Why investors hate it when inflation and rates leave the comfort zone

In late 2017, Arnott coauthored a paper titled King of the Mountain: The Shiller P/E and Macroeconomic Conditions that presented research showing where valuations stand at most times when inflation and rates are at moderate and far-out levels—and what happens following a “great disconnect.” The Journal of Portfolio Management’s editorial board voted the article, written with Tzee-man Chow, also of RAFI, and Denis Chaves, a portfolio manager at Capital Group, as its best of the year. Yet it didn’t get much attention from money managers or academics. Its findings should be top of mind today. The Arnott et al. data shows that the current scenario is such a wild outlier that it portends a long slide ahead.

I also spoke to Arnott at length about his thesis, so these observations are based on both that interview and the 2017 paper. Let’s start with inflation. Arnott notes that investors dislike inflation of over 4% because it raises uncertainty for the companies they’re backing. When inflation surges, prices don’t rise in a smooth trajectory. They bounce erratically. Hence, enterprises need to constantly readjust the prices they charge consumers and other businesses. Many enterprises are unable to raise their prices as fast as the increase in their costs, squeezing margins. That’s a major problem for utilities, whose rates are regulated by law. Super-low inflation is a downer as well. “Most depressions are deflationary,” says Arnott. “The Fed will do anything to avoid deflation. If the Fed’s taking strong measures, and inflation is heading toward zero, investors will worry that the economy’s in trouble.”

What about “real” rates (which we’ll henceforth simply call “rates”)? Stockholders start fretting when rates exceed 4% and get really spooked as they climb still higher. The reason? That trend raises the cost of borrowing to the point where companies hunker down, shunning promising projects that would have swelled future earnings. When yields are excessively low, from 1% to negative, there’s fear that they foreshadow slow economic growth. If the Fed is taking excessive measures to hold down rates, the case today, companies tend to choose any investment whose returns beat their ultra-low borrowing costs. The artificially cheap borrowing lures them into weak investments. “Low real rates remove the speed bump that discourages reckless investment in new initiatives, and high real rates create a speed bump that discourages betting on good ideas,” says Arnott.

Multiples are highest when the two metrics are both in the mid-range

According to Arnott’s study, investors are at their most optimistic, and pay most for each dollar of earnings, when the two metrics are modestly positive. The golden means are inflation at 2% to 3%, and real yields at 2% to 4%. That ideal range for inflation typically means that the Fed has inflation under control but that consumers are spending at a brisk pace that gradually lifts prices. It points to an economy on a steady climb that has legs. Rates that are neither too hot nor cold encourage profitable investments but keep borrowing costs high enough to dissuade squandering cash on projects that promise low returns.

To measure valuations, Arnott uses economist Robert Shiller’s CAPE, or cyclically adjusted price/earnings ratio. The CAPE calculates the P/E by dividing the S&P 500 price by a 10-year average of inflation-adjusted earnings per share. That methodology removes the distortions in the P/E when current earnings are either inflated or depressed. As the authors note in their paper, “Peak earnings no longer create an illusion of low P/E ratios; trough earnings no longer create artificially elevated P/E ratios.” (From here, we’ll call the Shiller P/E simply the P/E.)

Over its century-and-a-half history, the Shiller P/E has averaged 16.7, though it’s been higher in recent years. The authors found that when rates are between 3% and 4%, the CAPE outperforms at around 19. Likewise, when inflation runs at 2% to 3%, multiples also settle at roughly 19. Peak valuations arrive in periods when both metrics float in the band investors like best. In those cases, the CAPE sits at a premium 22.5.

The danger of the Great Disconnect

By comparison, P/Es are at their lowest in the opposite case—where both benchmarks register extremes in either direction. Using the study’s methodology, where do inflation and rates stand today? Arnott et al. calculate inflation as the rise in the consumer price index (CPI) over the past 12 months. As of June, that figure was 5.4%, versus virtually flat prices in the year before the onset of the pandemic. For the real rate, the authors deployed the current yield on the 10-year Treasury, less the average yearly increase in the CPI over the past three years. Since mid-2018, inflation’s been running at 3.4%; on Aug. 2, the long bond was yielding 1.18%. Hence, by Arnott’s definition, the real rate now stands at minus 2.22% (the 10-year at 1.18% minus 3.4% inflation). The picture: The real rate is extraordinarily depressed at the same time inflation runs well above the 2% to 3% ideal.

What are the valuations we typically see when this odd couple reigns? The authors found that at an inflation rate of over 5%, and real yield under a negative 1%, the Shiller P/E averaged 11. Here’s the haymaker. Today the CAPE stands at 38, a summit exceeded only during the tech bubble. The difference between what Arnott calls the current or “observed” P/E of 38 and the “adjusted” multiple of 11, reflecting where valuations fall in most periods featuring this combination of rates and inflation, is 27 points. Today, investors are paying almost three times as much for stocks as at most times when the two metrics hit these extremes.

The Arnott et al. data shows what happens when today’s “observed” P/E is far above the average “adjusted” P/Es that prevailed in periods that had the same—in this case highly unusual—combination of inflation and rates. The gulf gradually closes. And what a gulf! The chasm between the current P/E of 38 and the multiple of 11 we usually see at over 5% inflation and negative real yields is an incredible 27 points. Arnott found that the P/E gap, now 27 points, shrinks by 10% to 20% a year. Taking the top of the range, today’s P/E of 38 could shrink at five points a year (20% of the 27-point gap). By mid-2023, the P/E would fall by 10 points, from 38 to 28. That would represent a drop in the S&P of around one-quarter to roughly 3100.

As Arnott points out, other factors are at play besides rates and inflation. He notes that several special forces are holding stocks at unusually high valuations, and may keep doing so. “Market moves are based on a broad array of forces,” says Arnott. “As the number of baby boomers fast approaching retirement soars, they invest even at huge valuations because they have to put money aside. They’re what I call ‘valuation indifferent.’ There’s also lots of money being sent by the government as emergency aid to people who are investing it rather than spending, pushing up equity prices. And the Fed is using easy money to hold down real rates.” He also argues that big deficit spending translates into much higher corporate profits. The government, for example, buys far more goods from corporations that sell them those goods, boosting margins.

Still, Arnott thinks the rates and inflation picture will severely handicap stocks going forward. “Unless both of these factors normalize, the downward pressure will be intense,” he says. “Inflation even below these levels is dangerous, and real rates below zero are also dangerous.”

Put the two together, and you get what looks like the convergence of two hurricanes. And it’s a whopper few see coming.