During our quarterly webcast last week (October 21, 2021), someone asked us a great question. They asked, “Do the ten-year Treasury bond rate at 1.65% and an inflation rate of 5% teach us that inflation will be transient?” This is an important question because the majority of economists and market strategists bet that inflation is transitory. Look at the chart of 10-year Treasuries going back to 1970:
Our answer to the question goes back to 1981, when we were on the other extreme. Interest rates had been rising for years and inflation was as high as 11%. When the 10-year bond peaked at 15% in 1981 with an inflation rate of 11%, did that tell you where the interest rates were going? Indeed, did the large deviation of interest rates from inflation tell you that rates were going up (as most economists and market strategists thought in 1981)?
The answer to this question effectively answers today’s question. The 10-year Treasury bond rate fell from 15% to 11% in early 1983, as the psychological drop and large spreads that investors demanded from a 4% interest rate cushion laid the groundwork. a huge backlash in prices. By 1984 inflation had fallen to 4%, even though the economy was booming thanks to 79 million baby boomers buying homes and cars. They gave bond buyers a lifetime gift in 1984 by allowing us to buy bonds at 14% with a rolling inflation rate of 4%.
This brings us to today, when bond investors are paid interest rates that temporarily provide negative real returns. These negative real returns will exist until inflation falls below the current bond interest rate. History would argue that investor overconfidence in bonds and in the Federal Reserve’s ability to handle what we call “inflation wolverine” tells you that we could be at the opposite extreme of nineteen eighty one.
Therefore, based on history, what might happen when the bond market adjusts to much higher permanent inflation rates as 90 million millennials replace 65 million GenXers in the bracket? key age of 30 to 45 dominated by buying houses and cars? Where will interest rates go and how will this affect the stock market overweighted in technology and multi-billion dollar growth stocks? What stock sectors can make money in a much tougher stock market, with much higher interest rates and strong economic growth?
First, if inflation stays around 5%, the 10-year Treasury bill must gravitate towards a rate that gives a “real” return for investors of up to 6%. This would crush bond investments and likely crush the price-to-earnings and price-to-sell ratios of common stocks. For many investors who have come to the party in the past five years, this could start hell on their portfolios. Ironically, price-earnings ratios would likely have to be at best in line with historical standards and at worst below those standards. See the distribution of the price-earnings ratio since 1970:
Second, the law of fashion would gravitate innovation / tech actions towards companies and sectors that directly benefit from the surge in commodity prices and the revision of inflationary prices. To us, that seems to make the case for oil and gas land, residential land, and suburban land. Oil looks like the gold standard for all commodities, and land owned by oil and gas companies with proven reserves in the ground looks incredibly attractive in the future. We have continental resources (CLR, financial), ConocoPhillips (COP, Financial), Occidental Petroleum (OXY, Financial) and Chevron (CVX, financial), in this sector. As Mae West said, “Too much good can be wonderful. »Watch how Exxon (XOM, Financial) and Chevron did so in the inflationary 1970s against the S&P 500:
On the flip side, we believe the nationwide movement of millennials to buy homes in more affordable areas will make homebuilding thrive despite higher interest rates. Indeed, owning their own home is one of the ways the average American household can insulate themselves from inflation. This makes Lennar (LEN, financial) and DR Horton (DHI, financial) seem very attractive. As people buy homes far from major urban centers, suburban shopping / dining / entertainment centers (aka Class A malls) will be on land that increases in value as rents rise at rates of inflation. higher. Macerich (MAC, Financial) seems particularly undervalued on this basis as the owner of some of the best Class A malls in America.
To tie all this together, let’s remember that most investors will experience a stock market failure. If you think buying bonds at 1.65% when inflation is at 5% and owning the S&P 500 index loaded with growth stocks in a potentially rising interest rate environment is a good idea, we suggest you review your strategy.
The information contained in this letter represents the opinions of Smead Capital Management and should not be interpreted as personalized or individualized investment advice and is subject to change. Past performance is no guarantee of future results. Bill Smead, chief investment officer, wrote this article. It should not be assumed that investing in the above mentioned securities will or will not be profitable. The composition of the portfolio is subject to change at any time and references to specific securities, industries and sectors in this letter do not constitute recommendations to buy or sell any particular securities. The current and future holdings of the portfolio are subject to risk. In preparing this document, SCM has relied on and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management over the past twelve months is available on request.
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