Why persistent inflation poses a threat to the stock market

Some inflation data points you need to think about:

– Inflation is skyrocketing to 5.4%.

– The unemployment rate minus “leavers” is 1.9%.

– QE is still operating at full capacity at $ 120 billion per month.

– The Fed won’t even think about raising interest rates until QE ends.

If you don’t think inflation can be persistent, think again.

The Fed tells us repeatedly that the reason for keeping the monetary pedal to the metal is a weak labor market. The graph below challenges their logic.

Resigners are defined as those who leave their jobs voluntarily and, in theory, in search of better or better paid employment. The current dropout rate of 2.9% is the highest in its 20-year history. A high quit rate is a sign of a healthy labor market.

It’s not just high inflation and a strong labor market that are forcing prices up. We must also take into account the supply difficulties and shortages of many goods and commodities.

It is time for us to start thinking outside the stable inflation box. The inflation environment that most investors are very comfortable with could collapse.

As we have seen over the past few weeks, stocks are becoming sensitive to the growing possibility of persistent, not transient inflationary pressures. As such, it’s worth revisiting the fairness analyzes we shared in May 2020.

The specter of inflation

In May 2020, we wrote the following: “We leave the specter that inflation could result from the synchronized combination of a variety of factors, including an increase in the money supply, fractured supply chains and, ultimately, an economic recovery.”

These three factors are now causing inflation to rise. By mid-2020, no one expected supply line issues and product shortages to persist for more than a year. As a result, few economists predicted high inflation for such a long time.

The Fed is starting to recognize that this surge in inflation could last longer than a “transitional” period. According to Atlanta Fed Chairman Raphael Bostic, “US inflation widens, not transient. ” His statement is the first acknowledgment from a Fed member that higher inflation may no longer be transitory.

He began this speech with the following: “You will notice that I brought an accessory to the lectern. It’s a jar with the word “transient” written on it. It has become a bad word to my staff and I over the past few months. Say “transient” and you have to put a dollar in the pot. “

Investors prefer stability

Equity investors should be prepared to pay a premium for price stability. Price stability makes business forecasts more reliable, allowing executives to better manage expenses and ultimately increase profitability.

To understand why let’s buy a pizzeria. As a potential owner, wouldn’t you be willing to pay more if you knew that workers’ wages, rents and prices for dough, sauce, cheese and pepperoni will be constant over the next ten years? ? Price stability allows for better order management allowing the owner to effectively manage costs. As a result, the pizzeria can be more profitable.

Equity investors love price stability for the same reason a pizza restaurant owner does. Since the 2008 financial crisis, equity investors have enjoyed a healthy dose of price stability.

TThe orange line below the CPI charts since 1948. The blue line shows the standard deviation or volatility of inflation over one year. Before the pandemic, the standard deviation of the CPI was close to the lows of any period in the past 70 years (dashed red line).

cpi index volatility inflation data analysis table

As we show, with the recent spike in price volatility and 5.40% inflation, investors should not be so confident about the future. Last year’s price behavior is nothing like the last ten. That said, there have been many other periods over the past 70 years with similar increases in inflation.

The chart below shows that investors are willing to pay a premium when inflation is at the sweet spot. As noted, valuations are highest when the CPI is above 1% and below 4%.

Cap valuation equities inflationary periods historical chart

Prior to today’s instance in red, the highest CAPE occurring when inflation was between five and six percent was 22.42. At 34.77, the S&P 500 is expected to fall 36% to hit this high.

There are two considerations to explain today’s extreme valuations. Either investors don’t care, or they think the rise in inflation won’t last. If it’s the latter, we better have a plan if they’re wrong.

What if inflation is persistent?

Given the uncertainty, we should strategize around a range of inflation options. One of those options is not just high inflation, but crippling stagflation like in the 1970s and early 1980s.

In The Cross Currents of In / Deflation Part 2, We assess seven prior inflationary periods of the past 75 years to assess the performance of different sectors and industries in various inflationary environments. The chart below highlights these periods and their respective inflation levels. We also highlight the current period.

cpi index rising united states economic data chart

The bar graph below shows the cumulative returns for theach industry if you only owned each industry during periods of inflation.

cumulative returns of sector equity investments during periods of historical inflation in the chart

Materials, drug makers, and commodity companies tend to do their best in inflationary environments. On the other hand, the S&P 500 is in the red, as are finance, transportation, retail and real estate. About two-thirds of industries recorded a positive performance.

The large amount of data behind the chart is mixed. We do not show that the performance of most industries was appalling during the high inflation spikes of the 1970s and early 1980s. In most other cases of inflation, stocks hold up, at least for a while. nominal basis.

Next, we look at the two double-digit periods of inflation, the 1970s and the early 1980s. The chart below shows that only gold, oil, ships, and weapons produce positive returns. Everything else is in the red. In these two environments, the S&P has fallen by more than 50% cumulatively.

1970s Inflation Period Chart for Cumulative Returns on Sector Equity Investments

Profit margins matter

Inflation tends to reduce profit margins and therefore is a critical factor in forecasting stock prices. Below, we share an approximation of profit margins using total business profits as a percentage of GDP. Our data is closely aligned with that of Standard and Poors, but covers a longer period, which allows us to analyze the seven periods of inflation.

historical graph of company margins by year until 2021

In six of the seven periods of inflation, including the two episodes of the 1970s, companies experienced squeeze on their margins. The era of subdued inflation, following the 2008/09 recession, was the only time when margins improved.

Profit margins are now at their highest level since at least 1947. If inflation continues to rise and margins decline, profits will suffer. Now remember the graph we shared earlier with the ratings. If earnings fall due to falling margins and valuations fall to levels consistent with previous periods of inflation, stocks could easily drop 40-50%. Even larger declines would not be abnormal.

In the event of persistent inflation, stocks that can protect margins that do not trade at high valuations have the best chance of holding their value. Conversely, beware of those who trade at high margins with limited ability to pass higher costs on to consumers.

Conclusion

We still maintain a longer-term deflationary bias. Having said that, we don’t know what the future holds, and neither does anyone else. It is no longer a given that supply lines will moderate and inflation will normalize soon. Workers are increasingly emboldened to seek higher wages, threatening a wage-price spiral.

The Fed conducts its policy as if the economy is in depression when it is booming. More inflation is likely, at least in the short term, and we have a better understanding of how inflation can wreak havoc on stock prices.

Given the profit margins and record valuations, it looks like little benefit is emerging, especially if inflation remains problematic. Throw stagflation into the formula, and the outlook is bleak.

We urge you to carefully consider the risks and rewards in various inflation environments and trade accordingly. This time it’s different!

Twitter: @michaellebowitz

The author or his company may hold positions in the titles mentioned at the time of publication. All opinions expressed here are solely those of the author and in no way represent the views or opinions of any other person or entity.

About Andrew Estofan

Check Also

The Crypto Crash is just the beginning

Sign up for Derek’s newsletter here. The US economy is not doing very well right …