While it is just as perplexing that Goldman still has clients, what is most surprising in this week's David Kostin "weekly kickstart" is that Goldman's clients have shown a surprising lack of stupidity (this time around) when it comes to the impact of QEtc. Shockingly, and quite accurately, said clients appear to be far more worried about the inflationary shock that endless easing may bring (picture that), than what level the S&P closes for the year. Incidentally with Q3 now over, and just 3 months left until the end of the year, Goldman's chief equity strategist refuses to budge on his year end S&P forecast, which has been at 1250 since the beginning of the year, and remains firmly there.
From Goldman's "Conversations we are having with clients: QE has equity investors asking about inflation"
QE has succeeded in increasing asset prices and inflation expectations but has not convinced investors to raise their US growth expectations. Instead, equity investors have expressed concern about inflation risks while both gold prices and implied inflation rates show similar shifts. During the 1970s, US core inflation averaged 6.5% and impacted equity performance: the S&P 500 rose in 7 of 10 years by an average of 8% per annum, Energy and high yield sectors outperformed, and consumer sectors lagged.
The response to open-ended QE has been mixed. While asset prices have risen, so have inflation expectations and the performance of growth-sensitive assets shows skepticism about QE’s effectiveness.
Asset markets are giving the Fed credit for being able to reduce risk premium and inflate asset prices but have been unwilling to increase growth expectations. Equity investors have benefitted from higher asset prices, are concerned about slow growth, and are beginning to fret about inflation risk. A 1970s case study of equities and inflation is generally intuitive: equity prices rise in nominal terms, Energy and high yield sectors outperform, and consumer sectors lag the market.
Declining risk premium has driven the S&P 500 rally as negative earnings revisions continue and growth expectations have not improved. We estimate the S&P 500 Equity Risk Premium (ERP) has declined 20 bp to 7.2% this month (Exhibit 4). All else equal, that move equates to a 5% move in the index. Not surprisingly the Europe ERP has also fallen significantly. Investment Grade Credit Risk Premium (CRP) has also declined to 1.5% from 1.7% in June with a much larger 80 bp move in Financials.
Implied volatility is down sharply, including longer-dated maturities. The VIX fell below 14 in September, a level it has not sustained since pre-2007. In addition the relative demand and price of put options has fallen sharply with 3-month skew reaching a two-year low and the put-call ratio continues to show high demand for upside call exposure relative to put hedge positions. Perhaps most telling, long-term implied volatility has moved lower suggesting investors view recent global Central Bank actions credibly over the medium- to long-term.
Retail mutual fund flows show nascent signs of investor confidence. Our Rotation Index measures whether retail fund flows favor more or less “risky” fund types relative to choices such as money market or Treasury bond funds. The past four weeks show some early signs that individual investors may be comfortable with more risk even though equity flows in general have been negative (Exhibit 3).
Growth expectations have not risen this month. The equity market’s view on US GDP growth is at similar levels as during the middle of August despite an increase in inflation expectations and a rally in equity markets. Understandably, the primary cause of flat growth expectations has been weak US economic data that has also remained below consensus forecasts (Exhibit 2). A positive note on the growth side is that higher equity prices and lower corporate bond yields have helped ease financial condition that would spur GDP growth in the future if sustained.
Oil prices have declined in September after a 10% move over the summer. Lower prices are somewhat surprising given the large rally during QE2 (oil futures rose 50% from Aug-2010 through Apr-2011) but are consistent with the muted change in equity growth expectations. Our Commodity Strategists credit some of the recent move to soft growth data and market concerns over the potential for a release of strategic petroleum reserves.
Measures of inflation have moved higher. The spread between 10-year US Treasury bond yields and TIPS has widened by about 20 bp in September and nearly 100 bp over the past year (Exhibit 4). Evidence of rising inflation concerns are also visible in inflation swaps and the University of Michigan surveys, which are up over the past few months and accelerate recently.
Recent inflation data does not support a rise in expectations as core inflation dipped below 2% in August and has averaged just 1.6% since 2008. However, gold prices have soared 10% since the end of June and have marched steadily higher since mid-August as QE expectations intensified. Equity investors are looking back to the 1970s for a guide to equity performance in high inflation environments. Our US Economists do not expect inflation to rise markedly in the near term and forecast core PCE inflation of 1.4% in 2013. However, our conversations with equity investors show a shift in attention to previous periods of high inflation.
During the 1970s the S&P 500 had an average annual return of 8% during a period when core inflation averaged 6.5%. At the sector level performance was also impacted by rising prices. Consumer Staples and Consumer Discretionary shares consistently underperformed the S&P 500 while Energy, Utilities and Industrials reliably outperformed the market (Exhibit 1).
