, even if the Fed does not change course, higher inflation can still lead to asset prices dropping significantly - particularly in real terms - via other means. Inflation reduces the real value of nominal assets like cash and fixed rate bonds, which get inflated away if rates remain low and inflation rises. As the real value of the liquid capital stock declines relative to the stock of real assets, the real cost of capital will rise as the demand and supply balance changes, and given the sensitivity of asset prices to the cost of capital, this impact is likely to exceed the impact of higher nominal earnings - particularly because the associated economic fallout will pressure real ROEs. 

These dynamics would eventually drive up both real and nominal market-determined interest rates and costs of capital (e.g. on corporate bonds), and this can have a profound impact on the valuation of the levered-asset complex - notably real estate and private equity - because the carry cost of assets goes up. It is not a coincidence that if you track property rental yields by country and by decade, there is a high degree of correlation with interest rates. That's because interest rates reflect the financing "carry cost" of property. If rates are 3%, you can borrow at 3% to fund a purchase, and so have a self-funding property at a 3%+ rental yield. At 10%, you need a 10% yield lest you run significant negative cash flow.

The challenge for asset prices is that if inflation goes from 2% to 7%, mortgage rates charged by banks might go from 2% to 7%. Yes, your rent might now increase by 7% a year instead of 2%, but it will take 10yrs for the nominal rent to double at 7% per year, whereas your funding costs can go up 3.5x from 2% to 7% in a short space of time (even if holders have long term fixed rate financing, the marginal buyer would need to pay 7%, and asset prices reflect the marginal buyer's willingness and ability to pay).

Leveraged assets cannot run that degree of negative carry. Consequently, the price of the assets could go down by 60% even though in theory, the property is a real asset that is inflation protected (this is also not to mention that significant economic fallout associated with a rise in rates and decline in asset prices can and often will lead to significantly reduced real earnings/rentals). This is an example of how asset prices are determined not theoretically, but by the practical interaction of demand and supply, and the availability of liquidity and credit relative to the availability of assets.

The whole structure of financial markets and asset pricing - from bonds, to stocks, real estate and private equity - now reflects a widespread expectation and equilibrium asset pricing environment that assumes inflation and rates will remain perpetually low. Irrespective of what impact inflation theoretically "ought" to have on asset prices, if inflation and rates meaningfully rise, a huge cat is going to be thrown amongst the proverbial pigeons with significantly negative consequences. 

I've discussed in past blog articles about known unknowns and unknown unknowns, and major sell-offs typically occur when a new unknown unknown emerges - a risk factor not previously factored into investor expectations and positioning, and which create a sense that we are moving into uncharted territory. An outbreak of inflation will likely be one such instantiation, and it is difficult to imagine that it will not have fairly dramatic consequences for asset pricing and the economy were it to occur.

Will it actually happen? I don't know, and don't think anyone can know for sure. However, what we can say with assurance is that the risks are very significant, and in my assessment, the Fed is showing an unhealthy degree of complacency with respect to these risks, that is now beginning to cross the border into outright recklessness. The Fed's policy settings are the same today as they were in March/April 2020 at the absolute peak of the covid crisis, and yet at present the US economy is booming; labour and input cost shortages are rife; and a large number of companies are talking about significant cost pressures and intentions to increase prices. It is quite remarkable the Fed still believes ultra-emergency policy settings are required in this environment. Yes, there are "risks to the outlook", but there are always "risks to the outlook", and that does not justify taking extreme measures "just in case". 

The Fed is playing with fire, and if they get this wrong and inflation goes to 5-10%, they will likely engineer one of the worst recessions and financial crises in the past 100 years. It seems to be a remarkable misjudgment of the risk and reward associated with the current policy course. Given that central bank behaviour - as well as fiscal excess - has become steadily more and more extreme over the 13 years since the GFC, as complacency about inflation risk has grown, it was perhaps always only a matter of time before things were eventually pushed too far. If this trajectory continues, whether it is this cycle or the next, we are likely to eventually end up with high inflation environment with meaningful fallout. It may take such an outcome for central banking to undergo some much needed reform.