The Federal Reserve’s efforts to curb inflation over the last couple of years will all be for naught, says Bill Smead.
The founder of Smead Capital Management and the Smead Value Fund (SMVLX) co-manager, which has beaten 99% of similar funds over the last decade, said in a recent note that he expects inflation to flare up again in the years ahead.
The culprit? Fiscal spending. Smead said there seems to be little to no political will in Congress to either cut spending or raise taxes to reduce a growing budget deficit and national debt.
Here’s where M2 money supply sits currently. It exploded when pandemic stimulus was pumped into the economy and remains above historical trends.
With the Fed forced to continue printing money to meet this spending appetite, inflation will be an ongoing phenomenon. This scenario unfolded a couple of times in the 1970s, Smead pointed out.
“Left unaddressed, ongoing inflation with no fiscal will to pull back from the monetization of $11 trillion in fiscal stimulus leaves the Fed in a vulnerable position,” Smead said. “Either accept a deep recession (like Paul Volker did) or restore fiscal discipline by cutting government spending or aggressively raising taxes. Ultimately, inflating our way out of the mountain of federal debt now costing 4% interest remains the most likely outcome. This happened twice in the 1970s. Each time inflation pulled back, it was only temporary.”
For investors, an inflationary environment poses a tricky landscape to navigate. Higher inflation can mean lower valuations and poorer stock market performance, as the chart above indicates. With elevated valuations, it could indicate stocks are due for a rough period ahead. Plus, higher inflation erodes real returns.
Here’s the Shiller cyclically adjusted price-to-earnings ratio on the S&P 500. The measure is a rolling 10-year average so as to smooth out any irregularities. Right now, it’s above levels seen during the 1929 bubble.
“The problem is that stocks are not priced for any of these outcomes because of the financial euphoria created by years of declining interest rates,” Smead said.
He added: “The S&P 500 Index is likely to produce very poor inflation-adjusted returns for the next 10 to 15 years.”
What others are saying
Other notable market observers have been calling for weak stock market returns over the long term.
Jeremy Grantham, the co-founder of GMO who called the 2000 and 2008 market crashes, recently told Business Insider that the S&P 500 is doomed to drop more than 30% in the near future and will produce poor long-term returns.
He cites John Hussman’s measure of market cap of nonfinancial stocks to the total value added of nonfinancial stocks, which has a high correlation to forward market returns. Right now, it indicates the S&P 500 will deliver negative returns over the next 12 years.
Stifel’s Barry Bannister also believes the S&P 500 will be in a “secular bear market” over the next several years.
“We’re likely in a decadelong secular bear market and expect a range-bound S&P 500 in real terms to continue into the early 2030s,” Bannister said recently in his 2024 market outlook note.
Rob Arnott, the founder of Research Affiliates, shares Smead’s view that inflation could rise again.
“Inflation is not always transitory, it’s just one of a wide range of outcomes (and historically has not been the norm),” Arnott said in a July 2023 note. “Investors are cautioned not to be overly optimistic about inflation and to be prepared for the possibility of higher inflation in the future.”
Arnott is also forecasting weak long-term returns for the market.
Data backs up the notion that high stock valuations and higher inflation weigh on forward returns.
Here’s a chart from Bank of America showing that starting valuations explain 80% of how stocks perform over a 10-year period.
And here’s a 2022 chart from Guggenheim Partners showing inflation’s impact on stock valuations. November’s core personal consumption expenditures index was 3.2%, while the S&P 500’s current 12-month trailing P/E is 26.2. The data below suggests that should be around 18, meaning trouble could be ahead for stocks.
But these are all in the long term. Historically, starting valuations have little say in how the market does in the following year. With the economy still stable and the Fed preparing to pivot toward dovish policy, stocks could continue to build on their 32% rally since October 2022.