Unbridled inflation leaves equity markets pretty much cold

Eurozone countries report inflation rates in the 6% to 10% range. (Image: Shutterstock.com/oobqoo)

Market participants are likely to be in the fog when it comes to inflation forecasts. Once again, the numbers this week were above expectations. The bond markets react accordingly, but the stock markets are surprisingly calm. How much longer, DWS experts ask, and provide answers.

It is almost exactly ten years since Mario Draghi uttered his famous words "whatever it takes" slammed at the ECB press conference those investors who dared to doubt the solvency of European peripheral countries and/or the ECB's willingness to help them. This week, inflation rates of 6% to 10% have been reported in the euro zone countries. Of course, according to DWS, central banks were ready beforehand to do whatever was necessary to protect the people and the economy from major dangers. For example, the Federal Reserve in 2008 to counter the effects of the financial crisis. At that time, the central bank's balance sheet total rose from one to over 2 trillion euros. USD. Then, in the Corona pandemic, it rose from 4 to now 9 bio. USD. The USA recently reported an inflation rate of 7.9% for February. The fact that one, inflation, has nothing to do with the other, central banks' balance sheets, is something that not only central banks are regularly emphasizing at the moment.

"Consumers and employees are unlikely to care about the truth of this thesis, they only see the current rising prices. And they are rising, as are yields. As our chart of the week shows, the inflation component has been the driving factor behind the rise in yields on 10-year U.S. Treasury bonds since March 2020. Real yields, on the other hand, have been hovering surprisingly steadily between minus 0.5 and minus 1% for the past two years. But inflation expectations have risen by around half a percentage point since the outbreak of the war alone, which is hardly surprising in view of the current inflationary pushes. Extrapolated over ten years, this would correspond to an additional loss of purchasing power of a whopping 6%.", according to DWS.

Inflation and real components of U.S. interest rates

What is surprising, however, is the indifference of the stock market. The S&P 500 is back well above the level it was at before the war began. And yet, for the past two years, it has been said that equity valuations come under pressure when 10-year treasuries are quoted above 2%. However, at that time, higher returns were still thought to be driven by the real component in the context of the reopening economy.

As the DWS experts further explain, from a portfolio manager's point of view, rising or even positive real yields mean that bonds are becoming more attractive. On the other hand, shareholders are happy about negative real returns, because then the TINA argument (There Is No Alternative) would work – i.e. the supposed lack of alternatives for their investment. "But higher nominal returns driven by inflation expectations are a no-brainer for shareholders.", the experts pose the question. Your answer: "Well, ceteris paribus, an earnings value model would arrive at the same price value if the earnings and costs of the companies increased in line with inflation. The larger numerator would be compensated by an equally inflated larger denominator."

Market participants are poking around in the fog

However, it will become more uncomfortable if inflation takes on absolute dimensions that make business planning more difficult. At rates of, say, 10%, companies would realistically have to expect a 10% fluctuation corridor (five percentage points up or down). In the last decade, a corridor of 3% was already prudent. "This higher uncertainty should be reflected in higher risk discounts", according to the experts. There is little sign of this on the stock markets. Perhaps because the high inflation rates are still considered temporary. Or because it was believed that companies could continue to raise prices more than their own costs for a longer period of time.

But why should stock investors do a better job of forecasting inflation than bond investors, even if the latter have had their work made even more difficult for years by the massive bond purchases by central banks?. "The fact is that at the moment probably all market participants are poking in the fog, as was also evident on Wednesday, when economists' estimates missed the actual German inflation figures by a full 1.3 percentage points", comments the DWS.

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