Economic and market headlines have seemingly been awash in a barrage of inflation related scaremongering over the last few months.
“Hyperinflation is here!” “The Fed will have to slam on the brakes!” “Sell now before it’s too late!”
Given all this nervous handwringing, investors can’t be blamed for being on edge amid nightmarish visions of 1970’s style stagflation! Surely, after an epic rally the only sensible thing to do is to do is to raise cash, right??
Not so fast, let’s take a deep breath and look at the facts…deflating your inflation fears. First, we’ll examine the inflation bear case and then we’ll stress-test it to see if it’s worth all the attention it’s getting.
The Bear Case on Inflation
It’s true – inflation expectations have been rising amid a combination of global COVID related manufacturing shutdowns and surging demand for everything from homes to cars, as consumers favor buying goods over riskier services and experiences.
What’s more, recovering demand and COVID related supply disruptions have commodities of all stripes flying high. Add it all up and inflation is at multi-year highs. The five-year breakeven inflation rate is an objective, market-based indicator of where investors think inflation will be in five years. It’s currently hovering just under 3%, it’s highest reading in 20 years (see chart 1).
Inflation impacts asset prices through the Fed reaction function. Rising pricing pressures have investors increasingly worried the Federal Reserve will need to raise interest rates aggressively to curb inflation. Earlier this year, the Wall Street consensus didn’t expect the first Fed hike until the second half of 2023. What a difference six months makes! Wall Street now forecasts a 95% chance of the first hike by December 2022 and over a 77% chance we’ll see two hikes by then (see chart 2).
Historically, one of the biggest threats to bull markets has been an overly hawkish Fed that raises rates too far, too fast, sending the economy into a recessionary tailspin! The US treasury yield curve is a great real-time indicator of investors’ economic growth expectations. The steeper the curve, the more bullish investors are on the economy.
Conversely, a flattening curve signals growth jitters and an inverted curve has been an excellent historical predictor of recessions.
After steepening since March 2020 as the global economy began to rebound from its COVID induced stupor, the yield curve peaked in March 2021 at 156 basis points (bps) and has since flattened and now sits at 110 bps (see chart 3).
Why the Bears are Likely Wrong (Again)
So that’s the bear case. Pretty scary right? Pretty convincing too. But as usual the bears don’t include all the relevant information; they like to cherry pick the facts to suit their negative narrative.
There’s no doubt that rising inflation is bad news for bonds because bond prices move inversely with interest rates so as rates rise the value of bonds decline. Higher rates erode the purchasing power of bonds’ fixed rate of interest. Since 1927, US treasury bills and notes and long-term corporate bonds have posted sub-par returns in years of elevated inflation.
However, stocks have historically weathered moderate inflation just fine. Since 1927, in years that inflation has run above average, the S&P 500 (SPY) has registered average annual returns 4.9% above the prevailing rate of inflation (see chart 4). The reason for this is that inflation tends to rise when the economy is growing, demand is robust and pricing power is abundant – all of which are good news for corporate revenues and profits. Dividend growth also helps stocks weather higher prices as investors favor increasing equity payouts over fixed bond coupons.
Digging deeper, small caps and value stocks have fared best given that their greater cyclicality and leverage to the economic cycle. Large cap value (SPYV) has posted average real returns of 8% vs. only 4% for large cap growth (SPYG). Meanwhile, small cap value stocks (VBR) have been best in show generating stunning 12% average real returns vs. 5% for small cap growth (VBK).
At the sector level, Energy (XLE) is way ahead, doubtless thanks to its ability to pass on higher prices amid inelastic customer demand. Large dividend yields haven’t hurt either. Financials (XLF) have also outperformed as banks’ net interest margins widen as interest rates increase (see chart 4).
Deflating Your Inflation Fears, Never Ignore the Big Money
Surprise, surprise – the Big Money isn’t buying the inflation bear base. They’re not positioning for hyper-inflation and a Fed induced recession, on the contrary, our big money index is solidly positive at 69% and still well shy of overbought territory at 80%. Why? The big money knows that when inflation and interest rates are normalizing off rock-bottom levels it represents a validation of the economic recovery rather than a threat to growth.
Inflation and rates would have to be much higher to really threaten stocks. Absent that, the big boys know stocks follow earnings and with Q3 earnings season almost over, the outlook for corporate profits remains robust. Most companies are seeing very strong demand which is allowing them to pass on supply chain driven input cost increases and higher wages.
As such, S&P 500 net profit margins are only down slightly from Q2’s 13.5% all-time high at 12.5%. As COVID continues to fade globally, strong demand and easing supply chain snags will keep growth strong as inflation likely eases.
A look at 2021 consensus EPS forecasts shows estimates remain near record levels at $210. More importantly, 2022 EPS estimates are holding up fine at $226, implying 8% earnings growth over the coming year. This is a solid macro backdrop for risk assets like stocks.
What’s more, the Big Money favors cyclical, value-oriented sectors like Energy, Financials, Real Estate and Industrials as well as Technology, which benefits from above average organic revenue and earnings growth as the world gets ever more digital and automated. Meanwhile, counter-cyclical, defensive sectors like Utilities, Health Care and Staples that tend to outperform as the economy weakens and enters recession are lagging (see chart 6).
The Bullish Takeaway
Never forget that the bears are wrong most of the time. They’ve predicted 12 of the last 3 recessions and 20 of the last 5 bear markets! It doesn’t mean you ignore them completely. Sometimes it pays to be hyper-vigilant. But for the most part, following the Big Money has a much better batting average.
History demonstrates moderate inflation isn’t the end of the world for stocks. The Big Money knows 10-year Treasury yields have had to reach 3.5%-4% before they’ve depressed equity valuations in the past. At a recent 1.52% that’s a long way off! Many companies do very well when inflation heats up and rates rise as-long-as things don’t wildly overshoot, which seems unlikely as pandemic related supply and labor issues recede globally.
First off, remember pros never put all their eggs in one basket. These recommendations are meant as a complement to a well-diversified equity portfolio. These are areas to overweight as an inflation hedge, not to own at the exclusion of everything else.
Focus on high quality, dividend paying companies with strong pricing power, many of which sit in the value camp (SPYV). At the sector level, favor economically sensitive, high yielding sectors like Energy (XLE) and Financials (XLF).
Balance that with Tech’s (XLK) disruptive, outsized organic sales and EPS growth thanks to seemingly insatiable consumer and enterprise demand. Real estate investment trusts (REITs) also work given their ability to raise rents in inflationary times and their large and growing dividends (VNQ). And don’t forget small caps, especially on the value side (VBR).