Blog Posts — June 15, 2021

Inflation Will Likely Come Down, but It May Take Time for Markets to Benefit

by Christoph Schon, CFA, CIPM

US consumer prices in May grew at their strongest pace since 2008, overshooting the Federal Reserve’s 2% inflation target by 3 percentage points. The reaction? Stock markets climbed to record highs, while Treasury yields declined.

At first glance, that response seems counterintuitive—after all, inflation erodes the value of future cashflows, which should be bad for both stocks and bonds. However, a look at what happened almost exactly 10 years ago reveals that this behavior may not be that unusual after all. At the same time, history also indicates that there could still be choppy times ahead—especially for the Energy, Materials, and Industrials sectors, which are likely to be adversely affected by falling prices for commodities and consumer goods.

Comparing the current relationships between inflation, share prices and monetary policy with the environment during and after the global financial crisis (GFC) reveals some striking similarities. The chart below shows the STOXX® USA 900 (plotted in green against the right-hand scale) together with the 10-year breakeven inflation rate, derived from the price differences between inflation-protected and nominal US Treasuries, in dark blue. The light blue dots denote the realized year-on-year consumer-price growth rates on the days they were published.

US shares prices versus inflation: 2008-2011

Sources: Qontigo, FRED®

The correlation graph at the bottom highlights the close co-movement of share prices and breakeven rates during both the initial sell-off in the second half of 2008 and the subsequent recovery. Yet, when fears emerged in early 2011 that the US economy was on the brink of overheating, the stock-market rally began to stall, while inflation—realized and expected—continued to increase, briefly turning the correlation between the two negative. Shortly thereafter, breakeven rates peaked and began to descend again, but share prices did not benefit. On the contrary, the positive interaction resumed and both timeseries fell together. It then took another 10 months for the stock market to recapture its April-2011 highs.

The next chart highlights the strong similarities between recent events and the GFC, though things appear to be unfolding at twice the speed now. We see the concurrent drop and rebound of share prices and breakeven rates, as the crisis unfolded. Then, when expected inflation broke above the Fed’s 2% threshold at the start of 2021, the relationship briefly collapsed and eventually turned negative in May. Realized consumer-price growth, meanwhile, kept creeping up.

US shares prices versus inflation: 2008-2011

Sources: Qontigo, FRED®

If history is any guide, one could argue that we are now at a similar point as in March 2011 (highlighted by the dashed line in the first chart). Then, as now, breakeven inflation seemed to have peaked, but actual consumer-price growth kept accelerating. Share prices even continued to rise for another month or two. At the same time, the Federal Reserve saw no need to tighten its monetary policy, despite the growing inflationary pressure. On the contrary, it left its target rate corridor at 0-0.25% for a further 4.5 years, before finally raising it by 25 basis points in December 2015.

So, where does this leave us today? Assuming investors continue to trust the Fed’s assertions that the current rise in inflation will indeed be temporary, breakeven rates should continue to decline and revert to the long-term target of 2%. The challenge now is to guess how stock markets will react. To help answer this question, we ran two stress tests. The first scenario replays the actual market movements between the beginning of March 2011, when stocks and breakeven rates were inversely related, and mid-September 2011, when expected inflation fell back below 2%. The second analysis uses a transitive stress test to estimate the impact of a 50-basis point drop in the 10-year breakeven rate, calibrated on weekly returns from the three months ending June 4, 2021. The chart below shows the simulated sector returns for the STOXX® USA 900.

Simulated sector returns for a decline in breakeven inflation

Source: Axioma Risk™

The total index return of -11% for the 2011 scenario closely matches the actual losses incurred during the analysis period. A further breakdown reveals that almost all sectors—apart from Consumer Staples—saw share prices decline. The picture is more mixed, however, under the current correlation regime. While Materials, Energy, Financials, Industrials can expect similar drops in value, Information Technology and Health Care now show positive performances. Also, Consumer Discretionary, which contains online retailer Amazon, shows a much smaller simulated loss. This seems reasonable, as these companies are likely to continue to benefit from the still ongoing pandemic. And as these three sectors account for nearly half of the index’s market capitalization, it is not surprising that the average predicted loss of -3% for the overall benchmark in the current environment is much smaller than in the historical simulation.

In summary, historical evidence from the aftermath of the global financial crisis suggests that inflation could revert to the 2% long-term target, even if the Federal Reserve does not tighten monetary policy immediately. However, this does not necessarily mean that share prices will simply keep rising. In fact, both the historic scenario and the stress test with current correlations indicate that equity investors should prepare for short-term losses, especially in sectors that are sensitive to changes in commodity and consumer prices, such as Energy, Materials, and Industrials.