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Inside Markets — Future Return on Cash

Future Return on Cash

September 13, 2023

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.

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