Stock Returns and Inflation Expectations
Financial liquidity affects the stock and bond markets differently.
As the world has moved, more or less, back into a “risk-on” mode as discussed Monday (see Risk and Return in a Risk-On Era) and as that move has been attributable, more or less, to the flood of ersatz money flowing from central bank spigots (at least that is where I hope it is flowing from), let’s update that outlook.
Net Inflation Accrual
First, let’s map the total return paths of two Treasury Inflation Protected Securities (or TIPS) indices created by iBOXX: One for the instruments’ nominal returns and one for the “real” returns after the inflation accrual was removed against the total return for the Russell 3000. All are re-indexed to January 2, 2001 and presented on a common logarithmic scale. There is no direct way I am aware of to trade the real TIPS return; there is no shortage of mutual funds and ETFs to trade nominal TIPS. A simple way to trade the Russell 3000 is through the iShares ETF (IWV).
Now let’s isolate the net inflation accrual. This is different than plotting a breakeven rate of inflation against a stock index for the simple but easily overlooked reason that each basis point in a bond investment has a much greater dollar impact as interest rates drive lower. If we plot the total return represented by this inflation accrual (essentially the same as the return on the weighted-average breakeven rates in the index) against the total return on the Russell 3000, the differences appear in stark contrast.
Stock returns have been more volatile since the March 2009 market low, and the percentage of variance ( r2 ) explained in stock returns by inflation accrual since that time has been a so-so 0.675. The r2 since the Jackson Hole speech at the end of August 2010 has been a trifling 0.10. If excess money and rising inflation expectations were the drivers behind equity returns, the r2 levels would be much higher.
The TIPS Mystery Continues
One of the stranger aspects of TIPS breakevens is how they rise and fall quickly within a trading range and appear to convey a great deal of information in the process -- and yet have remained confined within a multiple year range with the very significant exception of the 2008-2009 crisis. They may be the most over-analyzed numbers compared to their actual significance that we have.
What is, or should be, clear right now is that the Federal Reserve’s profligacy has yet to propel these numbers higher. Worse, as nominal rates decline, a near-constant breakeven implies negative real rates for TIPS. If you buy stocks, you are buying a set of embedded call options on earnings growth and you have an alternative to the known real losses in the bond market. Why anyone should compare the two markets and posit an equivalence between TIPS breakevens and stock returns is unclear.
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