What stocks may need: a bit of inflation

Back in February I highlighted the interesting–read: troubling–divergence between stock prices and bond yields. Bonds were signaling an economic slowdown while persistent equity gains suggested a near perfect balance between growth and low inflation. Since then the divergence has only widened.

Equities hit a five-month high late last week, while bond yields fell to their lowest level since January of 2018. To be sure, much of the recent drop in interest rates reflects a rapid shift in Federal Reserve policy, one that suggests an abrupt end to the Fed’s tightening cycle. That said, with a dovish Fed already reflected in both bond and equity markets, can this divergence continue?

In answering the question, it is helpful to focus on one particular aspect of interest rates: inflation expectations. Nominal interest rates can be broken down into a real, or after-inflation component, and inflation expectations, captured by the break-even (BE) rate in Treasury Inflation Protected Securities (TIPS).

In the post-crisis environment long-term BE rates (derived from the 10-Year TIP) and U.S. equities have been closely correlated. Weekly changes in 10 Yr. BE’s have explained nearly 30% of the variation in S&P 500 returns (see Chart). To my mind this makes sense. In the post-crisis environment investors have constantly been worried about too little growth. In this context a positive relationship between inflation expectations, which are driven by growth, and stocks is intuitive.

However, since late November there has been a pretty significant divergence between stocks and BE rates. While inflation expectations have recovered from the December bottom, the 10-year BE is basically flat compared to where it was around Thanksgiving. During the same period, however, the S&P 500 has gained roughly 8.5%. Most of this divergence occurred in the immediate aftermath of the December low, but in recent weeks it has re-emerged. Inflation expectations have been flat during the past month while the S&P 500 has rallied another 2.5%.

A little inflation can be a good thing

Going forward, to the extent break-evens are flat-to-lower this calls the longevity of the rally into question. Why should this be the case? In one word: margins. Historically, higher inflation expectations have been associated with higher profit margins. This is because companies can enjoy better pricing power, and better margins, when inflation expectations are higher. This relationship is evident in the data.

During the past 20 years profit margins have averaged 6.5% in periods of below-average inflation expectations, defined as less than 2%. However, in periods when inflation expectations have been above average profit margins have averaged over 8%.

To the extent higher inflation expectations are associated with higher pricing power and better margins, a drop in inflation expectations would be another data point suggesting that the divergence between rates and stocks cannot go on forever. Either bond yields are too low or investors should be more nervous about earnings than they seem to be.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. ©2019 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners. USRMH0319U-794146-1/1

source https://www.blackrockblog.com/2019/03/29/stocks-may-need-inflation/