Category Archives: Inflation

Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

 

Economic Inequality

Income inequality is increasingly acknowledged as a key economic issue for the world.  The topic is a major theme at Davos this year.  Economic inequality is also an increasingly common topic in U.S. politics.

A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously.   The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult.  The numbers have not changed in three decades.

On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale.  The richest 1% of Americans now own 25% of all of the wealth in the U.S.  The share of national income accruing to the richest 1% has doubled since 1980.  In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.

Why is this happening?

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The Inflation Paradox at the End of 2013

The latest inflation numbers are out from the Bureau of Labor Statistics and they show that consumer prices barely increased over the past twelve months.  The most commonly-cited measure of consumer prices is the CPI-U, the Consumer Price Index for Urban consumers.  The CPI-U is up 1.2% over the twelve months through November, and this is almost identical to the 1% 12-month rise in the data through October.  The other major inflation measure, the Personal Consumption Expenditure index (PCE), is even lower because housing is a smaller component of PCE than CPIContinue reading

Low Interest Rates Through 2014 and Beyond

Ben Bernanke, in a speech on November 19th, made it very clear that the Fed is likely to hold interest rates low for an extended period of time.  This comes on the heels of similar comments by his likely successor at the Fed, Janet Yellen, during her confirmation hearings.  On top of this, inflation numbers released on the morning of the 20th show almost no increases in consumer prices over the past year and existing home sales have just registered a drop.  In related events, Larry Summers just gave a widely-noted presentation to the IMF in which he warned that the U.S. may be settling into a long-term economic malaise.  Larry Summers, who was previously a contender to be the next Fed chairman, surely considered his comments to the IMF very carefully. Continue reading

The Meaning of the New Highs in the S&P500

The S&P500 has recently been hitting new all-time highs, which would seem to suggest that the economy is recovering and that the U.S. economy is back on track.  The story does not look quite so rosy when you account for inflation, as Mark Hulbert has recently noted.  The current level of the S&P500 is, in fact, still about 24% below its high in 2000 once inflation is considered.  Economists and finance people would say that, measured in real terms, the S&P500 is 24% lower than it was at its 2000 peak.  What this means is that the proceeds from the sale of a share of an S&P500 index fund purchases considerably less in real goods today than it did thirteen years ago.  Continue reading

Financial Literacy: State of the Union in 2013

April is financial literacy month.  I believe that lack of financial knowledge is one of the most critical problems that our country faces. Continue reading