Goldman's Clients Are Confused About Inflation: Here's Why
In his latest weekly kickstart, Goldman’s chief equity strategist David Kostin (who has maintained his year end S&P price target of 2,400 of -3% from current levels), says that the one topic most confusing (and important) to Goldman’s clients in the past week, was what happens to inflation next: “the US inflation outlook and its equity investment implications were key topics of discussion during recent visits with clients in Boston, Chicago, and New York. Core Personal Consumption Expenditures (PCE) data released [on Friday] showed a year/year inflation rate of 1.5% in 2Q. Wednesday’s Fed statement acknowledged that inflation was running “below” its 2% target, a revision from the “somewhat below” description used previously.”
Kostin points out that while fixed income managers have always had to take a view on inflation, now that the Fed’s “reaction function”, to use an IMF-ism, is entirely driven by concurrent and future inflation expectations, and as a result “equity investors must also take a stand and position portfolios accordingly. The anticipated path of inflation is an important determinant of the trajectory of Fed policy tightening. Bond yields will be affected in turn via expectations of future hikes and the term premium, and stock prices by extension will be influenced through the equity risk premium.“
As for why Goldman’s clients are “confused”, Kostin points out something we have discussed on several occasions recently: depending on what indicators one uses, inflation can be expected to rise, drop, or stay the same:
“Looking forward, will the rate of inflation in 2018: (a) decelerate, (b) accelerate, or (c) stay about the same? The answer depends on the information source. Treasury Inflation Protected Securities (TIPS) imply inflation will decelerate; Goldman Sachs economics forecasts an acceleration (to 1.9%); while corporate pricing varies both across and within industries. For example, branded pharmaceutical prices are rising by 9% (offset partially by rebates) while generic drug prices are falling by 9%.“
Some more details behind these perplexing numbers:
- The TIPS market implies inflation will average 1.3% annually during the next two years and 1.8% annually through 2027. As a result, fed funds futures currently imply just a 50% probability the FOMC will hike once more by year-end 2017 and expect just two hikes in total through the end of 2018.
- In contrast, Goldman Sachs economics believes underlying inflation will trend towards the Fed’s 2% objective. Specifically, our economists forecast core PCE will reach 1.6% by year-end 2017 and climb to 1.9% by the end of 2018. The trend in inflation will prompt steady policy tightening starting with a 25 bp hike in December followed by four hikes in each of 2018 and 2019 that will lift the funds rate to 2.4% and 3.4%, respectively.
In a humorous swipe at his own economics team, Kostin writes that “we have met no equity investors who subscribe to this forecast.” So much for Goldman’s once legendary ability to shape and sway investor sentiment.
Then there are the government’s own measurements of inflation:
The components of measured PCE inflation are split 25% in Goods and 75% in Services. The goods category has shown consistent deflation for several years and our economics team forecasts that trend will persist in 2017 and 2018 (see Exhibit 5). A leading driver of disinflation has been the Video, Audio, and Computer category where prices dropped by 5% in 2015, by 10% in 2016, are declining at an average pace of 7% YTD, and we forecast will fall by 4% and 7% in 2017 and 2018, respectively.
However, Services PCE inflation is the more important category and the trends are mixed, which is why market participants have such divergent views on the underlying pace of inflation. The four largest Services categories account for 65% of core PCE inflation and include Medical Services (19%), Housing (19%), and Financial Services (9%).
Separately, what inflation information can investors glean from corporations and the equity market?
Confirming what the latest Census data showed last week, namely that asking rents across the nations just fresh all time highs…
… Goldman flags that apartment owners suggest rental inflation remains above the Fed’s overall inflation target of 2%. Six public apartment REITs own 357,000 multifamily units (AVB, ESS, EQR, AIV, CPT, UDR). Same-store rental growth in REITs has been a leading indicator of the change in owner’s equivalent rents (OER) in the government’s housing inflation measure (Ex. 3).
Average rental growth for these REITs equaled 5.6% in 2015 and 4.8% in 2016. More notably, Kostin writes that “because analysts forecast rental growth will slow to 2.9% this year and 3.1% in 2018, housing inflation represents a fading tailwind to core PCE inflation.” To be sure that would be great news to a middle class that has never had to pay more out of pocket for the monthly rent…
On the other hand, a conflicting picture emerges from the deflation observed in certain parts of Financial Services. The Investment Company Institute (ICI) reports that average fees for active equity management have dropped from 108 bp in 1996 to 82 bp today, although we doubt that one can seriously claim with a straight face that there is delfation because millionaire LPs are paying not 2 and 20 any more but 1 and 10 or less.
Meanwhile, inflation and interest rates affect equity valuations. The gap between the S&P 500 earnings yield and ten-year Treasury yield represents a short-hand measure of the equity risk premium. The gap in the “Fed Model” currently equals 320 bp (5.5% less 2.3%), below the average of the past 10 years (460 bp) but above the average of the past 40 years (250 bp).
Which brings us to Goldman’s summary: based on all the initial assumptions, Kostin’s S&P 500 price target of 2400 suggests the yield gap will narrow to 300 bp by the end of 2017. The yield gap has narrowed by 300 bp since February 2009.
Our economists forecast the Treasury yield will rise by 50 bp to 2.75% at year-end. Higher interest rates coupled with a slightly lower risk premium is consistent with our S&P 500 year-end target of 2400 (-3%). However, if inflation remains subdued and the bond yield hovers near the current level, the Fed Model would imply a S&P 500 fair value of 2650 (+7%) (see Exhibit 4).
Finally, and going back to the original underlying confusion, Goldman concludes that “whether they are bullish, bearish, or neutral, every equity investor is implicitly or explicitly taking a view on the inflation outlook.” That… or simply taking a view that no matter how this latest inflation vs deflation debate plays out, the Fed and central banks will always be there, ready to bail out the wealth effect that they have so carefully cultivated over the past 9 years with $15 trillion in liquidity injections, and which nobody seriously thinks they will let go to waste just to make a statement that the market can levitate on its own without constant central bank manipulation.