Shep Perkins, CFA
Chief Investment Officer, Equities
Donald E. Perks
SHEP: A few quarters ago, the idea of an overheating economy was unimaginable to most investors. In recent months, however, we’ve had a lot of great news to digest. The distribution of three effective Covid-19 vaccines is well under way, the U.S. economy registered growth above 4% in the fourth quarter of 2020, and we see growing optimism about a return to normal across global economies. Commodity prices are at multiyear highs and personal income is rising on the heels of government stimulus.
In this environment, we are seeing a sharp uptick in inflation expectations. In 2020, interest rates that had fallen to historically low levels were key to helping equity markets soar despite the pandemic. Stocks were extremely cheap when compared with bonds. The spread between the S&P 500 earnings yield and the yield of the 10-year Treasury note widened significantly, making stocks more attractive. Today, some stocks are struggling and equity investors have become more cautious as the 10-year Treasury yield reached its highest level in more than a year.
We believe that rising inflation will not dampen equity market performance. In fact, history has shown that rising inflation has generally been followed by strong equity returns.
The inflation situation today
DON: In addition to the rising 10-year Treasury yield, we have seen a considerable increase in the 10-year breakeven rate. This is a measure of the market’s expectations for inflation over a 10-year horizon. It is likely that the 10-year Treasury yield will follow those inflation expectations and rise further. It is worth noting that real interest rates — a measure of bond returns after adjusting for inflation — are still in negative territory. This means investors are paying a “safety premium” to keep their money in bonds.
How has the market responded to inflation?
DON: We analyzed changes in inflation during 3-month periods over the past 18 years. We then looked at how the equity market performed in the following six months. Returns for stocks were better after the periods in which inflation increased or decreased the most. This makes sense, as a modest increase in inflation would typically be accompanied by a strengthening economy, providing a positive backdrop for corporate earnings growth.
SHEP: On the flip side, for the periods in which inflation decreased the most, stocks also delivered better returns. Interestingly, this deflationary environment is also positive for equities because it is typically followed by aggressive monetary and fiscal stimulus.
The rise in inflation for the current three-month period should align with the top decile of 3-month inflation change periods, where inflation increased an average of 0.43%. Therefore, in our view, stocks are poised to deliver positive returns in the coming months, despite the uptick in inflation.
The inflation “sweet spot” for stock performance
DON: We Looked at inflation rates for every one-year period from 1974 to 2020. We then analyzed the equity market’s real return — the market return adjusted for inflation — for the following year. We found:
- Zero to 2% inflation was best for equity performance in the following year
- Higher levels of inflation resulted in weaker, but still positive, returns.
- Inflation sustained above 3% has historically been a drag on equity returns.
Some industries thrive with higher inflation
DON: Our analysis showed how changing inflation levels affect different industries. Some businesses clearly fare better in inflationary environments. They include companies whose products and services remain in demand regardless of macroeconomic conditions. Although input costs may rise, the businesses still perform well because they are able to pass the cost increases on to consumers. Also, there are not ready replacements for their goods, most of which are necessities.
Performance trends in a high-inflation environment are shown in the chart below. For example, when inflation was higher, average returns for telecommunications services, food retailing, and energy stocks were more than 10% higher, while returns for software and services stocks were more than 30% lower.
Don’t overlook inflation risk
SHEP: Our research suggests that equity markets are likely to hold up well despite rising inflation, especially because we are emerging from a period of historically low interest rates and inflation. However, rising inflation should not be disregarded as a risk for equity investors. What’s different today is that the composition of the S&P 500 is skewed more toward growing, asset-light, and high-quality companies — the stocks of which may be more vulnerable to higher inflation-led interest rates. Historically, when inflation accelerates sustainably beyond 3%, it has dampened real equity returns.
Goodbye to Goldilocks
For many years, the equity market has benefited from low inflation expectations and no deflation, which is a near-perfect Goldilocks scenario. As we move out of this range, we should see a shift in market leadership. And that shift could be dramatic. We could see disruption in the form of sharp sector rotations as so much of equity ownership today is skewed toward growth. In our view, high-growth stocks would be particularly vulnerable, as their elevated multiples have the farthest to compress. Until recently, investors have shunned stocks in cyclically sensitive sectors — those that tend to do well with higher inflation.