Quantifying the Impact of Vaccine Failure on Earnings Per Share

In a post last week, I raised the possibility that the vaccines might not get the virus under control this winter. Since the markets still seem to be pricing in vaccine success, this could have implications for investors. How might we think this through in more depth?

One way to do this is by looking at the Google Mobility Index and seeing if it is any good at explaining EPS growth in the S&P. Here I take an aggregate construction from the index that encompasses all of the economic variables – transport, retail, grocery and workplace movement. I also push the mobility index forward one quarter which seems to give a more reasonable fit – presumeably due to an accounting lag with the EPS data.

Looks pretty good. Here is the same data in linear regression space.

Okay, so at least histroically there appears to be a strong relationship here. It also makes logical sense as the mobility index should be tracking levels of footfall related to economic activity.

Because the EPS index always comes accompanied by handy analyst forecasts this means that we can pull out an implied mobility index forecast – assuming the linear relationship shown in the above regression. We can also construct a scenario where restrictions are reimposed (details in the appendix). Here is what they look like.

This tells us exactly what we assumed in the last post: namely, that EPS forecasts – and presumeably therefore price action in the stock market – is implying a slight improvement or at least stability in footfall related to economic activity; that is, no more lockdowns or similar interventions. By contrast our – very conservative (see appendix) – lockdown-simuluation shows a slight deterioration.

Using our alternative mobility index we can then pull out an EPS forecast and compare it to the analyst forecast.

As we would expect we see that EPS goes back into decline. Not a very marked decline, mind you – we have made a very conservative assumption for lockdown severity. But enough of a reversal that it would likely capture the attention of the markets.

So, is this model realistic? Maybe, maybe not. It is perfectly possible that businesses are now perfectly well adapted to lockdown and lockdown-lite interventions and that the correlation between the mobility index and EPS will breakdown this winter. But we are making very conservative assumptions about the impact of the lockdown on mobility for this reason.

I reckon that this is not an unreasonable estimate. Anyway, the real point of this exercise is to put some numbers on a much more important intuition. An intuition that leads us to ask the question once more: are markets ready for vaccine failure and possible lockdown-ish interventions this winter?

Finally, let us see what EPS looks like if we assume a severe lockdown scenario. This is a scenario where the lockdown is as punitive as it was in autumn-winter 2020 and we assume that businesses and consumers have not adapted since then. I do not believe that this is a reasonable estimate – for one, it seems unlikely that many red states would lock down even if blue states did this year – but it is a nice exercise to work through to see a true worst-case scenario.



I estimate the impact of a lockdown as such. I take the percentage decline from Q2 2020 to Q3 2020 and apply it to Q2 2021/Q3 2021. I do the same for Q4.

This is conservative because I am taking percentage decline instead of actual decline. We can see how this is conservative if we take an example.

Between Q2 2020 and Q3 2020 we saw a 12% decline in the Google Mobility Index. Applying this to the same period in 2021, the index declines from -44.6 to -50.2. If we took the actual decline between Q2 2020 and Q3 2020 (-9.6) and applied it to the 2021 data we would see the index decline from -44.6 to -54.3. This effect would be amplified further in Q4 which would fall to -62.2 rather than -54.8 using the percentage decline method.

As I have stated above, I use the percentage decline method to make a conservative assumption when considering future locdown-ish policies because there has probably been some level of economic adaption since last year.

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Double Bubble Trouble

Two weeks ago I wrote a piece for Newsweek outlining potential troubles in the junk bond market. I pointed out that there is a strong possibility that enormous junk bond issuance is floating companies that otherwise would have gone bankrupt due to the lockdown measures. Here is that piece:

The Next Financial Crisis is Coming

But that is not the only bubble on the horizon. The lockdowns and work-from-home appears to have driven investors pretty kooky because we also have what appears to be a major housing bubble inflating. I have outlined this in a piece I published today which can be read here:

Are We About to Repeat the 2008 Housing Crisis?

If you add up the employment in the threatened sectors you get a range of anywhere between 8% and 10% of total employment in the United States. In contrast, during the 2008 crisis – which was almost wholly driven by a housing bubble – only around 5% of employment was under direct threat.

It is hard to come to any conclusion other than that, if I am right about the bubbles, the economy could be under more threat from a financial crisis-cum-deep recession than at any time since the Great Depression.

When you make a claim as large as this and you’re not a permadoomer, it’s usually good to ask the question: what would it take for me to be wrong? So far as I can tell we would need to assume the following for my thesis to be incorrect.

  • The enormous increase in debt issuance by companies with balance sheets destroyed by the lockdowns highlighted by the BIS paper I cite is completely sustainable.
  • Revenues are going to soar for these companies in the coming months and they will pay down all the excess debt.
  • Further, the BIS stress test model – which is quite conservative and does not even assume another lockdown – would have to be totally wrong.
  • With respect to the junk bond market itself, the current very narrow spreads we see – especially relative to forecast default rates – would have to be a permanent feature of reality; presumeably this would be due to some permanent Greenspan put-style arrangement implicitly promised by the Fed.
  • Implicit in the last point is that the Fed can actually control junk bond spreads, even during a market meltdown or crisis.
  • With respect to the housing market we would have to assume that the screaming valuations – which are just as high as in 2008 – are now a permanent feature of reality. These will either continue to expand indefinitely – rendering houses more and more expensive – or it would stabilise at its new high-level.
  • The record levels of private sector residential investment growth is either sustainable or will not end with a bang but rather draw down slowly over time as we replenish the nation’s housing stock – the 2008-era lingo for this, now much derided, was ‘soft-landing’.
  • MBS spreads, artificially lowered by the Fed buying up around 30% of the market, will remain suppressed allowing for the current levels of mortgage lending to continue; the record rates of growth of MBS issuance will either continue on or experience a soft-landing.

I think those are the assumptions you have to make to think that I am totally wrong about these bubbles. If you find them unreasonable – I do – then you have to conclude that we could be sailing into seriously choppy waters.

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Vaccine Failure, Market Expectations and Inflated Valuations

For the last year and a half the biggest sentiment driver in markets has undoutedly been COVID-19. This is perfectly reasonable as the virus is probably the biggest single driver of variables that matter in financial markets – from inflation expectations to earnings. Yet it has been striking that most financial analysts have been outsourcing their analysis of the trajectory of the virus to those in public health.

In theory this is reasonable. Many are assuming that the public health experts are, well, experts. And since financial analysts are not experts in epidemiology, deferring to those that are is a rational course to take. Yet if this pandemic has made one thing crystal clear it is that the public health experts are far from infallible.

This seems to be coming to a head this week. This week at least three major newspapers are throwing in the towel and admitting that the vaccine is not nearly effective enough to get the virus under control. The Financial Times runs the headline “Are vaccines becoming less effective at preventing Covid infection?”; the New York Times has “Israel, Once the Model for Beating Covid, Faces New Surge of Infections”; while The Times of London has “Double Covid vaccine doesn’t stop symptoms for half of Delta cases”.

The problem here for markets is simple enough: reflation and solid earnings growth was thought to be coming because the vaccine would return things to normal. Now that this looks unlikely, it is difficult to provide an alternative rational for reflation and solid earnings growth.

Are the markets waking up to this? Maybe. UK gilt yields have been tracking hospitalisations and in recent days they have ticked up.

Inflation expectations took a dip too, although they later reversed.

It seems fair to say that markets are currently attempting to process the facts as they come in. There is no way they are at the point where they are accepting widespread failure of the vaccination program, but they are starting to feel out this possibility.

This isn’t just a question of interest to traders either. Investors should pay close attention too. Stock market valuations have gone truly nuts on what we must assume are very inflated future earnings growth expectations. The Shiller CAPE is at it’s second highest point in history.

Tobin’s Q has gone totally gangbusters, now exceeding any previous peak.

Q Ratio

These are markets priced for perfection. Yet as we enter autumn/winter with a vaccine that is not keeping to the promises made on its behalf, we could be facing down another wave of the virus. This will then spur debate about more interventions that will impact the economy and with it earnings.

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Inflation, Real Earnings and Recessions

In my previous post, I laid out some issues with the methodology being used to explore the relationship between inflation and asset prices.

One issue that I raised was with respect to the observation that inflation below 1% seemed to lead to lower stock market earnings. In the previous post I pointed out that this was likely misleading: it was unlikely that the low price growth itself was giving rise to such poor earnings; it was far more likely that this was mainly being driven by recessions that in turn caused low price growth.

In this short post, I hope to be able to show this. Here we will be using a different sample due to our needing quarterly real GDP figures to do the calculations. Here is the full sample of real earnings growth categorised by inflation bucket.

Here we see much the same pattern we saw in the post-1925 sample. It shows that historically high inflation (above 5%) and low inflation (below 1%) have been associated with low real earnings growth. Now let’s strip out recessions. (For the sake of simplicity I will not use NBER recessions but rather any quarter that saw negative real GDP annual growth numbers).

As predicted, the negative real earnings growth in very low inflation regimes disappears. True, the real earnings growth in these low inflation regimes is lacklustre, but it is not negative.

In addition to this, real earnings growth in high inflation regimes has also improved on a relative basis. This means that at least some of the impact that see on real earnings during inflations is actually due to the recessions that take place in those inflations.

This is a fairly easy exercise. It was fairly obvious when given any thought whatsoever that the poor earnings growth in very low inflation regimes was probably driven by recessions. The really interest question is this: is there a variable that is not inflation that might be driving the low returns in the inflationary period we have in the sample?

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Prolegomena to a Discussion of Inflation, Asset Returns and Real Earnings

Many today are examining the impact that inflation has on asset prices. One of the best papers on the topic is by Harvey et al and it is well worth a look. What I am going to write here does not refute these sorts of analyses, but I think it raises issues that at least serve to lower our confidence in the findings.

The issues that I want to explore are as much methodological as they are empirical, but these two aspects can be approached simultaneously.

When analysing equity returns, the tendency is to examine what has happened in the past and extrapolate this into the future. There is nothing inherently wrong with this approach and it certainly gives us one window into the dynamics of asset markets, but sometimes it can prove misleading. This especially so when it comes to a very historically contigent phenomenon like inflation.

Take the well-known correlation between energy stock returns and CPI. Analysts often take this correlation to mean that energy stocks are an inflation hedge. In assuming this they are implicitly saying something like: “Inflation is a cause of relative energy stock outperformance.” As evidence of this, they show the correlation between these two phenomena in the historical data.

But now consider this: that series is dominated by a single inflation, the inflation of the 1970s. Yet this inflation itself was in large part caused by a run-up in energy prices as the OPEC countries hiked the oil price in response to the Yom-Kippur war in 1973. The more realistic causal account then runs something like this: OPEC raised oil prices for geopolitical reasons; this gave a boost to energy stocks; it also gave rise to inflation.

The correlation between inflation and energy stocks is thus spurious. It is driven by a third variable: the OPEC price hike. All this correlation tells us is that energy stocks will do well when energy prices are hiked. Not exactly a genius-level insight.

To get a better sense of the causal dynamics we should step back. In theory, how should inflation impact stocks? Presumeably it should impact them through its effects on real earnings. If inflation hits and real earnings remain buoyant then – not to put too fine a point on it – who cares? If stock prices fall during an inflation and earnings remain buoyant investors should see that as a buying opportunity and so inflations are merely a behavioural driver of bargain basement buying periods for smart investors. So, in order for inflation to have a true negative impact on equities it should be hitting the company’s bottom-line – otherwise it is just noise.

Here is real earnings annual growth for the S&P sorted into various inflation buckets using Shiller’s data.

Now we are starting to get a sense of how inflation actually impacts companies’ bottom lines. It appears that, at least historically, high and very low inflation regimes have overlapped with periods of low real earnings growth.

Let us pause here for a moment to firm this up because in this data there are two very different inflationary regimes as can be seen below.

Up until around 1925 CPI was incredibly unstable. This was the period of flex-prices in the US. After this, prices became much stickier. So, let’s also seperate out the more sticky price regime we live in today to make sure we’re not being fooled by structural breaks in the data.

The post-1925 era is a little different to the full sample. Very low inflation/deflation is now the worst possible regime for real earnings growth historically. CPI of 1-2% is now the sweet spot, but the full sample sweet spot of 2-5% is still pretty rosy.

At this point it would be tempting to tell a tidy story about inflation and real earnings growth. But remember that spurious correlation from earlier? Let’s tread carefully.

One simple test to see whether the various levels of inflation are causing the low real earnings growth is to run non-linear regressions. If the inflation is causing the low real earnings growth we should see that relationship clearly in a regression. Since the historical data suggests that high inflation (over 5%) and low inflation (under 1%) overlaps with low real earnings growth, we should be able to fit a second-order polynomial to the data and it should look like an upside-down smile. Crucially, however, this second-order polynomial should produce a high correlation coefficient. Here is the model fitted to the data – both full sample and post-1925.

The shape of the fitted curve looks good but the correlation, well, it sucks.

This implies – implies, not proves – that there is no hard and fast relationship between inflation and real earnings growth. Thus all the historical data tells us is that, in the data sample that we have, real earnings growth were lower in both low and high inflation periods. But it seems likely that something else could have been causing the low real earnings growth.

Take the example of low inflation growth for simplicity. Why would periods of low real earnings growth overlap with periods of low inflation – especially in the fixed-price regime post-1925? A little thinking and the answer becomes obvious: these are recessionary or depressionary periods. It is not the disinflation causing the low real earnings growth, it is probably the recession/depression.

Okay, so what should we learn from all this? Others will tell you what to invest in based on previous events. I will tell you to take these analsyses with a large pinch of salt. In reality, because inflation is such an historical and contingent phenomenon, at best we will need a much, much more sophisticated analysis to determine the actual effects of inflation on equities and on equities market. We will need to control for other factors, most notably fluctuations in GDP and we would probably do better focusing on the point at which inflation may impact the bottom-line of companies – not on simple correlations with asset returns.

A negative finding, yes. But a necessary one to stomach before moving forward if we are to approach this seriously.

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Why Lower Yield Treasuries Are More Attractive Than Higher Yield

In what follows, I want to draw out some implications of an interesting post by Greg Obenshain at Verdad Capital. In the post, Obenshain laid out data showing a number of things about Treasury bonds. Most notably, that they are a great investment if you are worried about the prospect of a recession or depression – and this is so no matter at what starting yield you are investing.

One of the exhibits Obenshain showed, however, did not get sufficient attention. I think that it may have something to tell us about how we can start to think about his findings in an actual investment context.

Let us frame the discussion in terms of a standard 60/40 portfolio. But let us ignore the 60 for the moment and focus on the 40. Typically, the 40 can be disaggregated into cash and bonds. Usually, we are talking 30 in bonds and 10 in cash – although there are no firm rules for this.

Okay, so how might we start thinking about deciding how to allocate to cash versus bonds. One way to do this might be to take a familiar model from monetary economics and merge it with a familiar model from financial economics.

Below we have two such models. On the left, is the liquidity preference (LP) model from Macro 101. The red LP curve shows that, at higher/lower rates of interest (i) lower/higher amounts of cash (M) will be held by investors. The intuition is simple: a higher interest rate means higher return on cash savings invested, and this means less cash held.

On the right, we have something resembling a CAPM model. I have simply called it the risk-return (RR) curve and it shows that, in theory, a higher yield – in this case, the interest rate (i) as we are dealing with bonds – should compensate for higher risk measured as volatility.

When we add the RR curve to the old liquidity preference model we get what the economists call an equilibrium outcome. What we find is that a decision-maker using such a model would balance their desire for the higher yielding asset with their aversion to the higher levels of volatility entailed.

Now, here is where it gets interesting. Obenshain shows that volatility is not actually an increasing function of the interest rate. Chart below.

Instead what we see is that the one-year forward change in yields is ‘contained’ up until the interest rate rises to around 9%. After this, the market becomes more volatile. We can modify our little model to capture this.

Here I have included two seperate boxes, A and B. In box A there is no risk-reward trade-off, while in box B there is. What this means is that when we are in box A – roughly below 9% nominal interest rates on a 10-year bond – our allocation to bonds is purely driven by our desire for yield. While in box B we have to also consider volatility.

What does all this mean in plain English? We must be clear that this all rests on the assumptions embedded in the model. But if we accept them, then it means that on a purely mechanical asset allocation basis, lower yield Treasuries (sub 9%) are actually more attractive than higher yield Treasuries (above 9%).

“No way!” you might say, “When markets and/or the economy get rocky having higher yielding Treasuries are a boon because their yields will fall further and provide higher returns.” But Obenshain’s data shows that this is not the case.

Below is a regression plot of Obenshain’s two samples. The regressions shows the relationship between the starting Treasury yield and the total return in the period. The blue series are NBER recessions, the orange are S&P500 drawdowns greater than 10%. (I have removed the extreme outlier in 1981-82 as it throws the regression off).

There you have it. On a purely empirical basis we should be ‘indifferent’ to the starting Treasury yield insofar as we are seeking protection against recessions or stock market drawdowns. Yet on a theoretical basis – assuming we do not like volatility – we should be more inclined to invest in lower-yielding, sub-9% Treasuries.

It can therefore be said that it is, on balance, better to invest in lower-yielding than higher-yielding Treasury bonds. Pretty counterintuitive.

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New Review of My Book

A nice review of my book by Marc Morgan has appeared in American Affairs. Morgan works with Thomas Piketty at the World Inequality Lab at the Paris School of Economics. He is doing interesting work on profit accounting and determination.

I would also note that Morgan attended the same secondary school (high school) as me in Dublin. Apparently, Christian Brothers College, Monkstown — although not a very prominent school in any meaningful sense — is creating a lot of heterodox economists. Or, perhaps, the children of my generation found the free market nostrums they were handed by the pre-2008 politicians so nauseating that they decided to critically study economics. Who knows?

Morgan’s review is excellent and although I could pick over details, I won’t bother. I will note one thing, however. Morgan’s review is extremely extensive but, when it comes to the theoretical architecture I lay out in the book, seems to focus heavily on profits and distribution. This probably reflects Morgan’s own research priorities and there is nothing wrong with that.

That said, however, I thought that this section of the book — while important — was almost wholly derivative and widely known by people well read in heterodox and especially Kaleckian economics. Perhaps my explanation was more lucid — I should be happy if it were — but it was not any more original.

The section of the book on finance and investment, on the other hand, I thought was the most original part of the theoretical section of the book. While there is a case to be made that the theory of finance is not wholly original, resting as it does on modern finance theory, Keynes’ theory and GLS Shackle’s theory, I nevertheless think that it is an oirginal synthesis.

In spite of this, no one has yet assessed it in any detail.

Anyway, the review is fantastic and I recommend it to all.

The Reformation in Economics: Back to the Future


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How Far Can We Push This Thing? Some Optimistic Reflections on the Potential For Economic Experimentation

Readers are probably aware that there is quite a lot of discussion of Modern Monetary Theory (MMT) and the potential for fiscal experimentation batting around at the moment. Others have weighed in on this already, and I have little to add.

It is striking, however, that most of the push-back — where there is push-back — is not focused on trying to discredit the idea that we should engage in fiscal experimentation. Indeed, the notion that we should engage in fiscal experimentation seems to be, if not mainstream, at the very least part of the discussion.

Yet, vulgar strawman-style arguments against MMT aside, no one seriously disputes the fact that if too much fiscal expansion is undertaken the economy will eventually hit a hard inflation barrier, past which any increase in spending will generate inflation rather than real output expansion. Interestingly, no one seems to have tried to come up with a new framework for estimating where this inflation barrier might be and whether it is too risky to overshoot it.

So, I’ve decided to fill that gap. Linked below is a paper where I use a new capacity utilisation-based framework to provide hard, yet optimistic numbers of how far we might push the economy in the spirit of fiscal experimentation.

I find that we could probably safely increase the current US fiscal deficit by around 5% of GDP structurally — that is, from the current level of around 3.8% of GDP to around 8.8%. This would give rise to annual real GDP growth of around 6% and a once-off shot of inflation that would drive the annual growth in CPI to around 4.9%. As I say in the paper, this would then lower the private debt-to-GDP ratio from around 200% of GDP to around 190% in the first year and this decline would continue every year that the new 5% rate of inflation was maintained.

I argue that, based on a new framework I’ve developed for measuring the likelihood of sustained, runaway inflation that I call the Worker Bargaining Index (WBI), it is highly unlikely that a sustained inflation will result.

That said, after undertaking such an experiment, we would be wise to watch whether sustained, overly high nominal wage growth results and if so take action. Given the current institutional arrangement, tight monetary policy would probably be the best response but it would also be possible to tighten the fiscal stance.

So long as nominal wage growth merely kept pace with the new 4.9% rate of inflation and did not greatly outstrip it, the economy will certainly be safe from a wage-price spiral. We probably want to see some real wage growth, however. At the very least we should want to see real wage growth keeping pace with productivity growth. And given the redistribution from labour to capital in the past few decades, we may want to even see real wages outpace productivity growth, for a few years at least.

It should only be if there is clear evidence that wage growth is getting out of control that we should consider slamming on the brakes. If we start to see wage and inflation growth feed upon each other that should be our signal to act.

Here is a link to the paper:

How Far Can We Push This Thing?

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Some Reviews of My Book

I have come across two academic reviews of my book which can be found here and here. There is also a nice popular review in the Irish Times that can be found here.

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2017 Presentation on Ireland

My 2017 presentation on Ireland and the Eurozone has been uploaded to YouTube. See the previous post for the link to the full conference, which includes the Q&A.

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