Interest Rates Explained: Why are stocks going down? Is it too early to buy?

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Elon Musk Smoking Joe Rogan's Weed Somehow Ended Up Costing Taxpayers $5  Million

So… Tech stocks are dropping.

The former poster boy of the tech rally Tesla, is now down 30% from its Feb highs.

I saw a question in the Facebook Group:

And again from a FH Reader:

Curious. These few days. Tech sell offs. What’s your plan vis a vis tech stocks, buying more or wait and see?

So I wanted to share my views with all of you. Hopefully, it would help with your investment thinking.

All this is in line with the framework in my article 2 weeks ago. So if you want the background, do check it out.

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Why are interest rates going up – Doesn’t the Fed peg it at zero?

Short answer – The Feds control the Federal Funds Rate, which is:

Federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight.

So Feds only control short term interest rates that banks use to borrow overnight.

Longer term interest rates are set by US Treasuries.

US Treasuries are traded on the open market, so their prices (and yield) are determined by supply demand.

The Feds can influence it by buying Treasuries, and they have been buying at $120 billion a month (Quantitative Easing).

But in recent months, supply is greater than demand.

Supply goes up because the US government has to issue more treasuries to fund all the stimulus.

Demand from the Feds is constant at $120 billion a month – they didn’t increase the pace of buying.

Which means the buyer at the margin is the private sector. But private sector sees all that stimulus coming and bonds at 1.0% don’t look super attractive. So demand from private sector drops as well.

Bond yields are inverse to prices.

So when price of Treasuries fall, the yields (interest rates) go up.

What is going on with yields?

There are 3 things you need to look at with yields:

  • Absolute level
  • Nature of move
  • Speed of move

Absolute Level

The US 10-year Treasury is at 1.57% now.

That may not seem like a lot, but don’t forget we were at 0.5% in Aug last year. So that’s a TRIPLING in the most important interest rate in the whole world, in 6 months.

And don’t forget that the yield on the S&P500 is 1.5%, so at current levels the 10-year treasury yields more than the S&P500, completely risk free.

Things like that may not matter to you, but they matter to guys like GIC and Pension Funds who are throwing around hundreds of billions.

Nature of move

This part’s a bit technical. But it’s really important to understand, so bear with me.

Nominal interest rates are broken up into 2 components:

  • Interest Rates (expected investor return)
  • Expected inflation

Think about it this way – imagine you’re GIC and you need to achieve a 3% inflation adjusted return.

So if inflation is at 1.5%, you need to get 4.5% nominal return on your bonds to achieve this goal.

So when interest rates go up, we need to know whether it is due to (1) rise in the expected return that investors are asking for, or (2) rise in expected inflation.

This is where breakevens come in.

There are inflation indexed Treasuries – Treasury Inflation-Protected Securities (TIPS). By looking at the price of TIPS, we can work backwards to figure out what level of inflation the market is pricing in.

From Jan 2021 to today, inflation expectations have barely gone up, only about 0.2%

But interest rates have gone up 0.5%.

What does this mean?

What this means, is:

Interest rates are going up because investors demand a higher return, not because they expect more inflation.

Or more simply – Real rates (inflation adjusted) are going up.

This is super important, and will affect the rest of this entire discussion.

A lot of people confuse a rise in nominal rates with a rise in real rates. Don’t make the same mistake – each has a very different implication on markets.

Speed 

In Aug 2020, just 7 months ago, the US 10 year was at 0.5%.

In Jan 2021, 2 months ago, the US 10 year was at 1.0%.

So we’ve tripled the US 10 year in 7 months, and a 50% increase in 2 months.

In the most important interest rate in the whole world.

This has created a lot of unwinding in other asset classes.

So far it’s been quite orderly, but that may change in time.

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Why are stocks going down?

For those familiar with discounted cash flow (DCF) – what is the risk-free rate that you use in a DCF calculation?

The US 10-year Treasury.

So what happens when the 10 year yield triples in the span of 7 months?

Answer – valuations that look good 7 months ago, suddenly look very pricey.

This is particularly pronounced in long duration assets – things with cash flow that are very far away in the future.

Time Value of Money

For the old school folks, think of this as the time value of money.

With interest rate at 0%, a dollar 10 years from now is worth the same as a dollar today.

When interest rates go up to 1.5%, a dollar today is worth much more than a dollar 10 years from now. Because of the time value of money.

So when interest rates go up, companies with a lot of future earnings do poorly. And companies with a lot of earnings today do better.

So which is the industry with most of its earnings that are very far away?

Absolutely right – tech stonks.

So Tech stocks are taking an absolute beating right now. The more hypey the stock, and the further out the earnings, the bigger the hit.

The other asset class super sensitive to real rates is gold – which is why we see gold taking a huge tumble.

Fixed income proxies like utilities and REITs as well. Which is why we’re seeing underperformance there.

Why are the Feds not stepping in?

I find it crazy that people think the Feds will step in now.

Cmon guys, the S&P500 is down what, 100 points from all time highs?

I said this last week, and I will say it again.

Feds will not come in so quick. 

Don’t count on the Feds saving the day so soon.

The Feds will only come in if there is Systemic Risk.

If March 2020 happens and credit spreads blow out, the Feds will step in.

But if Tech stonks are down 20-30%, and the move is limited to momentum names without broader contagion, no way in hell.

Removing the froth in the market is exactly what the Feds want, and so far they’re achieving it without having to touch interest rates – which is just an amazing job from Powell.

When will the Feds step in?

The million dollar question then – When do the Feds come in.

In my article 2 weeks back, I split this up into 2 phases:

  • Phase 1 – Yields go up
  • Phase 2 – Yield Curve Control

In Phase 1, yields continue to go up, together with expectations for economic growth. This is actually good for stocks, leaving out the frothy momentum names.

Cyclicals like banks and energy will do well.

But at some point in time, the rising yields will affect stocks because the market just cannot take higher interest rates anymore.

My reasoning is set out in the original article, but broadly:

  1. Stock valuations are very high for the start of a new cycle
  2. The stock market is very tilted towards growth stocks
  3. Global debt levels are crazy high (and long duration)

And I think eventually, Powell will be forced to implement yield curve control by bringing the long end rates down.

And once that happens, we transition to Phase 2.

When do I see this happening?

Gun to my head, I think a 3 to 6 months timeframe. Probably before the year is over.

But things need to really blow up before the Feds step in. Think systemic risk, with bonds, gold, stocks, FX selling off all at the same time.

A sell-off in some meme stocks is not going to cut it.

What to buy in each Phase?

I wrote a detailed article for Patrons this week on what does well in each phase, so do check that out if you’re keen.

Broadly:

Phase 1 – What does well is cyclicals like banks, energy, commodities. Tech should do ok too if you leave out the frothy momentum names. But anything that is sensitive to real rates will suffer – gold, fixed income, bond proxies (eg. utilities), REITs.

Phase 2 – What does well is risk assets generally, commodities, tech, REITs, Gold, BTC, silver etc. Fixed income does well during the transition phase, but after that probably not. Cash definitely suffers. Banks are tricky – because it depends on how economic growth does (do we see stagflation?).

Is this a buying opportunity?

I think the 2021 market is going to be incredibly hard to play.

Much harder than the 2020 one – which was really just waiting for the Feds to step in and buying the dip.

I think in Phase 1, we’re going to see vicious rallies and drops, that will trap bulls and bears alike. It’s just going to be very choppy.

And then we have some kind of massive event in markets.

And then Powell finally steps in to save the day.

So how to invest in this market, really depends on your risk appetite.

Do you want to buy now and average in all the way? Do you want to try your hand at timing the collapse? Do you want to hedge via options?

Many ways to make money.

But what I will say is that I think passive investing is dead. Don’t approach investing the same way it was done the past 40 years.

The 1980s to today was a 40 year bull market in bonds.

Just look at the chart below. Sure, there are rate hikes during this 40 year period, but the broader trend is down.

So in the past 40 years, you just buy stocks and you buy bonds, and you passive index, and you retire.

But going forward – all that changes.

We’re going to be in an environment where interest rates are going up and inflation expectations are going up.

Very few people today have experience investing in such a market.

The closest period historically was the post-WWII period.

But this isn’t exactly the same, because we now have the internet, and we have technology, and we have rampant option trading.

Start thinking from first principles, and don’t get carried away by mainstream media narratives.

Am I buying tech?

As shared 2 weeks ago – I’ve been doing a lot of rebalancing recently.

I sold some gold, I sold my US banks, I sold deadweights like Comfort and Singtel, I sold bond proxies like Netlink Trust. I also sold REITs that I didn’t want to hold long term.

I didn’t want to go to cash entirely, so I rotated into long term positions I wanted to hold in tech, real estate and commodities. You can check out my portfolio moves and names I’m keen to buy on Patreon.

But again, I just think 2021 is going to be a very tricky market.

I would say understand your risk-reward, and control your risk.

Don’t FOMO either way in this market. And don’t leverage.

If there is big weakness like yesterday, I may add to positions. But if we see big strength in the coming weeks, I may look to close some positions.

I think the real mega event for markets will only come later in the year, and until then it’s just about playing it out.

As the saying goes – Bears make money. Bulls make money. Pigs get slaughtered.

Don’t be a pig. Don’t get carried away in this market.

Closing Thoughts: ARK is becoming a problem

It’s been a monster of an article, and I know it’s a lot to digest.

I’m still working through all this information myself, so I would love to hear from you guys.

Whether you agree or disagree – share views below, and we can have a constructive discussion on how to make money in this market.

But one point I wanted to leave you with, is that Cathie Wood’s ARK is becoming a real problem.

The liquidity issue is covered by some other commentators, but basically ARK’s trades are copied by Nikko and Sumitomo. And because of how big ARK grew the past 12 months, it’s getting to a point where ARK now holds significant stakes in very illiquid stocks.

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You can see in the chart above – combined positions exceed 25% for some of these names.

And these are small caps with $2-3 billion market cap. Very little liquidity – more than 20 days to sell in some of them.

Don’t forget ARK is an ETF not a hedge fund, they cannot hold cash positions. So if investors sell out of the ETF, Cathie Wood needs to sell the underlying stocks to raise funds.

And as an ETF – Cathie needs to disclose these positions publicly.

If things go bad, other hedge funds are going to front run Cathie Wood by shorting these names, and with the kind of liquidity in play Cathie Wood is going to be in a world of pain.

And the icing on the cake – Tesla is the single largest holding for ARK. Who now has taken a big position in Bitcoin.

This works very well on the upside, but if things start to go the other way, it could blow up very fast.

Love to hear from you below!

As always, this article is written on 6 March 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patron.


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27 COMMENTS

  1. A lot of people confuse a rise in nominal rates with a rise in real rates. Don’t make the same mistake – each has a very different implication on markets.

    Hi FH,

    Can I clarify what the different implications on markets are?
    1) rise in nominal rates (implies increasing inflation)
    2) rise in real rates (implies a demand for higher returns)

    • Really good question, I think the key is that in the rising inflation expectations scenario, you need to hedge against inflation as well.

      And the rate of inflation matters.

      At really high inflation levels, equities will underperform, only hard assets like real estate, gold, commodities continue to do well. And some of these like real estate / gold, don’t do well in a rising real rate scenario.

      Hence it’s important to know the difference between which regime we’re going to see, because it impacts asset allocation.

      Inflation is like alcohol. A bit of it is good and healthy. Too much of it is really bad for the system.

  2. Good analysis. Your article attributed the increase in nominal interest rates recently to an increase in investors’ expectations of returns and not so much on inflation. Fair enough. Be it as it may, why do you think investors are expecting higher returns on their bonds? Is it because the risk for them has gradually increase? Why has risk increased then when global economy is returning to more healthy level compared to last year? Love to get your comments.

    • I think the simple answer – investors expect higher economic growth going forward. With higher economic growth, the same amount of money in stocks / real estate / commodities will achieve a higher return.

      Hence for investors to park their money in bonds, they need a higher real return.

      Going to be really tough for Feds to respond to this one. It’s a true paradigm shift. Past 40 years the Feds can cut rates and investors respect that. Next 10 years Feds ability to cut is going to be impaired due to inflation.

      So for the first time ever, markets are starting to rebel against central bank control.

  3. Id like to counter the TIPS comparison and say that investors are pricing in long term inflation. Since CPI data is not forward looking, I dont think TIPS is pricing in what will be happening(correct me if wrong). I think rising oil and food price will eventually reflect in CPI. So assuming fed is OK with 3% inflation for 2021 you need more than 3% asset return, which is why bond selloff resulting in stock selloff. Just a rough assumption I have. And taking into account OPEC not increasing production and cap on shale expansion, and also food shortage from the locust swarm and COVID in 2020 its going to be a very rough year. Perhaps holding TIPS for for short term is a viable option based on my frame of thinking, but who knows?

    • Great point Little Monkey. I considered raising this in the article but it’s pretty technical, so I’m very glad you brought it up.

      I think another concern is that the Feds are buying TIPS, so it’s possible this has distorted TIPS as a price signal. Personal view is that we still need to respect what TIPS are telling us though, it would be hubris to think otherwise.

      But I could be wrong. I think the other big question is whether economic growth holds up in 2022 onwards.

      Europe/Japan did a decade of free money and that didn’t work out so well, is this time going to be different. I think there is a small possibility of a stagflation style scenario, but way too early to make that call.

    • On the CPI data – if Investors expect 3% inflation in 2022, would they not frontrun it today? But this ties back to the Fed buying TIPS point.

  4. regarding the ARK ETFs, the only one I am genuinely sizing up is ARKF. two reasons: (1) it doesn’t hold tesla, which i am mildly bearish on even in the longer term, and (2) ARKF’s top holdings are mainly mid-to-large caps which have plenty of liquidity and aren’t likely to get squeezed in the way that say ARKG is.

    however, I do wonder if ARK’s woes at large might affect the long term sustainability of all its ETF offerings, ARKF included. not sure if anyone has further thoughts on this one.

    • Very interesting point. I haven’t looked closely at ARKF so can’t comment.

      I don’t think ARK is definitely going to crash, just highlighting there are risks associated with it due to it’s widespread popularity and illiquidity. If things turn south and hedge funds want to short the meme stocks, a good shortcut is to just short ARK and engineer a blowup in some of the underlyings.

      When you’re this big, you become a target for everyone, and the ETF structure ARK uses constraints her options in a way.

  5. Hi FH,

    Great analysis as usual. Just my two cents below.

    The challenge everyone is facing is that the actions of the Fed have removed regular price discovery in the market. So no one knows how to value something anymore. In a normal situation, stock markets should have tanked last year but are instead at record highs because of Fed intervention. What you have written is sensible but it is reliant on predicting how the Feds will behave, in other words, how they will distort market pricing through their actions.

    As a result, we are seeing many things in the market contrary to conventional wisdom. For example,
    – gold is supposed to be a hedge against inflation. Yet, with inflation expectations rising, it is falling.
    – a computer program generated token is given value in the tens of thousands, its value supported only by the belief of those who buy it. (not that different from fiat currency today though)
    – it used to be said that a bad day in stocks was a bad year in bonds in terms of % decline. Yet, “safe” investments like US treasuries e.g. TLT have fallen 20% in the last 6 months, 15% in the last month alone.
    – Tesla was at one point valued higher than all the oil majors combined

    I bought into banks and oil about 6-9 months ago so that has worked out well but in this situation I am thinking seriously about going back to first principles. REITs I keep for income as rents will vary based on inflation anyway and in the long-term, so will the value of the underlying assets so short term fluctuations don’t really matter. Beyond this, it is back to asset allocation principles and since we don’t know what will happen in this crazy world, the Ray Dalio All Weather portfolio approach is looking more attractive to me now.

    6 months ago, I was a lot more unsure about the All weather portfolio approach for the long term because bonds were so expensive which such low yields that further upside from bonds in times of turbulence would be limited so protection would be limited. Gold was also very high so it faced the same challenge. However, with bond and gold prices coming down so dramatically, if they fall another 20-30%, they reach a level where I think the protection from turbulence element becomes substantial again. At this point, there is a good chance I will start to build an All Weather portfolio.

    The All Weather portfolio has achieved near equity level returns with a max. drawdown of only 11% over 30 years which is a fantastic risk-return profile. So in this, I don’t quite agree with you that passive investing is dead. I think it is still very relevant, perhaps more so in this world where central banks seem to have lost their reticent to print money and take on debt.

    • Great comment CMC, lots of fantastic points. I don’t disagree with you.

      Some views:

      1. Gold is sensitive to real rates. With real rates going up, gold is falling so actually it’s doing its job. If we see mid term inflation (and I think we will), gold will make a comeback.

      2. You’re right and a lot of asset allocators are calling for an all weather style portfolio too. Split between bonds, gold, commodities, equities, and do well in all situations.

      3. When I meant passive investing, I meant more of the 60/40 style portfolios or a pure S&P500 strategy. All weather is a more nuanced portfolio that will never go out of fashion, it just doesn’t do very well in any scenario. That said I can see many “passive” style portfolios built using ETFs that will do very well going forward, the question is whether such tilts are truly passive or are they active.

      4. Interesting point on “central banks seem to have lost their reticent to print money and take on debt”. I think this is a true paradigm shift from what we’re used to. Past 40 years – anything goes wrong CBs just cut rates and problems go away. That’s because inflation was not a problem. Going forward, inflation is the constraining factor, and ability of CB to raise/keep rates low is going to be constrained by inflation fears.

      That’s just a paradigm shift for me. I think central banks will lose their omnipotence, and markets are starting to wake up to that fact. Bond markets see inflation coming, and they’re making the call that Powell will be forced to do something about it in time, whether he likes it or not.

  6. I don’t think you have a good understanding how ETFs work. Unlike an open ended mutual fund, Ark does not need to sell positions to raise cash – there are specific agents in the market that play this role but under no scenario will they need to force sell positions.

    The advice on “passive investing is dead” is poor too – please do not encourage unnecessary market timing

    • I’m not sure if I agree with this one. What happens if a wave of redemptions hits the ETF? Without a cash position, they will need to sell stocks. Haven’t looked at the fund docs so perhaps they can gate redemptions when that happens, but that would only make things worse. So options are (1) sell pro rata, (2) sell the liquid names like FAANG, (3) sell a custom basket.

      They did an interview with the COO where he runs through the options, it was pretty well done – https://www.etftrends.com/ark-coo-tom-staudt-deep-dive-on-liquidity/

      On market timing – I think the point I’m trying to drive is that the next 10 years is going to be very different from the past 40 years. A rising inflation rising yields environment is a paradigm shift from what investors today are used to – which is a secular bull market in bonds. Hence the call to start from first principles here. Don’t just buy a 60/40 and expect it to hit the same returns we saw in the past.

  7. Catherine Wood from ARK Invest explains that she only needs to do investment decisions and has no issues with liquidity during large fund inflows and outflows for the ETFs.

    • To be fair, I can’t imagine her saying anything else.

      Anyway – the ARK point is intended more as an FYI. I don’t think it’s guaranteed to blow up, it’s just to highlight the possibility.

  8. No, no, no, no, no. That is the wrong understanding – even the link which you sent tried to explain the differences between ETFs and MUTUAL FUNDS.

    ARK is an active ETF – when investors sells the ETFs, they don’t get their cash from ARK, they get them from investors who want to buy the ETFs. As a result, the prices of the ETFs could deviate from the NAV of the underlying holdings – this is where the Authorised Participants (APs) steps in, they are essentially market makers who seek to earn arbitrage profits from this deviation between the price of the ETF and that of its underlying holdings.

    However, APs are not obliged to close this price deviation particularly in a stressed and illiquid market – we saw this back in March 2020 for Bond ETFs.

    Of course future returns is going to be lower than past returns – but advocating against passive investing cos of that is simply unwise.

    • Let’s say I’m an insti holding more than 50,000 units. If market price is significantly below NAV, can I go to ARK’s trustee/fund manager and ask for them to redeem the stake?

      Haven’t checked ARK’s fund docs so I legit don’t know the answer here, but that’s common practice for most other ETFs.

      Great discussion btw – that’s what I’m here for. Really enjoying the discourse on this article!

  9. I don’t think long term inflation is a done deal. Sure the pent up demand + supply chain issues + Big Bang stimulus + base effects will all combine to create a perfect storm this year.

    But the structural forces (demographics + technology + less bargaining power for labor) that have been weighing on inflation over the last decade are still there and didn’t just disappear over night. So over the medium to longer term, I do still think we are living in a disinflationary world.

    • I completely agree. Even the TIPS market seems to agree with this as they’re not pricing in inflation.

      Of course, one can argue that TIPS is no longer a good price signal because of Fed buying, but not sure if I agree with this one.

      But yes, I do agree that it’s not a done deal that all the stimulus is going to create lasting inflation. If it doesn’t though, the world is going to have really big problems ahead of it.

  10. On ARK, Cathie Wood recently did an interview where she discussed ARK’s holdings in the context of the recent rising interest rates. She somewhat unwittingly conceded that ARK fund holdings are prime candidates for a valuation reset if rates stay/continue to rise (unsurprising given no free cash flow or even revenue anytime soon). The firm’s strategy is also to prune lower-conviction holdings and redeploy cash into higher conviction holdings if such a valuation reset were to happen.

    Some of these smaller companies which ARK is a big investor in are potentially in for a big bloodbath.

    • I think I saw this interview as well – and the part where they sell FAANG to redeploy into the small cap names is slightly concerning.

      Because of their status as posterboy of the momentum stocks now, if things start to reverse, they could be a prime target on the way down.

      Again, not saying it definitely plays out, just something worth monitoring in the months ahead.

  11. Good article, what are your outlook on semi cons industry ? ( Eg. Vaneck Semicon ETF) Would they be a beneficiary or victim of rising bond yields ?

    • I would say short term if tech gets hit it will not do too great. But mid to long term, very bullish, and I’ve been using this sell-off to add to semicon stocks. I stock pick though, I don’t ETF for semicon. 🙂

  12. Hi FH,

    Interest Rates Explained: Why are stocks going down? Is it too early to buy?

    Thank you for the article, good information as always.
    As you get more famous, more ppl will target you as well, it is normal and in a way recognition of your success. Keep it up, rooting for you.

    During 2017 to 2019 where the Fed started to increase interest rates, Reits prices were doing well.
    Inflation stays low during this period though.
    Economy growth was decent during this period as well.
    Reits were able to offset the increase cost from their debts by increasing the rental prices.
    If there is decent economy growth, then an increase in the interest rate is actually more positive than negative for Reits?

    Powell had repeatedly mentioned that the Fed is not keen to increase interest rate in the short term.
    While the 10 years treasury yield had increased to 1.64%, , I noticed that Reits’ prices are slowly creeping up or are stable during this period.

    Moving forward, let’s assume that higher inflation is a done deal and combined with strong economy recovery, wouldn’t it be positive for Reits since they can stop reducing the rental price or even start to increase them slightly?

    Pls correct me if i am wrong and would love to hear your thoughts, thank you.

    • Thanks for the support bqwire, really appreciate it.

      I get your point – great question.

      REITs are very sensitive to 2 things – Inflation + Interest Rates. Inflation is good for REITs, but inflationary regimes tend to come with high interest rates, and high interest rates are very bad for REITs. So there’s a bit of nuance here in how the inflation translates to interest rate increases.

      My personal view – I’m not sure if inflation is here to stay. I think we get a burst of inflation in 2021 because of all the stimulus, but 2022 is a big question mark to me.

      If there is no/low inflation in 2022, then interest rates stay low, and that’s good for REITs. If there is small inflation in 2022, then interest rates stay low too, again good for REITs. If there is high inflation in 2022, Feds are forced to hike, which would be bad for REITs.

      So there’s quite a broad spectrum of possibilities here, and I think it’s on the early side to make the call.

      Personally though, I like the risk-reward of REITs (mainly Industrial). I will use the rising yield environment in the coming months to add.

      Just shared an article with Patrons on this the past week if you’re keen – broadly similar to what I share above. 🙂

    • And to answer your question – If there is economic growh + inflation (ie. the good kind), then it really depends on how high an inflation we see.

      I think anything below 2.5% is ok. But if it starts to go higher than 2.5%, we could be in trouble and that may accelerate the pace of hikes (ie. bad for REITs).

      It’s funny because in the 1980s inflation went to double digits. But the world today is juiced up on too much debt and growth stocks, and I think inflation even in the 3% range (sustained) will blow everything up.

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