Is Inflation Or Deflation Coming? Part 2

inflation deflation part2

In Part One of this two-part series, we differentiated between nonmonetary forces pushing up prices as opposed to the monetary forces pushing them down.

We closed with acknowledging that some will say, “Yes, but interest rates have been rising.”

Indeed. Here’s a graph of the 10-year Treasury yield.

10yr yield

Look at that big move up since August. Back then, the rate was 0.57% and now has hit a recent high of 1.5%.

But let’s put it in perspective. The yield has never been lower than it is now, even after this big move.

The Treasury is not the only interest rate. More germane to the analysis of prices, is the effective interest rate to businesses.

AAA corporates

We see a blip up there—to the low achieved just prior to Covid.

Another yield to watch is the earnings yield of stocks, the trailing 12 months earnings divided by the share price. Here is the graph of the S&P 500, showing back to around 1870.

S_and_P earnings yield

Source: Multipl.com

Other than the brief spike low of the last global financial crisis, the S&P earnings yield has never been much lower. That is important because this is one way of looking at a corporation’s cost of capital.

It’s also a way of looking at the hurdle. The hurdle is the rate of return on capital that an investment must get over, in order for the company to decide to do it.

What Would ACME Corp Do?

For example, Acme Corporation is earning $25 million, and its market cap is $1 billion. In other words, it matches the S&P average (it’s smaller, to keep the numbers simple).

The CEO, Wile E. Coyote, is thinking of selling shares to build more hamburger shops. Assume a store generates $250,000 in annual profit. If it costs less than $10 million to build, he may pursue the opportunity. And doing it will be accretive to earnings. Suppose it costs $5,000,000 to build the store. $250,000 is 5% of $5,000,000. Each store increases Acme’s earnings yield. Or, if the market sets earnings yield at 2.5% due to monetary policy, then Acme’s share price will go up, after selling new shares to finance new stores that generate double the yield of its existing business (along with Mr. Coyote’s annual bonus).

If the earnings yield of a new store is really double that of the earnings yield of their shares, then Acme and its competitors will build a lot of new hamburger stores. Assuming the same thing is true for pizza places, steak houses, and crab shacks, then there will be a lot of capital raised to build a lot more capacity to sell burgers, pizzas, steak, and seafood. This process will continue until either the interest rate (and earnings yield) ticks up, or until they build out so many stores, that profit per store drops to around $125,000.

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Disclaimer: The content in this article is provided as general information and for educational purposes only and should not be taken as investment advice. We do not guarantee the accuracy ...

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