The bond market sided with the Fed perceiving inflation to be transitory, but even as the Fed has terminated this language and said inflation is more deep rooted and persistent than initially thought, the bond market keep predicting inflation to remain low. This is based on the high debt-to-income levels in many parts of the world, ageing populations, and technology advancements all supressing inflationary forces longer term. The stubbornly low nominal yields while realized and expected inflation are rising have caused a massive downward pressure on real yields, which sets in motion a sizeable reallocation into equities.
Why would you invest in bonds when your capital is being destroyed in real terms? You might as well swing for equities despite historically high prices and valuation because maybe you can at least defend capital against the corrosive inflation. In other words, TINA (there is no alternative) is still very much alive in financial markets as 2022 approaches, because as John Maynard Keynes and Warren Buffett both have observed but in different context, inflation is the enemy of the capitalistic economy and investors.
Profit bonanza driven by record stimulus
While low nominal yields have played their part in the equity rally this year through their impact on the cost of capital which is used for discounting future free cash flows, investors should not ignore the fact that earnings in the MSCI World Index are up 104% for the first three quarters of 2021 compared to the same period of 2020. For those who think that this is just the rebound effect should note that earnings in the first three quarters of 2021 are up 28% compared to the same period of 2019. In other words, the earnings power of companies coming out of the pandemic has been extraordinary and driven by the enormous loose monetary and fiscal stimulus operating on a combined level not seen since the post WWII years. The deficits across many of the world’s largest economies have created a corresponding surge in private sector surplus.