Inside Markets — Future Return on Cash

This morning’s August CPI print did little to shift the inflation narrative in either direction. Headline CPI came inline, up +0.60% MoM, while the rounded core rate came in hotter, up +0.3% vs. expectations for +0.2%. This takes the YoY headline rate to +3.7%, up from +3.2% last month, while the YoY core rate slips to +4.3% from +4.7% in July. Participants supporting the disinflation theme can point to the continued progress in core CPI with assumed weakness in shelter prices going forward. Those supporting a prolonged period of elevated inflation are citing upward pressure from energy and sticky core services CPI (services ex-housing). In aggregate, the report should keep the status quo in place with the Fed unlikely to close the door on future rate hikes anytime soon. OIS-based probability for a November rate hike ticked up two percentage points to 39% and there’s talk of the ’24 dot moving higher in next week’s Summary of Economic Predictions (SEP).

The current earnings yield on the S&P 500 (SPX) is 5.8% using the consensus 12-month forward EPS estimate of $260.00. There’s nothing wrong with a 5.8% earnings yield until you compare it to the current 10-year risk-free rate of 4.25%.  It’s even worse if you compare it to a current T-Bill yield of 5.25%. But most Discounted Cash Flow (DCF) valuations use a 10-year Treasury yield to determine longer-term terminal values. The yield on short duration T-Bills is also more volatile than the yield on 10-year notes, which raises a question about the future return on cash. In a roundabout way, the market is implying a much lower cash return in the future, which should be our cue to add duration.

The SPX is richly valued regardless of what model you use, but valuation is a dull instrument when it comes to timing markets. Using the aforementioned DCF model, the current forward multiple should be closer to ~14.5x than the current multiple of ~17.3x. An expensive valuation tends to cap the upside rather than generate downside when equity volatility is subdued. However, a spike in equity volatility would likely begin to close the 2.7 turn valuation differential, suggesting as much as 16% downside from current levels. This makes the CBOE Volatility Index (VIX) the most important near-term gauge to watch with sustained closing levels north of 22 potentially starting the process.