With brief interludes for the Archegos saga, meme stocks and a crypto collapse, inflation has dominated headlines for weeks on end.
It may be that we’ve reached the point of diminishing returns when it comes to torturing history in an effort to extract clues about what the future holds for asset prices in the event higher inflation in advanced economies proves to be something other than a “transitory” phenomenon.
Traders will get a fresh read on consumer prices in the US next week. A “disappointment” (where that means a downside surprise) wouldn’t actually be “disappointing,” or at least not for those worried that an encore to April’s blistering print might inject a sense of urgency into the Fed’s preliminary taper discussions. Across the pond, inflation moved up to the ECB’s target last month. That’s expected to prove fleeting.
Until it’s possible to say, with some degree of confidence, that the sharp increase in price pressures is over, market participants will continue to debate the ramifications of a high inflation regime for equities. The discussion usually begins with somewhat misguided assumptions. As Goldman’s David Kostin reminded folks in his latest, “inflation has mixed implications for earnings but is generally a positive.”
After all, Kostin wrote, “equity earnings and the prices tied to them are nominal and typically rise with inflation.” Clearly, some sectors and styles benefit more than others from, for example, higher commodity prices, but as a general rule of thumb, higher nominal sales growth tends to make up for inflation-related margin compression — and then some.
That’s not to say anyone is excited about the prospect of a high-inflation macro regime, but between incessant media coverage (which at times can be quite shrill), elevated multiples and the fact that many market participants in developed economies have never traded in an environment characterized by high inflation, there’s a demonstrable tendency for investors to adopt the view that a moderate rise in inflation that sticks around for a while would be inherently detrimental to stocks almost as a matter of course.
As the figure (below, from Goldman) shows, median monthly real returns for US equities during high inflation regimes have historically been around 9% annualized compared to 15% for environments characterized by low inflation.
Typically, healthcare, energy, real estate and staples outperform. Crucially, returns are markedly lower during periods when inflation is running and still rising versus environments when inflation is high but falling. Specifically, median monthly real returns in a “high and rising” environment are a mere 2%, versus a robust 15% in “high and falling” regimes.
Kostin reiterated the obvious — namely that “inflation can become a headwind to valuations if it leads to expectations of Fed tightening and thus higher real interest rates.” The figure (below) shows the relationship.
It’s also possible that a Fed taper will mechanically lead to higher (albeit still negative) reals. I talked about this at length in “The Reality Of Distorted ‘Expectations’.” “As of early March, nominal rates have been relatively stable, but breakevens have widened on the back of a rally in real rates induced (presumably) by distortions due to Fed purchases,” Deutsche Bank’s Aleksandar Kocic said Friday evening, recapping. “So, while not much was happening with nominal rates, this was really the effect of offsetting trends in real rates and breakevens,” he added, cautioning that this may be “exacerbat[ing] long-term risks [as] reflected in the market’s alignment of inflation risk premium with Fed purchases.”
More broadly, I’ve consistently argued that the biggest risk from a macro regime shift resides in modern market structure which, to a great extent, was built atop an environment characterized by tepid (but acceptable) growth in developed economies and subdued inflation. If those macro conditions no longer prevail and we in fact realize the “overheat” policymakers are (almost explicitly) trying to engineer, it could upend key assumptions, correlations and model inputs, on the way to crumbling more than a decade’s worth of consensus positioning and trades.
In any case, those interested in reading (or re-reading) more on that can peruse the linked articles here and here.
Zooming back in on the more narrow issue at hand, Goldman’s Kostin wrote Friday that in the bank’s view, the “recent popular investor focus on earnings yield less the inflation rate is misplaced.”
Instead, he pointed to the EPS yield gap versus 10-year yields, a commonly-cited proxy for the ERP which, he noted, “actually remains above its long-term average.”
With all due respect a 3% inflation in NOT high inflation. In fact there is nothing magical about 2% and its selection was arbitrary and frankly not useful. Policymakers would be far better off focusing on nominal gdp growth as well as income distribution. If you don’t get nominal growth of 4% you are in danger of a disinflation/recession as nominal growth below 4% makes it difficult for private financial actors to service debt. A better target would be 5%. Using nominal growth would eliminate a useless debate about what the inflation rate or real growth rate is. Wall Street is clacking about inflation without acknowledging that the economy has been put through the blender and it is just about impossible to construct a market basket to measure it right now. Economics 101- demand generally adjusts more quickly than supply in most markets. The street seems to have forgotten that as well. I will bet that absent a fairly big infrastructure bill – the next problem will be an inventory oversupply once production bottlenecks are fixed – give it a year. Powell and Company are correct to be cautious about taking away the punchbowl too quickly.
I used to read Scott Sumner blog, The Money Illusion. I have to say, I never got the importance of NGDP targeting or how different it was from the dual mandate i.e. concentrating on balancing inflation and unemployment.
Furthermore, given how bad the CBs have been at engineering higher inflation when they’ve wanted to, I’m not sure extra extra QE makes all that much sense without a more radical recreation of our financial systems.
Finally, we see nowadays that fiscal policy is a lot more effective at boosting inflation/activity than monetary policy. Personally, retrograde Keynesian that I am, I never really doubted that but…
The ECB seems to be more emphatically “not talking about not talking about” withdrawing stimulus. Which makes sense, as they’ve barely started opening the EU taps. Euro markets tend to be less tech/high gro, more old economy/value. And ex-UK, the other side of the pond is a few months behind the US in vaccinations and reopening. Reason to look abroad?
Meanwhile, LatAm is way behind the US in vax and reopening, but the doses are starting to flow. Those countries – here’s looking at you, Brazil – lack the financial firepower for big stimulus, but may start getting it anyway thanks to rising commodity prices. More reason to look abroad?
H
You cite several sources here who essentially say that stocks do not generally perform well when inflation is high. This pronouncement would seem to contradict the conventional wisdom that stocks are a hedge against inflation.
One other point about inflation has to do with the effects of income. Data show that the budget proportions of household expenditures change considerably as income rises (also geographically). For instance, the proportion of a family’s income spent on housing is far higher for earners in the bottom two income quintiles than for families in the top 20%. Most of the expenditures generally considered to be necessities comprise a much higher percent of the budgets of lower income households, the ones with little or no savings as well, compared to those in the top 20% of earners. This means inflation in housing and food is less likely to have a major impact on those who can afford to spend most of their income on discretionary categories like travel, entertainment, second homes, etc. To someone who spends 40% of their income on housing and 20% on food, even a 3% increase in prices in either of those categories can be painful, even with a $15 min. wage. Context is everything. If anyone is interested, the WSJ printed a primitive version of a personal inflation calculator a while back.
https://www.wsj.com/articles/inflation-rate-calculator-customize-your-own-consumer-price-index-11621503004?mod=djemalertNEWS
If one wants to check more carefully one can go to:
https://www.bls.gov/opub/reports/consumer-expenditures/2019/home.htm
These charts and tables break down personal consumptioon expenditures by category (for 2019) and Table C shows the breakdowns for each income quintile. Anone who wants can take the inflation figures from the WSJ calculator and apply them to your own known budget expenditures or the quintile data from the BLS. It’s not hard to actually find how inflation affects the real “you”.
— “You cite several sources here who essentially say that stocks do not generally perform well when inflation is high.”
No, I don’t. That’s basically the opposite of what this article says.
The numbers are right there, from Goldman (in the table). And, I mean, not to be derisive, but there are any number of passages in this article that say the opposite of what you’re suggesting I (or someone else) said. E.g.:
“The discussion usually begins with somewhat misguided assumptions. As Goldman’s David Kostin reminded folks in his latest, ‘inflation has mixed implications for earnings but is generally a positive.'”
“…as a general rule of thumb, higher nominal sales growth tends to make up for inflation-related margin compression — and then some.”
Etc. Etc.
But the discussion is far more nuanced than that in the context of modern market structure.
And the near- to medium-term problem is that an inflation overshoot could catalyze a more hawkish Fed and higher real rates, with the latter being pernicious for equities (and all risk assets, really).
I am still in “transitory” camp. I just finished traveling a bit and although open, most places are not at capacity and need more guests and employees to get to those last dollars, which are generally the majority of the profits. When I flew home, we sat on the tarmac forever because United did not have enough employees to refuel planes – which was causing havoc. Flight schedules are still less than they were in “pre-covid” times.
There are places in the world where I would like to travel- but do not yet feel comfortable doing so either due to lack of vaccines at those locations or the emergence of the Delta strain of covid.
Despite Jamie Dimon’s statements about going back to the office, not everyone will do that. If a corporation owns their space, sure – because otherwise it sits empty. If a corporation can reduce rent expenses, I think more of a hybrid.
People who have paid down credit cards and/or increased savings or reached to buy a house will not be traveling and eating out excessively.
Finally, covid is not over. Therefore, the world is not reverting, in entirety, to our pre-covid ways. See increasing death rates in the UK.
Just came back from a trip from our highly compliant bubble in a university town to rural central Pennsylvania, which boasts the lowest vaccination rates in the state. On June 1, vaccinated folks were permitted to enter stores without masks. I visited the local supermarket and was the only one with a mask (and I’m vaxxed). There’s going to be another wave in rural areas.