Cluster Struck

TUE 12 APR 2022

The news flow this week is likely to be relatively important for markets. Of course, as we often note, it is how price responds that matters. The key information to be released is the US CPI later today and the start of the earnings season tomorrow. Over time the two key influences on stock prices are corporate earnings and inflation. The latter clearly influences the discount rate, via the risk free rate and the equity premium (the equity valuation multiple and risk perceptions). It is also likely to have an important influence on profits due to input cost pressures. The extent to which individual companies have pricing power will likely be illuminating during the reporting season.

We turned cautious on equities again at the start of last week and reduced net exposure. While policy rate hikes in response to inflation pressure are well appreciated, three additional factors amplified our caution last week. First, price itself had rallied materially off the March low. Second, communication from the Fed (especially the dovish members of the FOMC) reinforced the commitment to hike rates and actively reduce the balance sheet (Quantitative Tightening). Third, there appears to be a material slowdown in the macro news flow, confidence and assets that lead the cycle (cyclical/defensive, financials, homebuilders, semiconductors and yield curve). As we have noted before, the policy error was normalising too late. Stated differently, a long phase of artificial stability (through policy actions and promises) breeds explosive instability.

The good news on inflation is that it is probably near a peak on the headline index. That is partly due to base effects and also the probable top in energy prices (in rate of change terms) and other goods components. On the negative side, as Cam Crise noted overnight, inflation – like volatility – tends to cluster or remain persistent for behavioural reasons. Put another way, the year on year rate of change in the CPI tells us what has happened. However, what matters is how inflation behaves looking forward. While the 2 year breakeven inflation is clearly lower than the spot CPI, it remains at 4.4% or the highest in more than a decade and well above the Fed’s target (chart 1). The belief that inflation will remain persistent could influence companies to push through price rises and employees to demand higher wages.

The big picture point for investors is the influence inflation has on corporate earnings and the valuation multiple or discount rate (there is a self-reinforcing de-rating of valuation during phases of high inflation). While equities are a “real” asset in the sense that companies can raise final prices to offset an increase in input costs, not all companies are created equal. It obviously matters how much pricing power they have. Historically, equities have tended to perform well in moderate inflation regimes, phases of very high or low inflation have tended to be detrimental to share prices (on the low side stock prices are pricing recession).

The good news is that this risk has clearly become the prevailing bias and is well appreciated. On the negative side, inflation has become political and is the reason why the Fed will be forced to respond even if equity prices decline. Global bonds are now the most oversold in at least 20 years. Given that the cyclical lead indicators are now consistent with a growth scare, there will likely be an opportunity to buy fixed income and/or bond proxies. However, we should also be aware of inflation persistency in this episode. As we have noted previously, equities typically cope with early cycle tightening. The risk is that this cycle is hotter and shorter and macro conditions are more typical of a late cycle environment. Equity risk is probably still biased to the downside in the near term.