Pondering the Future of the Two Percent

The first half of 2022 is better consigned to the archives for most participants in the financial markets. The ebullience of recovery from Covid produced some startling results in 2021, not only in stocks but in many markets. That turned to caution or, in some cases, outright fear in 2022. The reason was, of course, central banks, led by the Federal reserve, who realized that they were sleepwalking on the subject of inflation. With the zeal of the converted they revised their plan and declared war on inflation, which at the recent reading on the Consumer Price Index was over 8%. The Fed’s target is 2%, and they promised the most aggressive tightening of monetary policy in almost three decades. That prospect ended the party in the financial markets. By June the S&P 500 Index was down 20% and smaller stocks were down more.

This was justice for skeptical observers who watched the recovery from the previous Covid contraction turn into a roaring bout of speculation that equaled, or exceeded, the dotcom boom and bust of 20 years ago. We can see this in graphical form in the performance of the cyclically-adjusted price/earnings ratio, popularized by Professor Robert Shiller of Yale and shown in Chart 1:

Graph showing the price/earnings ratio

Data source: Robert Shiller website

If we include speculation in additional assets such as cryptocurrencies, the latest episode may well be the greatest ever.

It is also apparent from the chart that what follows the peaks is a hangover, in which prices and valuations decline. So how should we prepare?

Antii Ilmanen is a principal at AQR Capital Management, and has been studying this question. His first book on the subject was in 2011, and recently published his second, Investing Amid Low Expected Returns, in 2021. It begins with a dose of cold water:

Savers and investors have enjoyed benign tailwinds for many decades, but the question now is between headwinds and no winds. Low expected returns for most assets will make it hard for pension savers around the world to reach their retirement goals and for many institutions to reach their spending goals. It may seem trifling to worry about cooling investment conditions at a time of global warming and pandemics, yet this counts as one of the most important generational challenges we face.

Reorganizing the data in Chart 1 makes clear the problem of expected future returns. We can use the same data to calculate the earnings yield, which is simply the reciprocal of the price/earnings ratio. It is the return that an investor can expect from the asset based upon the relationship of the earnings per share divided by its price (Chart 2):

Graph showing the earnings yield

Data source: Robert Shiller website

The returns offered have only been lower at the price peak in 2000, and you may recall what happened then—the dotcom boom turned to bust.

It would be less troublesome if, as in recent years, lower equity returns were balanced by bonds performing relatively well. This attenuated the damage to a typical 60/40 mix of stocks and bonds. But the returns available from bonds became perhaps even more derisory than that from stocks—that is, until recently:

Graph showing the 10-year Treasury yields

Data source: Robert Shiller website

The sudden reversal at the lower right in Chart 3 appears to be a break in the persistent decline in bond yields over decades. But it is part of a broader development. To quote Ilmanen:

This is not only a world of low bond yields. Virtually all long-only assets appear expensive compared to their own histories. The price of any asset is the sum of the market’s expectation of future cash flows discounted to their present value. The common element is discount rates—the riskless rate—is near (an) all-time low. Thus, equities and illiquid assets too appear to have expected returns near record lows; these are just not as visible as they are for bonds.

Addressing the conventional 60/40 mix, or other similar portfolios:

The diversification argument remains strong as long as one believes that government bond yields can fall further in those crucial equity bear market scenarios when the safe-haven service is most valuable. That said, a rising inflation scenario would certainly hurt bonds and if this were to trigger rising real yields on riskier assets, the safe-haven service also would be in doubt.

Investing Amid Low Expected Returns was, according to the author, sent to the publisher in October, 2021. In this Ilmanen may have detected signs of accelerating inflation, which of course is now the topic of the day. On the question of what to do, his conclusion is not novel. It is essentially to ride it out. He eschews the common answer of raising cash on the observation that the general record of investors doing so is poor. His principal recommendation is a high level of diversification on the principle that such an approach is empirically the best defense; he even favors the use of leverage to do so. The skeptic might observe that had one followed that suggestion, the recent decline in multiple asset classes would have left him or her a bit glum.

It is therefore useful to consider how much worse it can become if the Federal Reserve follows through with their plans to tighten policy further for months to come. The Leuthold Group studied past declines in stocks to quantify the damage. Using six valuation measures they calculated expected declines yet to come if equities were to decline by the same percentages as occurred in two past historical episodes (note1). The results from the end of June, 2022 are summarized in Table 1 (Leuthold numbers through May adjusted to include June):

Past cycles are indicative, but not prescriptive. A healthy level of caution is implied in any such analysis. The only certainty is that the Fed’s hiking cycle will end one day. How long it takes, and the circumstances that end it, is the question. Their recent declarations of intent are the firmest they have been in many years.

But unintended consequences of central bank actions follow. The more vigor they employ, the greater the chance that something goes wrong—such as distress of levered borrowers. There are plenty of those in the financial system. Urgency always elbows importance aside, and in such events the Fed, and other central banks, stop tightening and soon after cut interest rates.

The question is then the level of inflation at the time. But if the Fed stops tightening sooner than they might now expect, inflation would remain at a level in excess of their target of two percent. While that might seem abhorrent to inflation hawks, it would in fact have a silver lining. The inflation of the 1970s reduced the debt to GDP ratio, which had risen significantly in the financing of World War II. It could have the same effect a second time. The Fed already loosened their calculation of the target from a cap to an average in response to the Covid pandemic. While they might not abandon the number explicitly, if it proves difficult to get inflation back to their target, they could relax their policies to tacitly allow higher levels to persist. Two percent inflation could be headed for the history books.


  1. Leuthold Group, Green Book Summary, June 2022. The valuation measures used are price/earnings ratio on operating EPS/ p/e ratio on “adjusted EPS”, ROE-based P/E, price to cash flow, dividend yield and price to book ratio.


Ilmanen, A. 2022, Investing Amid Low Expected Returns, Wiley.

Leuthold Group, Green Book Summary, June 2022.

John R. Gilbert

John is a Senior Research Consultant whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.

In addition, he writes investment commentary, which is published on our website.

John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.

John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.


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