US equities and inflation: it’s all good now
As for the outlook: how much inflation is too much?
Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.
The publication, on 2 February, of a non-farm payrolls report showing the biggest jump in US wage gains since the end of the Great Financial Crisis prompted a 10% correction in the S&P 500 equity index. After a rally throughout 2017 amid low volatility, this was – some would say – a healthy injection of volatility into financial markets.
Another inflation surprise, this time in the US January CPI print released on Valentine ’s Day, led to a 1.3% rise in the S&P 500. The headline CPI index rose by 0.5% month-on-month (MoM), while the core CPI index was up by 0.35% MoM compared to consensus expectations of just 0.2% MoM.
Firmer tone to inflation does not change the picture
Most importantly, the January core CPI figure adds to a string of solid readings in recent months: on an annualised basis, core inflation is up by 2.9% over the past three months, and by 2.6% over the past half year. The temporary dip in inflation in the spring of 2017 due to a handful of transitory factors served to mask a clear firming trend in core consumer price inflation over the past several years, as seen in Exhibit 1 below. Once the weak March 2017 reading drops out, the year-on-year rate of core CPI inflation should rise from 1.8% currently to 2.4% by June, assuming upcoming monthly readings are similar to what we saw in 2016 and most of 2017.
Broadly speaking, the recent trend in the CPI data suggests ongoing firming in core service prices that has been accompanied by less core goods deflation (and indeed, some modest inflation most recently). Still, we should not see this one CPI report as drastically altering the inflation picture, as the recent trend in goods prices is not likely to be sustainable.
This latest CPI report is commensurate to the 0.34% increase in average hourly earnings in the non-farm payrolls report from 02/02/18 when, again, markets had expected a gain of just a 0.2%. Why the difference in the equity market reaction?
On more steady feet after the kneejerk reaction?
The first explanation is that the initial shock has now passed. The big mystery of 2017 was why, at a time of tight conditions in US labour markets, inflation pressures were so absent. The gains in payroll costs were seen as the first signs of the price pressures that investors had long foreseen in an economy growing at a solid clip and marked by an ever-tightening job market.
Financial markets quickly repriced Treasury yields, inflation expectations – both up – and marked down equities on concerns about the prospect of accelerating policy tightening at the US Federal Reserve. The subsequent inflation data just confirmed the new consensus and required no further price adjustments in the markets (see exhibits 2 and 3).
The good side of inflation
The second explanation is that inflation is not inherently bad for equities and this realisation has gained ground. Rising prices may mean rising input costs and salaries, but it should also mean rising corporate revenues and hence profits. In fact, the correlation between returns for the S&P 500 and changes in expected inflation is modestly positive (as shown by the dotted orange line in Exhibit 4). We expect any further increase in inflation to be modest.
No time to be complacent (again)
The benign reaction of the markets to date does not mean, however, that investors need no longer pay attention to, or worry about, inflation. It’s a question of how much is too much, that is, will inflation accelerate so quickly that expectations for the future path of the fed funds rate advance to the point where policy action risks tipping the economy into a recession? We are not there yet, but that’s not to say we never will be.
Central banks induce regime shifts
So far so good, but markets underestimate risks
SUMMARY: US equities continued to outperform other markets such as EMU and EM equities. This partly reflects the divergence between the US economy -which is supported by fiscal expansion and a patient Federal Reserve- and relatively weaker growth in the eurozone and EM. But there is more to this divergence than faster US economic growth. The US equity rally has been led by the IT sector. This has accounted for 20%-50% of US equity returns since 2016. The rally is now looking stretched on various metrics. The other salient development in August was renewed stress in emerging markets (EM). A combination of economic stress in Turkey, weaker growth in China, Sino-US trade tensions and a stronger US dollar hurt EM assets. We believe there is value in EM assets, but the obvious circuit-breakers are still absent: a weaker USD, aggressive China stimulus and fresh Sino-US trade talks. EM assets prospects have soured and protectionism and tighter liquidity continue to cloud their longer-term prospects.