Inflation and equities - counterintuition

[MacroTrad]

Looking around and with an ear to the ground, many retail traders, and some investors, are exasperated by the recent strong performance, almost unrelenting performance, of developed market equities and indices. How can they be so strong in the face of such potential economic turmoil and even financial crisis?

Here's my developing theory.

Observe the equity indices of Turkey, Argentina and Egypt (EGX30). These are very useful pronounced examples. The trend will show rapid, exponential and hyperbolic growth in those index prices. Why is that? Is it because those economies have such strong historical performance and reliability and such great futures ahead of them? Is it because demand is booming for those assets?

No.

It's because those economies are experiencing high inflation from heavily devalued currency. Yep, more money printing, without the economic performance to justify it, has caused systemic inflation in everything in those economies. It's not the 'value' that's inflating, it's the 'price'. And everything must adjust in price to maintain comparable value to everything else, especially when a currency is heavily devalued. This seems to be the trend with systemic inflation, as opposed to non-systemic (one asset group changes in value comparable to others because of actual supply and demand of that asset).

So what does this all mean?

It means that developed markets and their economies seem to be acting like emerging markets when it comes to irresponsible monetary and fiscal policy. It's not so pronounced, it's less drastic but maybe will occur over a longer period. It is not confidence that's pushing these prices up, but counter-intuitively, it's fear. Under these circumstances, other factors such as interest rates and unemployment/recession no longer matter as much. The market may believe that systemic global inflation caused by systemic global currency devaluation (especially USD) will result in equity assets, if not all assets (look at the price of gold), never returning to these price levels again. They are getting in while they can (this is likely what drove the equity asset boom from the dip of 2020).

Perhaps it's a signal that they believe the central banks have actually completely failed?

[Adamski]

Bit confused? Developed markets didn't have a strong performance last year. They went down. Growth stocks and Bitcoin crashed.

The recent one month upturn could just be a bear market rally. You get those on way down. Called a bull trap.

Markets went down last year and expected by many to fall this year (first half at least) as well.

Money printing does inflate asset prices. But what's the alternative. If they let economies crash in 2020 would have led to a depression.

The UK market done relatively well last 12 months but that's cause was undervalued and oil stocks benefited from oil price rises.

[MacroTrad]

Bit confused? Developed markets didn't have a strong performance last year. They went down. Growth stocks and Bitcoin crashed.

The recent one month upturn could just be a bear market rally. You get those on way down. Called a bull trap.

Markets went down last year and expected by many to fall this year (first half at least) as well.

Money printing does inflate asset prices. But what's the alternative. If they let economies crash in 2020 would have led to a depression.

The UK market done relatively well last 12 months but that's cause was undervalued and oil stocks benefited from oil price rises.

I'll try and help you with the confusion.

I'd pan out from 'last year' and look at the bigger picture. Recall my original post, I stated that the performance in my emerging market examples were extreme and pronounced. I'm not suggesting the trend will be exact in developed markets. I'd also put to one side the talking head narrative about 'expectations'. It's as much about what's not being said.

I'm not going to get into a debate about the virtues of MMT, that's a different thread.

Market prices did go down, because inflation started to rise which led to an increase in central bank rates. This is typical and expected for reasons you probably already know. But I use the emerging market examples to show that there is a tipping point where these relationships an trends breakdown.

Observe Argentina and Egypt v Turkey. All are experiencing high inflation, dramatic increases in money supply and currency devaluation. But while Argentina and Egypt have dramatically raised interest rates, Turkey were even cutting them! A contrarian policy that many have questioned and criticised. Yet, regardless of monetary policy, all three equity indices have risen dramatically. Why haven't high interest rates brought them down?

It's only a theory of course, but we do know that equity indices in the EM examples above have increased despite hawkish rate policy due to systemic inflation/currency devaluation. What I'm suggesting is that we are at the beginning of a similar phenomena for the big developed market equities. Yes, they have declined last year (though many are still above pre-covid levels) in the expectation of recession. But I posit that despite this concern, the prior belief (and current narrative parroted and propagated to the general public) that inflation will rapidly decline, may now have changed. The core inflation metrics are perhaps not declining as fast as expected. They may also fear large increases in wages to continue and it gets to a point where rate increases (or even anticipation of them) have less and less effect.

Is it possible that the big equity consumers are beginning to worry that inflation will rapidly drive up prices despite any drop in earnings, employment and even recession and the performance since October 22 is illustrative of that?

[gpadsa]

"The Borsa Istanbul 100 equities index has soared almost 200 per cent this year. Even in US dollar terms, which take into account a steep fall in the lira, Turkish stocks rallied 110 per cent, compared with a fall of 22 per cent for MSCI’s broad gauge of emerging market equities."

FT Dec 30
https://www.ft.com/content/df4e49b1-572 ... bf0c6ff05b

gpadsa

[MacroTrad]

"The Borsa Istanbul 100 equities index has soared almost 200 per cent this year. Even in US dollar terms, which take into account a steep fall in the lira, Turkish stocks rallied 110 per cent, compared with a fall of 22 per cent for MSCI’s broad gauge of emerging market equities."

FT Dec 30
https://www.ft.com/content/df4e49b1-572 ... bf0c6ff05b

gpadsa

Which means what? I'm not sure what you're trying to assert.

The currency didnt move in exact tandem to equities. So comparing 2022 performance between currency and equity, while ignoring the lead up in 2020 and 2021 is quite frankly disingenuous. Not that I'd expect anything less from the Investment Industrial Complex.

Also please don't hide behind 'experts' and use them as your mouthpiece. I'm far more interested in your opinion.

[MacroTrad]

I'll elaborate further on my developing theory.

The point being developed here is that there's a difference between the revenue and earnings going up from increased trade volumes, and going up from increased prices (where trade volumes, supply and demand, remain relatively constant).

Let's take two companies. Company A and company B have P/E ratios of 15x. Company A has an increase in revenue from increased trade volumes and market share. It's subsequent earnings also increase. If the market wanted to maintain a P/E of 15x, and E increases, P would also have to increase to maintain the ratio. Thus, the market price of the shares would have to increase in price.

Company B also has increased revenue and earnings but not from increased trade volumes and market share. Systemic inflation has caused a rise in input and output prices. Again, if the market wants to maintain a ratio of 15x, and E goes up on the technicality of inflation, P would still need to increase. I posit that this increase would have to incur no matter other macro-economic conditions. This is the key difference.

My point is this. The scenario for company A is obvious, the economy is booming, consumption and sales volumes have increased, earnings are up. The shares increase in price to reflect that.

But scenario B is far less obvious. The current and future outlook of the economy could be pessimistic and poor. There could be much uncertainty and monetary and fiscal policies have turned hawkish and credit conditions contracting. We would normally expect to seek risk assets like equities decrease in price. But, and this is the key, we actually observe them continue to relentlessly increase seemingly against all odds.

The point that's missed here seemingly by most literature, retail investors and Investment Industrial Complex talking heads, is that it is fear of inflation that drives the increase in equity. This is counter-intuitive to most (but not to those that matter in the market).

The example gpadsa offers above is a great case in point. The index has seen a 200% increase in a year, an astonishing increase by any metric for a national index, but there is seemingly no economic justification for it apart from price inflation and currency deflation (and perhaps some speculation).

[MacroTrad]

So, I come back to my original point. Let's take the DAX40 as an example. While it has decreased in price from its ATH at the beginning of 2022, since reaching an apparent bottom in October 2022, it has increased around 28% almost relentlessly since. No plateau, no major pause, no particular consolidation. Other developed market indices have performed in a similar style. This seems counter-intuitive considering the variety of not inconsiderable problems and uncertainty the German economy faces. While these factors should not necessarily precipitate a market crash, a relentless 28% increase is also way beyond the typical distribution of returns in that timeframe, especially where there doesn't appear to be any change in outlook.

Therefore, it leads me to consider that this performance is not driven by optimism, but is motivated by fear. A fear that inflation in the German economy (and maybe broader) is actually not going to go away quickly and might even get worse somewhere up the road. That we are not going to see any deflation. I know 'inflation expectations' suggest otherwise, but really, who are these expectations made for? While retail sits around in cash or shorting waiting for the inevitable crash, they get left dramatically behind by the market makers and big money who are more savvy.

We talk about the bond curve inverting and what that signals. I posit the equity market also sends signals, but that these signals can be counter-intuitive an maybe even contrarian and ultimately difficult for the general investor and trader to spot or even comprehend until it's too late.


In summary, equity indices can dramatically increase in price, but sometimes this is not motivated by optimism of economic performance and growth, it is motivated by fear of chronic and intense inflation and by the technicality of systemic price increases. This increase can be contrarian to all other macro-economic indicators, monetary policies and business sentiment.