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Dear Stock Bulls: Don’t Fear The Inflation Monster

Will rising inflation weigh on equity prices via higher nominal interest rates?

Spoiler alert: Probably not, because that question assumes i) inflation actually rises, and ii) nominals manage to move materially higher. Neither of those assumptions seem particularly likely at a time when the deflationary fallout from the pandemic is still working its way through and the Fed is keen to keep a lid on long-end yields.

Nevertheless, Goldman’s David Kostin says clients are concerned that the current policy conjuncture, alongside higher operating costs for corporate management teams and additional fiscal stimulus, may conspire to push up consumer prices, especially now that the Fed has adopted average inflation targeting (AIT) to “correct” the situation illustrated in the figure (below).

While it’s true that lower yields have supported equity prices, it’s deeply negative real rates that have done the heavily lifting in that regard.

Remember, nobody wants a deflationary spiral and rangebound nominals over the summer “hid” the rebound in breakevens to pre-pandemic levels as well as the plunge in reals to record lows.

For their part, Goldman says rising inflation will be supportive of equity returns, at least in the near-term.

“From a fundamental standpoint, rising inflation lifts S&P 500 earnings”, Kostin writes, noting that nominal revenue growth generally outstrips input cost inflation, leading to higher earnings. “All else equal, a 100bp increase in average annual core CPI relative to our baseline assumption would boost our 2021 S&P 500 EPS forecast of $170 by around $1/share”, he says.

While unemployment has obviously come down quite a bit from the pandemic panic peaks, labor market slack is almost sure to persist for the foreseeable future. To suggest otherwise is to posit a miraculous recovery on par with something out of a Larry Kudlow cable TV cameo.

Given that, wage cost pressure will probably be “muted”, Goldman says. Between that, and “strict” cost management efforts aimed at offsetting sales lost to the pandemic, margins should remain supported.

Of course, equities are preferable to bonds and cash when inflation is rising, and there’s still quite a bit of cash on the sidelines waiting to be deployed. Total money market fund assets dropped by another $2.11 billion last week, the latest ICI data shows, but that was entirely down to outflows from prime funds. Government funds saw an increase of $8.71 billion. For the year, money market funds are still sitting on a net inflow of ~$800 billion.

While valuations generally start to compress as inflation rises beyond a certain threshold, history shows that multiple expansion is likely up to that point.

“Early in the economic cycle inflation is low and rises as economic growth accelerates and consumer demand increases”, Goldman’s Kostin went on to say Friday, adding that “since 1976, the S&P 500 forward P/E multiple has averaged 15.8x during periods when core PCE has registered below 1% compared with 17.3x when core PCE was between 1-2%”.

The key point to understand, though, is that under the Fed’s new framework, the threshold for rate hikes is higher. The institution of outcome-based forward guidance at the September meeting enshrined that into policy.

“In previous cycles, inflation generally had a negative impact on valuations when core PCE neared 2%, in part because of anticipated rate hikes”, Kostin says, before noting that “the AIT strategy means the Fed will temporarily lift its inflation target to roughly 2.25-2.5% [and] as a result, the headwinds to valuations from inflation should also only occur near the new target inflation rate”.

This is comforting for equity bulls in the near- to medium-term.

From a financial stability perspective, though, it could be construed as just another way of suggesting the Fed will countenance an equity bubble. Indeed, that’s precisely what Robert Kaplan told Bloomberg when asked about his dissent at the September FOMC.


7 comments on “Dear Stock Bulls: Don’t Fear The Inflation Monster

  1. Goldfinga' says:

    You said………While it’s true that lower yields have supported equity prices, it’s deeply negative real rates that have done the heavily lifting in that regard.

    How do we possibly know that as a fact?

    There are dozens of factors that go into equity prices. Deeply negative rates are a sign that something is seriously wrong in the economy.

  2. Steve Nellissen says:

    Inflation schmation keep printing and QE’ing. Let’s see

  3. runamok says:

    That “Exhibit 1” chart, sourced from S&P, BLS, and Goldman Sachs, seemlngly provided by the GS researcher and taken from their letter, is ripe for a second degree polynomial fit. Maybe they had to meet a deadline, or an intern did the chart, or a curve confuses ultra-rich clients who pay for their research.

    Yes, the Fed will countenance an equity bubble…uh, will continue to countenance an equity bubble. We should expect that if there is ever a hint in the charts that equities are getting batoned in the calf by evil wage inflation, the kind that helps low-wage workers, the Fed will tap the Pastis.

    No one wants a deflationary spiral. Let’s face it. Keep the markets up. Keep the zombies walking. It’s not the 2010s any longer. The “moral hazard” era is quaint. We’re still years away, hopefully, from the end, end of all this.

  4. jyl says:

    A polynomial fit would show an even stronger relationship between inflation and sales growth, at low inflation levels.

  5. jyl says:

    Classically, the theory is that higher inflation led to higher interest rates which lowered valuation multiples. (Whose theory? Well, mine, although I’m sure I read it somewhere.)

    Look at the present value formula V = C / ( r – g ) where V is present value, C is present cashflow, r is interest rate, g is growth rate of future cashflow. Higher interest rate increases r. Higher inflation may or may not increase g. Inflation increases both sales and expenses, how much for each – and thus whether profit and cashflow increases – varies by industry. For the S&P 500 overall, g increases less than r. So r – g increases, and V declines. C is fixed, being today’s cashflow. So V / C declines, and that is your valuation multiple.

    The real world is too messy and aberrant to closely fit such a simplistic formula, but I think that helps at least with thinking about directional changes.

    As for why higher inflation leads to higher interest rates, classically if investors expect a future dollar to buy fewer goods, services, and labor on Main St, they demand more of those future dollars on Wall St. This is a link between the real economy and the financial economy.

    What happens if you break those classical relationships, and higher inflation does not lead to higher interest rates? Break that link between real and financial economies by applying some force to hold rates constant regardless of inflation.

    Now r is constant but g increases, r – g decreases, V rises, V / C rises, and valuation multiples rise.

    Central banks have learned how to push rates down, by buying bonds (QE).

    Goverments have always known how to push inflation up, by spending lots.

    The disconnect between the real economy and the financial economy widens.

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