The Macro Code #5: Inflation troubles, corporate profits and equity valuations
What is the link between inflation and the performance of equity indices?
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Recently there seems to be a single macroeconomic variable that the markets are paying attention to, and it is called inflation. The market is focusing on a mouth-watering combination: inflation rates, employment levels and commodity price trends.
In this newsletter, we will provide a recap of the global inflation dynamics and subsequently, we will answer two questions that are central to those involved in equity valuation.
Why can equities perform well during a period of rising inflation?
What is the link between inflation and the performance of equity indices? Could equities be classified as inflation-insensitive real assets?
A recap on global inflation dynamics
It is becoming increasingly apparent that the pick-up in inflation, particularly in the US, is cyclical. It is not just a consequence of base effects. Traditionally, any cyclical pick-up in inflation has required a monetary policy response. But that is not the intention of policymakers at present. The FOMC continues to believe that the pick-up will be transitory in the short term. While there are starting to be doubts among market analysts regarding the timing of a return to the inflation target. Inflation is by definition "transitory." What should be discussed is the length of the transience.
For now, core inflation is at 4% in the US. Below is a month-on-month heatmap of changes. The volatile components are fading, but the median price increase is on its way up!
Moreover, according to a survey released on Monday 13th September by the New York Federal Reserve, U.S. consumers' expectations for how much inflation will change over the next year and the coming three years rose last month to the highest levels since 2013.
Year-ahead inflation expectations increased for the 10th straight month to a median of 5.2% in August, according to the monthly survey of consumer expectations. Inflation expectations over the next three years increased to a median of 4.0%. Both metrics are at the highest they've ever been for the survey, which was launched in 2013.
U.S. central bank officials are keeping a close watch on inflation expectations as they try to evaluate whether the pricing pressures triggered by the coronavirus pandemic will pass or have more lasting effects on the economy.
In the eurozone, inflation rose more than expected, although the ECB maintained its belief in a temporary spike caused by rising oil and commodity prices and pandemic-related shortages of components such as microchips.
However, it should be noted that commodity prices remain strong and are another driver of headline inflation. For an idea of exactly how strong the fundamentals are for commodities such as metals, agriculture and oil today, consider this: these markets are now showing the steepest backwardation in more than 14 years.
That is, the premium for commodities that can be delivered now versus later into the future is the highest it has been since at least 2007, signaling just how strong the world’s demand is for raw materials and how tight supplies are. (In commodities markets, futures are frequently pricier at longer maturities because they reflect the cost of carrying inventories over time as well as future demand expectations. But urgent demand has flipped about half of major commodity markets tracked by the Bloomberg Commodity Index including oil, natural gas, copper, soybeans into backwardation).
In China, the Producer Price Index (PPI) of August surprised to the upside and now hovers around 9.5%, the highest in 10 years. High producer prices in China often translate into higher consumer prices in the U.S., suggesting a potential uptick for the Consumer Price Index (CPI).
The U.S. yield curve steepened last week after the release of strong wage data, despite weak employment data; this suggests that the market is starting to focus more on inflation than Fed guidance, in a way.
Meanwhile, bond investors just can't make up their minds.
One minute they're bailing out of debt, confident that central banks will soon dial back emergency stimulus. The next, they're snapping up bonds, hopeful that tapering will be modest.
For now, the latter view prevails after the European Central Bank trimmed emergency bond buys but stressed this was not tapering. The relief was palpable with Italian yields posting their biggest one-day fall since March.
Why can equities perform well during a period of rising inflation?
In an environment of rising inflation worldwide, do equity investors have performance opportunities?
Typically, in a period of rising inflation, the equity segment could perform reasonably well. This is because earnings are expressed in the nominal form (include real business growth + the price at which that business is sold). One could assume that in the long run the level of inflation is neutral to the valuation of a company. However, one could also assume that in such a context, earnings inflation is due to price inflation and not business inflation. Thus, we might find ourselves in a situation where the business might perform badly and earnings might be positive because of rising inflation. This could generate a negative scenario in two respects: 1) Equity research analysts notice this right away: business declines and earnings are inflated. 2) Taxes are paid on nominal results, not on real results: consequently, a business that falls and therefore pays more taxes loses attractiveness to investors.
There are various academic strands on techniques for evaluating the effects of inflation on corporate performance. The chart below shows us that in the past there was a fairly clear relationship between the level of inflation and US corporate profits. However, it should be noted that this relationship (except for periods of recession) has not held true in the last 30 years.
A key point to consider in this context is that the stock market could experience a negative twist when inflation unexpectedly rises.
The stock market, of course, expects there to be a certain amount of inflation each year and adjusts what the expected returns should be relative to the expected inflation.
For example, if investors expect a return of about 6% per year after inflation (including dividends) and inflation is 2% per year, investors will expect a return of about 8% per year when inflation is factored in (this is in fact on the long-term return on stocks, over many decades). But if inflation suddenly goes from 2% to 4% very quickly, history indicates that the market as a whole will react negatively. This is because investors will now demand a higher yield to compensate for the now higher risk. Instead of an 8% return, investors may demand a 10% return. Prices will likely fall. This change in expectations is evident in the historical record. A 2000 study by Steven A. Sharpe at the Federal Reserve (see here) concluded that "market expectations of real earnings growth, particularly long-term growth, are negatively correlated with expected inflation...inflation also increases the required return on equities in the long run."
What is the link between inflation and the performance of equity indices?
When we talk about shares, we must remember that we are referring to financial instruments closely linked to real quantities. This means that they are instruments capable of incorporating inflation. If the aggregate price level rises, it is reasonable to assume that, for the same amount of goods sold, a company's turnover will increase to a similar extent. Consequently, costs will also increase in equal proportion, but the difference between revenues and costs (the profit), will also increase due to inflation. This is general reasoning, applicable to a "typical" firm. In fact, some companies may experience cost increases greater than revenue increases, while others will experience the opposite, but at a general level, inflation will inflate the profits of the companies, whose stock market quotations should, ceteris paribus, grow at the same rate as inflation.
Could equities be classified as inflation-insensitive real assets?
At first glance, we can answer this question in the affirmative. This is because when faced with profits "pumped up" by inflation, companies will be able to pay their shareholders higher dividends, which should in turn justify higher prices, thus defending investors' assets from loss of purchasing power. But this is only part of the story. When price increases reach excessive levels, inflation raises uncertainty about the future of the overall economy, and to increased uncertainty, markets respond by demanding higher yields.
The chart below shows the relationship between Cyclically Adjusted Price Earnings - CAPE (obtained by relating the current price to earnings over the last 10 years) and inflation. It should be noted that the relationship is inverse. Above a certain threshold of inflation (3% per annum) the market begins to pay for shares with lower multiples, therefore with equal earnings prices fall.
Consequently, high levels of inflation depress equity multiples, partially or completely nullifying the beneficial effects due to the increase in corporate balance sheets mentioned above. However, it must be stressed that the analysis was carried out on five-year data, since on shorter horizons, inflation does not seem to influence stock valuation parameters. Therefore, in order to observe a significant reduction in multiples, we would have to experience an average annual level of inflation of over 3% over the next five years. This is an unlikely assumption as an average inflation target over the long term, despite the current upticks. In fact, to move to a longer-term inflationary view we can look at breakeven inflation rates derived from bond markets. For the US, the breakeven outlook is 2.5% per year. In essence, this is certainly higher inflation than that observed over the last ten years, but not such as to depress equity multiples. This is even more true if one considers that the alternative to equity investment, i.e. the bond segment, does not currently offer any protection against inflation.
If we look at the chart showing the real yield on the 10-year U.S. Treasury bond, we will notice that the yield is at its lowest since the last 20 years, below zero.
But the story is similar across the globe.
The real yield is the yield adjusted for inflation. A negative real yield attests to the unusual condition in which long-term bonds offer a yield lower than expected inflation and therefore expose investors to a loss of purchasing power.
In conclusion, we can say that equities (albeit with some limitations) offer a degree of defense against inflation. Therefore, the only real risk to the financial markets from inflation is that it will exceed expectations, making the monetary authorities nervous and causing them to tighten monetary policies. This is a risk to be kept in mind, but at the moment the apprehension with which the political and monetary authorities are taking care of the economic recovery seems to us a good guarantee that this time the mistakes of the past will not be made.
As an additional note, a focus should be made on which category of stock performs better in a rising inflation environment.
High inflation expectations tend to favor value stocks, since it typically comes with faster economic growth and higher bond yields, hurting tech stocks whose long-term prospects now have to be discounted at higher rates. For instance, surprising earnings from the energy, materials and financial sectors have indeed helped make hunting for value this year’s second most successful equity strategy (+16%), while growth stocks, like Tech, has been the worst performer (9%). In the equities rally that followed initial vaccine breakthroughs last November, the most successful equity strategy has been stocks with high buyback ratios (+21%). Companies’ free cash flow is likely to rise faster than dividend allocations during the recovery, creating more room to buy back shares and invest.
Indeed, value stocks, which have led the market’s recovery coming out of every one of the last 14 global recessions, bounced back “with a vengeance” after underperforming growth stocks by the largest margin in history. These stocks still have enormous rebound potential as the relative performance of the MSCI World Value index compared to the MSCI World index has never been so low!
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