In this week’s newsletter, we take a special look at inflation and its impact on equity markets.

Is the era of low inflation coming to an end?

Inflation is once again the talk of the town. According to a recent poll of fund managers, inflation has overtaken coronavirus as the top risk that keeps investors up at night. So this week, we’re taking a closer look at the risks of inflation and its potential impact on equity markets.

First, a look at the historical picture: regime changes in inflation do not happen overnight and they are usually explained by exogenous reasons. As the chart below shows, you have to go back to the beginning of the 1980s for the last time we saw double-digit US inflation. You must cast your mind back even further to find the origins of that peak. In the 1960s, theVietnam War and President Johnson’s Great Society spending programme exploded the US budget. Inflationary pressures steadily built up and were then greatly magnified by two oil shocks – in 1973-74 and 1979-80 – which sent inflation soaring to 14% in early 1980.

The question for us is whether the combination of fiscal and monetary stimulus deployed by policymakers today – unseen even during the Great Financial Crisis – will trigger an upward shift in inflation. Are we entering a new regime of higher inflation?

Regrettably, this newsletter’s crystal ball has been misplaced, so we won’t be making any predictions here. But there are early signs that inflationary pressures are building. Inflation hawks point to a 26%rise in the monetary aggregate – a measure of the money supply in the economy –as an ominous signal. More immediately, manufacturing prices have shot up due to supply chain disruptions and we have witnessed sharp increases in prices on online platforms. Coupled with a base effect from the impact of the pandemic last year, we may well see a short-term rise in inflation this summer.

 What, then, would the impact of higher inflation be on equity markets? Historically, equities have performed well in low inflationary or deflationary scenarios – a relatively sound indicator for economic growth and, therefore, company earnings growth. Only when you have very sharp moves upwards or downwards do we notice a detrimental impact on equities. When inflation rises more than 3% YoY, equity markets tend to suffer.

Rising inflation expectation is also fueling the age-old value vs. growth debate – the adage being that higher inflation augurs well for value stocks. The massive outperformance of growth over value in the low inflation period since the Great Financial Crisis lends credence to that thinking. The relative performance of value and growth stocks is also related to equity duration, which increases with rising P/E ratios. Given the duration of growth stocks reached new extremes recently – comparable to when the tech bubble burst in the early 2000s – some investors believe a shift from growth into value is taking place.

Taking that logic further, a period of higher inflation would bode well for European markets, which have a stronger bias towards value stocks. If the global economy comes roaring back, cyclical stocks would also likely stand to benefit from the upturn, with defensive stocks underperforming.  

All that being said, it remains early days. The only certainty is that markets will be keeping a close eye on inflation during the months ahead and a keen ear out for how central bankers intend to address rising expectations.