US inflation remains stubbornly high, printing at 8.3% last reading for the week.
Many people believe this gives the Fed more ammunition to continue raising short-term interest rates from their current levels of around 2.5%. Rates can go up to 4-5% before all is said and done.
Ray Dalio He thinks this could be bad for the stock market:
I appreciate that A price hike from about 4.5 percent will have a negative impact of 20 percent on stock prices (On average, though greater for assets with longer duration and less for assets with shorter duration) based on the effect of discounting the present value and about 10 percent of the negative impact of lower income.
This makes sense from the perspective of financial theory. Any financial asset is simply the present value of future cash flows discounted to the present. And the way those cash flows are discounted is through interest rates.
In theory, higher interest rates are supposed to lower the present value.
This makes sense not only in theory, but logically as well. If your hurdle rate is higher, you will need a lower starting rate to make a worthwhile investment.
Dalio may be right. This is the first time in a long time that government bond yields have offered prices to investors that could make them stop and consider putting their money into risky assets.
The one-year treasury is now yielding 4%. Real yields remain negative because inflation is still very high, but these are the highest nominal yields for short-term bonds since before the 2008 crash:
It’s not just about the level of prices but also the speed at which they go up. The yield on the one-year Treasury was only 0.07%. It increases about 60 times a year.
Is the stock market tight?
Can. Dalio’s logic is logical.
But the stock market doesn’t always make sense, especially when it comes to interest rates.
Here the federal funds rate goes back to the mid-1950s:
Interest rates have been declining chronically since the early 1980s, but the previous three-decade period has been an appreciable price hike.
A 3-month Treasury bill is a very convenient proxy for the federal funds rate:
Since there is some price movement between meetings, it is easier to use these short-term T-bills as a proxy for historical comparisons.
The 3-month Treasury bill was just over 1% in 1954 but ended the contract at more than 4%:
During this time frame, the S&P 500 is up 21% annually or more than 210% overall.
Short-term rates nearly doubled in the 1960s, going from just over 4% to 8%:
The 1960s wasn’t a great decade for the stock market, but the S&P 500 was up 7.7% annually. Roughly 8% annually isn’t bad during a time when interest rates have doubled.
In the 1970s, short-term returns rose from 8% to 12%:
Nominally, the US stock market did well in the 1970s. Shares are up 5.9% annually even as interest rates breached double-digit levels.
The problem is that inflation was 7.1% so stocks are down on a real basis.
This is the biggest difference between the fifties, sixties and seventies. While inflation was more than 7% annually in the 1970s, it was only 2.0% and 2.3%, respectively, in the 1950s and 1960s.
So while the real returns were astounding in the ’50s and pretty good in the ’60s, they were awful in the ’70s.
You can never measure markets using any one variable, but if you had to rank them in terms of importance, inflation would get more votes than interest rates.
The stock market has performed well in the past when interest rates were rising. But the stock market tends to underperform when inflation is higher.1
Using data going back to 1928, I looked at how the stock market performed in a given year depending on high/low inflation and high/low interest rates:
This is a simple exercise but it tells the story. The stock market doesn’t perform nearly as well when inflation is high, and it does well when inflation is low (on average).
But when it comes to interest rates, there aren’t a lot of patterns to discern. I know a lot of people like to think that low interest rates were the only reason for the entire bull market in stocks since the early ’80s, but my belief is that inflation was an even bigger catalyst.
Does this mean that Dalio will be proven wrong?
I don’t know. Perhaps interest rates are more important now because investors are used to being very low for so long.
But the biggest danger to me is not that prices go up, it’s that high inflation lasts longer.
Michael and I talked about the impact of high hurdle rates on the stock market on live recording of animal lives this week:
participation in the complex So you don’t miss an episode.
Inflation affects the stock market more than interest rates
1Read more over here For a few thoughts on why the stock market doesn’t like high inflation.