Equity markets – in search for the accurate inflation

Several variables indicate to reflation in 2021-2022, with a brief overshoot in the US and the Eurozone. Financial markets have priced an inflation risk premium based on:

(i) the recent input cost bonanza,
(ii) greater services inflation when the economy reopens in H2, and
(iii) significant pandemic-related roller coaster base effects.

While an inflationary scenario cannot be ruled out, we do not anticipate inflation starting on a fundamental regime shift since weak demand dynamics hint to a potential head fake: I excess savings from individuals and non-financial companies, which serve as a drag on money velocity; (ii) continuously negative output gaps as a result of reduced capacity utilization; (iii) slightly high unemployment rates maintaining a lid on wage growth (below 3%), and (iv) the negative impact on firms’ balance sheets from the phase-out of support measures.

Is realized inflation, however, the important metric?

Simply by looking at certain inflation vs. equities charts, it is possible to deduce that realized inflation rates, or historical CPI growth rates, tend to lag behind market changes and are not contemporaneous with sharp market swings. This disparity is caused not just by a publishing delay, but also by markets anticipating inflation.

How much influence did inflation forecasts have on equities performance in 2020?

Attempting to explain stock performance using macro factors is always a difficult affair since it implies that all market participants take the same variables into consideration when looking at capital markets and trade under the same knowledge. A top-down approach like this sheds some light on the relative impact of several broad economic factors on equities performance. In this example, we use a monetary aggregate, long-term inflation expectations, real yields, and nominal exchange rates to approximate stock performance. This multivariate method works best in the United States, but it can extract some information in the Eurozone as well.

Some models indicate that the M2 money supply appears to be responsible for the majority of the 2020 market boom, putting a nearly constant arround +10pp upward pressure on yearly equity returns since April 2020. Real yields, on the other hand, have been putting arround a -2 to -3pp downward pressure on equity returns since the beginning of 2020, but this is beginning to reverse. The inflation component, which imposed significant negative pressures immediately following the initial March 2020 shock (-8pp), has eventually turned positive, reaching arround +7.5pp upside pressure in February 2021. Overall, the inflation component’s coefficient is fundamentally positive, implying that greater inflation predictions should lead to higher eguity returns. These are the average data, taken from the mulitple models.

Investors believe the epidemic has reached a tipping point. Vaccine campaigns increased in the first quarter, fatalities and infection rates fell from high in several countries, and some economies began to reopen. Despite some losses, especially in Europe, the MSCI World Index gained 6.1 percent in local currency terms. US small caps, US equities, Japanese companies, energy, and financials outperformed in regions and sectors that benefit from cyclical rebound. Utilities and consumer staples were among the worst performing industries.

Chart: US small caps and Japan stocks led gains as cyclicals outperformed

Market gains have been disguised by constantly changing market circumstances. While official interest rates stayed at historic lows, the 10-year US Treasury yield increased by 89 percent to 1.74 percent by the end of the quarter, raising fears about an inflationary outbreak driven by huge fiscal stimulus and pent-up consumer demand. Value stocks, usually regarded as the more immediate beneficiaries of a stronger economic recovery, beat growth stocks by a large margin, extending a rally that began in November. However, the equity style rotation was not seamless, with investors alternating between growth and value equities on a daily basis.

Chart: Value stocks vs growth stocks returns. Style rotation remained volatile.

Volatility was also fuelled by individual investors’ rising involvement, which was fueled in part by huge fiscal stimulus. Wild activity in a group of equities including GameStop and AMC Networks was prompted by Reddit trading boards (left). According to Goldman Sachs trade statistics, retail investors account for 20% of trading activity in the United States, up from 10% in 2016. At the start of the first quarter, US families owned more than 27% of their wealth in shares, surpassing the record of 25% during the 2000 technological boom (right).

Chart: US Retail trading trends

Looking closer at inflation

The markets have raised the inflation alert. Inflationary measures depending on the market should be regarded with caution. Actually, we believe that markets are overreacting to the reflation story due to taper phantasies rather than real-world events. Our proprietary model for 10-year US breakeven inflation rates, which is based on a direct link between realized monthly inflation rates (smoothed) and market-based inflation expectations, is now overshooting. The 10y US breakeven inflation rate is now trading at 2.3 percent, which is more than one standard deviation above the fair value, which is projected to be 1.5-1.6 percent, severely restricting the possibility for further rise.

A coming wage-price spiral will undoubtedly take us back to the 1970s! The rapid upswing will provide labor markets a much-needed boost, but clearing up the Covid-19 economic legacy will take time. In the longer run, subdued labor market prospects in the Eurozone should keep wage growth (below 3%) in check.

The extraordinary policy reaction will almost certainly result in fundamentally higher inflation! For the time being, we believe it is a free lunch. Money supply growth is a poor predictor of realized inflation; instead, focus on money velocity, which fell in 2020 as part of a long-term pattern. This long-term trend, as well as its current acceleration, represent an increase in the demand for money for preventive measures.