Inflation and markets

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   By Guest Blogger Ryan Lewenza

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In my last post I provided a ‘101 tutorial’ on inflation. This week I want to take it one step further and discuss the outlook for inflation and the implications for the equity and bond markets.

In client meetings we’ve been stressing the high inflation and the implications of this on the markets. It’s probably the single most important factor right now for the global economy and financial markets.

We’re seeing this in politics as well with President Biden and Prime Minister Trudeau down in the polls, in part due to the high inflation, which is making life harder for many people. We’re seeing this on an individual level with some Canadians boycotting Loblaws due to the high food prices. Can you blame them with food inflation up over 20% in the last few years.

And, most importantly for investors, the high inflation levels are forcing central banks around the world to jack rates up to the highest level in over 25 years, to help combat these intense inflationary pressures. This is our focus today.

Starting with bonds, high inflation can be a bond return killer. When inflation is high, like in the 1970s and early 1980s, central banks aggressively hiked rates to slow down the economy and help bring inflation back down. As we all know, when interest rates rise, bond prices fall, so this was a challenging time for bond investors.

During the inflation spike of the 1970s, US interest rates surged from 6% to over 16% by 1981. Paul Volker was the Chairman of the Federal Reserve and he helped to end the high inflation levels with aggressive rate hikes.

Below is a good chart showing the returns of different assets during the 1970s. Bonds (US treasuries) did ok in ‘nominal terms’ with bonds returning 7% annualized. How can this be as bond prices fall when rates rise? There are two components to bond returns – the annual coupon or interest payment and the bond price return. With interest rates being high during this period, coupon rates were high, which helped to offset the falling bond prices. So, bonds did provide a positive return during this period before inflation.

Real returns are returns adjusted for inflation. When inflation levels are applied to the bond returns you can see that real returns were negative (-1% annualized) during this period. This is how high inflation impacts bond returns. Your bonds might provide a positive return in a year, but if inflation is high in that year then your ‘real return’ can be negative as your money is losing purchasing power.

Generally speaking, in high inflation times, bonds will tend to underperform stocks and other assets like commodities, due to the fixed nature of bond returns.

Annualized returns of different assets during the 1970s

Source: Haver Analytics, Deutsche Bank

Now let’s look at how inflation impacts stocks.

Generally, stocks tend to outperform bonds and other fixed investments when inflation is high. This is because companies can often pass on the rising costs to customers by raising prices on their goods and services. Whether it’s McDonalds raising its prices on Big Macs or Apple raising the price on the iPhone, companies can offset the impact of higher costs by raising prices. So, revenues and earnings will rise during inflationary times, which is a key reason why stocks can still do ok when inflation is high.

Put simply, stocks can provide a hedge to inflation through rising revenues, earnings and ultimately dividends.

Now, that doesn’t mean stocks are completely immune from high inflation. When inflation starts to accelerate and become more entrenched, this forces central banks to hike interest rates, which is exactly what occurred in this cycle.

When interest rates rise this can negatively weigh on stock prices through the price-to-earnings (P/E) ratio. Recall stock prices are driven by two factors – corporate earnings, which I already covered and a changing P/E ratio.

Below is a chart showing the relationship between interest rates and P/Es. It shows that as interest rates decline (note: interest rates are inverted on the chart to better show the relationship) this often leads to a rising P/E ratio and vice versa. For example, you can see that as the US 10-year bond yield increased because of the Fed rate hikes, this caused the P/E to compress or decline in 2022. The S&P 500 fell 20% in 2022 and it was due to this declining P/E ratio.

So, inflation impacts stock prices in a few different ways, and it depends on which factor – corporate earnings or the P/E ratio – wins out in the end.

Relationship between P/Es and interest rates

Source: Bloomberg, Turner Investments

Now where is inflation headed and what does this portend for the equity and bond markets?

Inflation has clearly peaked and continues to trend lower. In Canada inflation has been below 3% for four consecutive months. Inflation is slowing in the UK and across Europe. It’s basically a lock that the Bank of Canada and European Central Bank will soon cut rates. Inflation in the US has been a bit more ‘sticky’ so the Fed will be slower to cut rates. But we believe the high interest rates are having the desired effect of slowing inflation, and that soon the global central banks will begin to cut interest rates.

This should help stock prices by: 1) the lower interest rates should provide a boost to the economy and in turn corporate profits; and 2) the lower interest rates could help to drive the P/E ratio higher given this important relationship.

As for bond returns, lower interest rates will help to drive bond prices higher. The combination of the higher coupons and the potential for bond price appreciation, should result in decent bond returns over the next few years.

If all this unfolds as expected, our little old balanced portfolio should do pretty well over the next few years.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.