The seat ties it all together
The second episode continues our discussion of our “Three-Legged Stool” market model. A three-legged stool will provide a very stable platform when all three legs are strong and supporting the seat. However, if one of the legs begins to become unstable, that can result in a loss of stability for the entire structure. In this episode, we are going to look at the seat, which is interest rates and inflation.
The key points in this episode:
- The seat of the stool itself is interest rates and inflation. These are sort of basic building blocks that we use to look at what the market is doing and may be doing in the future.
- These fundamental factors affect what various asset classes are theoretically worth (leg one). They are indicators as to how the economy may be doing in the future (leg two) and they can create market stress (leg three).
- Market expectations for real return (real interest rates) plus inflation are the primary components of risk-free rate.
- The functional (as opposed to theoretical) risk-free rate is market-derived (i.e., driven by how much people will pay and expect to be paid for U.S. government bonds).
- This risk-free rate is a primary comparison point in determining whether we are getting a good expected return on our investments in the other asset classes.
- It is also a good indicator of the market expectation for how the economy is going to grow in both absolute number terms and in terms of real, or inflation-adjusted, terms.
- While markets can certainly be off in terms of their predictive power, they do give us a consensus view on the most probable future, given what we know at the moment.
- So when we see large or rapid or unexpected changes in any of the interest rate components (inflation being a major component), it can produce significant dislocations in almost all asset classes as the market (comprised of market participants like all of us) goes back and tries to digest the impact of these changes (and that certainly can produce increases in indicators of market stress).
We hope you enjoy this video and future episodes to come. As always, please don’t hesitate to reach out with any questions or concerns.