Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.
This month’s author: Shep Perkins, CFA, Chief Investment Officer, Equities
Anyone with nostalgia for the 1970s is probably not including the macroeconomic environment of that time. It was the decade that introduced “stagflation” — an unpleasant combination of rising inflation and anemic economic growth. Investors faced a multitude of challenges, including inflation that eventually reached 12%, compressed price-to-earnings (P/E) multiples, and stock market performance that was essentially flat for 10 years.
With similar challenges facing us today, it’s not surprising that some market observers suggest history may repeat itself. Are equity indexes destined for a new version of the “stagnant ‘70s”? We believe the answer is no, and that a different, more positive outcome is likely for investors.
Higher inflation may be here for a while
For many investors, inflation is an unfamiliar challenge, as it was largely nonexistent through the 1990s, 2000s, and 2010s. In these decades, deflationary forces included healthy global trade in a period of relative peace, remarkable innovation and technological advances, and slowing population growth. However, inflation has now reached a 40-year high. We believe it will be sustained at a higher rate than we’ve seen in recent decades, but lower than what we're experiencing today. The deflationary impact of global trade may be in the rearview mirror as the world order evolves and more diverse, but higher-cost, supply chains are established. Even with a slowing economy, high inflation — especially for food and energy — is not likely to abate soon, regardless of central bank measures.
The impact on equities: What history shows us
What could sustained inflation mean for the equity markets? History provides some perspective. Based on our research of earnings and P/E multiples during inflationary periods since 1900, we found:
- On average, nominal earnings growth was robust and real earnings growth was solidly positive. The exceptions were in periods where inflation sustained above 6%, in which case real earnings growth was negative
- S&P 500 P/E multiples were in the mid-teens, except when inflation was greater than 6%, in which case multiples collapsed
- S&P 500 nominal and real returns were positive, except in the highest inflation tranche, where nominal returns were just 1% and real returns were sharply negative
- The most inflationary decades were the 1910s, 1940s, 1970s, and 1980s
Earnings growth was solid in all but the highest inflationary periods
S&P 500 average earnings growth by inflation tranche, 1900-2021
Source: Putnam. Past performance is not a guarantee of future results.
P/E multiples held up in all but the highest inflationary periods
S&P 500 average trailing P/E by inflation tranche, 1900-2021
Source: Putnam. Past performance is not a guarantee of future results.
S&P returns were positive in all but the highest inflationary periods
S&P 500 average returns by inflation tranche, 1900-2021
Source: Putnam. Past performance is not a guarantee of future results.
Today’s S&P is much different from the 1970s
The composition of the S&P 500 Index has changed meaningfully over the past several decades. For example, in the 1970s, capital-intensive, cyclical companies in industries such as energy, materials, and industrials made up a significant portion of the index. Today, much more of the S&P consists of high-quality, fast-growing companies that tend to be resilient in times of economic turbulence. Unlike General Motors and Exxon Mobil decades ago, today’s digitally focused market leaders may not be as vulnerable to the negative effects of inflationary forces. Instead, their key risks include issues such as technological obsolescence.
The structure of the index is meaningful. Today, the 10 largest companies comprise 30% of the S&P 500 Index, which is comparable to the index composition in the early 1970s, but typically the index has not been this concentrated. While both groups could be described as market-share takers and proven fast organic growers, the companies in the 1970s were more cyclical and used more leverage. Today’s S&P leaders — higher-margin and capital-light businesses in sectors such as technology, communications, and health care — are likely to fetch higher P/E multiples than the S&P leaders of the past.
The changing composition of the S&P 500
Higher-margin, capital-light businesses make up more of the index today
Source: Putnam. The chart shows the change in the combined weighting of each group over 10-year periods. Real estate is included within financials. Past performance is not a guarantee of future results.
A number of trends may help cool inflation
For many reasons, we believe we are nearing peak inflation, at least from a demand perspective. While supply-induced inflation is difficult to curtail in the short term, historically it has been consistently rectified over the medium to long term.
- The global economy is slowing and is likely to slow further, while financial conditions are tightening
- China is under pressure from its own Covid-19 restrictions, but even as those end, the country won’t be on the same infrastructure-led growth trajectory as in years past
- The U.S. housing market has been growing at a torrid pace, but it is destined to slow as mortgage rates have moved sharply higher
- Globally, there is less government stimulus. This, combined with higher food and energy prices, is likely to curtail consumer spending
Resilient multiples in recent decades
S&P 500 price-to-earnings and inflation by decade
Source: Putnam. Past performance is not a guarantee of future results.
Reasons for optimism: Earnings growth and resilient multiples
Based on history, if we do sustain an inflation rate of 7% or more for the next few years, equities are in for a challenge. However, in our view, it’s more likely that inflation will slow as demand slows. Arguably, an inflation-induced P/E compression is already reflected in the market. The P/E multiple for the S&P 500 has dropped five points, and at 18x, it is now below its five-year average. And despite recent high-profile earnings cuts by companies like Netflix, Meta, and Amazon, earnings growth estimates for the S&P have been rising. It appears they will eclipse 10% growth this year and will accelerate from the first quarter’s low of 7% year-over-year growth. Looking ahead, we see earnings growth combined with a resilient market multiple driving the market higher from here.
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