Two macro factors – one economic and the other monetary – have each historically weighed on stocks multiples. These are inflation and the contraction of liquidity. The combination of the two factors today puts equity markets in serious danger.

What should central bankers do, stop contracting at the risk of runaway inflation? Continue contracting at the risk of a market crash?

Dilemma.

For 150 years, investment cycles have been mostly controlled by the balance between efficiency and scarcity. Efficiency when primary energy is abundant and cheap; Scarcity when primary energy is scarce and expensive. In efficient times, the stock market thrives; In times of scarcity, it trembles.

Historically, expensive energy cycles tend to last a full decade. What if history repeated itself?

A ‘Giffen good’ is a strangeness. When its price increases, its demand does not fall, it rises. Simply because it is an essential good – not substitutable – which  constitutes a significant part of the buyer’s income.

In times of economic stress, companies that produce Giffen goods are a safe-haven for the stock market investor.

We are now in a time of economic stress; here is an example of the Giffen portfolio, with seven good old essential stocks!

Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:

In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.

For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.

The economy and stock market’s profitabilities do not always walk hand-in-hand. In 2020, for instance, to the surprise of many observers, we saw the former collapsing and the latter booming. Is it possible 2021 might see the opposite?

A protest movement in France named the “Gilets Jaunes” (Yellow Jackets) began in October 2018 due to a tax increase on fuel. The movement was populist, widespread, and spontaneous, and only weakened in 2020 due to coronavirus lockdowns.

Was 2.6 cents per liter extra tax on gasoline such a big deal?

The answer is yes. Inflation on a household’s constrained expenditure can unleash the “Gilets Jaunes multiple,” and kill consumption and stock markets.

The risk has now crossed the Atlantic.

Some forty years ago, Charles Gave introduced the “Four Quadrants” concept, used by generations of investors to drive asset allocation in global investment portfolios. The concept crosses inflation and growth to cluster four macroeconomic situations: inflationary boom, inflationary bust, disinflationary boom, and disinflationary bust.

Here we revisit the concept with a scientific eye, applied to ecosystems. We focus on the second derivative of economic production or asset prices, i.e. the acceleration or deceleration of growth and inflation, intentionally ignoring the levels of inflation and growth. A new “Four Quadrants” is born, bridging macroeconomy and simple mathematics. It massively amplifies Charles’ discovery decades ago.

What is it telling us? That the US game on equity price-earnings’ expansion is over.

Equity holders are brave investors who abandon their capital forever (unless they find a third party in the marketplace to replace them, which is never guaranteed) against a flow of uncertain future dividends. Companies, therefore, must distribute dividends, and they can only do so in two ways: they either pay dividends on capital if earnings are sufficient, or they pay dividends off capital.

The worse of the two is the latter and leads to capital destruction. So, who is responsible? The most influential macro factor on portfolio construction for long-term investors, today on the verge of resurfacing: inflation.

Inflation kills equity returns. This has been the case for more than a century in the US, and nearly all countries in the last twenty years, as evidenced in this letter.
So, are we in – or about to enter – the dangerous territory, turning the equity dream into an equity nightmare?
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