Inflation is a hot topic for capital markets at the moment. Green shoots of an economic recovery are coming through all over the world, and investors are betting on a post-pandemic boom. Meanwhile, both monetary and fiscal policy is expanding, while consumers and businesses are regaining confidence to spend and invest. This is expected to bring the economy to the boil and put upward pressure on prices – most of all in the US (as discussed in the previous article). But what this means for equity markets is not entirely straightforward. At the simplest level, aggregate company earnings are directly related to nominal growth, meaning any move up in prices should be matched by a move up in earnings and – in theory, and over the long-term – an increase in share prices. In this sense, equities are a ‘real’ asset: they give investors a hedge against inflation in a way that fixed coupon bonds cannot.
Looking at a deeper level, though, there are many more factors to consider. Ultimately, the issue comes down to how investors value assets, and in particular how different parts of the ‘accepting risk for the prospect of higher reward’ are priced. ‘Risk premia’ (how much extra reward/return investors will receive over the long term for a given level of risk) is with reference to government bonds – the so-called ‘risk-free rate’.
By working out the difference in returns between government bonds and equities or corporate debt, we can tell how much markets are demanding as a return premium for taking on company risk. However, as a multi-asset investor, we want to work out the difference between corporate bonds risk premia and equity risk premia.
To get a reading of how the market values corporate bond risk, we look at the fixed coupon corporate bond yield less the fixed coupon government bond yield. Trying to transpose this to equities, inflation complicates the picture. Therefore, maybe it is better to try to neutralise it out of the equation. This we can measure by adding together the yield on real government bonds (in the US case, inflation-linked US Treasuries) with the difference (spread) between nominal corporate bonds (in this case, the average of BBB-rated corporate credit) and risk-free nominal government bonds. That gives a measure of the real return on company debt. (This implicitly assumes that the market price of inflation doesn’t have a risk premium, and that discussion is definitely for another time!)
Now, when we put this together with another measure of equity value, we see an interesting relationship. Investors might be familiar with price-to-earnings ratios for equities, which tell us how highly the market values a particular stock relative to its expected profits. But if we flip that equation round (earnings-to-price), it effectively gives us something like a yield equivalent for equities. With valuations currently so high, the inverse is that the equity ‘yield’ is pushed low. This is not so surprising, given that central banks are holding down yields across the world. But the interesting part is how this relates to the ‘real’ corporate bond yields we established in the previous paragraph. The chart below shows the difference between the two measures (spread) – between inflation- adjusted corporate bond yields and the yield investors demand from equities.
As you can see, prior and immediately after the global financial crisis of 2008, this spread moved around a fair amount. But since then, it has been remarkably stable. This is despite the underlying components – equity prices, valuations, inflation, growth expectations, etc. – changing substantially over that time. We think this makes it currently a pretty stable measure of the relative equity risk premium, which means that should one of the other variables change (i.e. corporate earnings or real yields), we can expect share prices to change as well.
Recent historic observation as per the chart above remind us there is a strong relationship between equities and real yields. The implication is that, in itself, inflation is not all that important for equity prices. That is, looking at the broader equity market, inflation is seen by investors as something of a ‘pass through’ in prices – not a great concern, even if everything is pointing to structurally higher inflation.
One shouldn’t take that too far. Inflation and real growth tend to go hand in hand. That is, a big push forward in real growth expectations will tend to be accompanied by a similar move in the price level. So, if long-term inflation expectations rise – all else being equal – so too will estimates for real growth. But these long-term expectations of the real growth of an economy are what drives real yields of government bonds – precisely the factor that ties in so strongly with equity prices.
A sharp rise in real bond yields has stung capital markets in the past, namely the previously mentioned ‘Taper Tantrum’ days of 2013, when a policy misstep from central banks sent real yields sharply higher, driving down risk premia and punishing stock values. Recently, rising real yields have led to similar concerns. Central banks have tried valiantly to reassure markets that a similar policy mistake – tightening conditions too soon – will not happen this time. But the factors discussed above make things tricky for central bankers. By keeping policy loose, they force up inflation expectations, thereby forcing up real growth expectations and, ultimately, real yields.
This has the potential to put pressure on equities, because long-term growth expectations are already at 20-year highs. At the moment, a sharp rise in real yields is one of the main risks to the ebullient mood in markets. We should point out that the relationship between real yields and equities does not have to remain as stable as it has done – not if, say, longer-term expectations of earnings growth swamp shorter-term concerns. But if the stability in that ratio persists, a few things that could happen have the potential to markedly change equity valuations as they stand to today, which are: a shock to real yields after a central bank mistake; a shock to corporate credit spreads after unexpected increases in corporate defaults; or an earnings shock, which would push up earnings yields by earnings increasing unexpectedly fast.
These are scenarios we will have to monitor closely over the coming months – particularly as we come out of the pandemic and the resolve of central bankers is tested. But for now, we can comfort ourselves with the reminder that, over the long-term, equities remain the most profitable asset class, and will ultimately win out if growth is strong.