Soft Landing. Let us assume today’s bond market pricing is spot on. Today’s nominal 10-year Treasury yield is near 3% and 10-year BEI is also near 3%, thus providing a 10-year real TIPS yield of about zero. The 5-year BEI of 3.5% assumes that CPI falls toward 2% soon given that today’s year-over-year CPI is running at 8.5%. If the Fed manages to achieve this benign path for inflation and interest rates as implied by the bond market, without causing a recession along the way, then the recent decline in stock prices may be behind us. While the present S&P 500 earnings yield of a little above 4% is well below its long-term average of 7%, it provides a reasonable risk premium relative to today’s long-term real rates of 0%.
Recession. Today’s bond market pricing might be right, but the required tightening, taking the fed funds rate to 3% by early 2023 along with aggressive quantitative tightening, may cause a recession. If so, we may expect the stock market to price in a higher risk premium until it perceives the end of the recession. Stocks would likely fall further from here, but valuations may remain within the elevated range we have experienced in the 21st century.
Prolonged Inflation. If the Fed fails to tame inflation, then both stock and bond prices have further to fall. When investors price inflation as a prolonged problem, BEI will rise along with nominal rates. Investors will suffer losses in their bond portfolios. In this scenario, expect the equity risk premium to rise and stock prices to decline. History, and common sense, teaches that high inflation coincides with high volatility of inflation, interest rates, and equity prices. Volatility in capital market prices is like a thermometer displaying an elevated temperature. It reveals a disease. Following this analogy, the disease is flawed economic policy. High volatility raises risk premiums and lowers stock prices.
Stagflation. If the Fed fails to tame inflation and we have a recession or two, then expect capital markets to behave as in the late 1970s and early 1980s. Interest rates will soar toward or above the-then current rate of inflation. Equity prices will tank and P/E multiples will contract. In the last period of stagflation, Shiller’s CAPE fell to below 10 in 1977, bottomed at 7 in 1982, and failed to rise back above 10 until 1985. With today’s CAPE well above 30, a fall even just to 10 implies a frightful decline in stock prices.