Monday, March 20, 2017

   

“Does Higher Inflation Signal Trouble For Stocks?”

In a world of record-low interest rates and sluggish growth, it should be no surprise that inflation has been all but absent since the end of the Great Recession. Tighter monetary policy, wage growth and potential fiscal stimulus, along with an expected jolt to cyclical economic expansion, have many forecasting higher inflation and interest rates on the horizon.

So what does that mean for stocks?

There is little doubt that low interest rates have been a boon for stocks over the past decade. Post financial crisis, the 10-year Treasury yield dipped below the dividend yield on the S&P 500. This seldom seen scenario presented investors with the oft-mentioned trade-off of owning a guaranteed low fixed rate of return or the same stated yield with the potential of earnings and valuation expansion in stock prices. The “equity risk premium” had seldom been so attractive relative to bonds.

Bond bulls might point to the head fakes we have seen over the past five years in which rates moved higher only to reverse course and make new lows. With the Fed already having hiked short-term rates to 0.75-1%, it would likely take a recession to see long-term rates move to new lows again. So with the increasing likelihood of rising rates, many are now forecasting a reversion in the relative valuation stocks should command compared to bonds.

There are a couple things to consider before rushing to fear on stock valuations. First, is the underlying corporate earnings expansion currently in progress. One of the reasons the current market valuation level, or price-to-earnings ratio, is so high is because earnings were relatively depressed over the past two years amidst a contraction in the manufacturing and energy sectors of the economy.

As of today, analysts are expecting earnings to recover and grow 10% in 2017 and a further 12% in 2018, according to FACTSET1. So if the “E” in the “P/E” equation is increasing, the overall valuation level is likely to reduce or remain steady over time assuming prices do not move substantially higher. If earnings are increasing at near double digit rates, it is very unlikely that a significant correction in stocks happens. Should these estimates turn out to be wildly inaccurate, then stocks could feel some pressure.

Second is the relative sweet spot for inflation in valuation multiples. The notion that higher inflation and interest rates are headwinds for stocks is no doubt accurate. Investors could take their cue from the early 1980’s in which stock multiples retracted to low single digits in the midst of runaway inflation. After all, why take the risk of owning a stock when you can get a risk-free return of 10-15%? On the flipside, deflation (negative inflation), is typically coupled with recessionary economic conditions, which are also a poor prelude to equity price performance.

The answer lies somewhere in the middle of these two extremes. Current inflation is just above 2%, which has historically been a good range for relative equity valuations. Should inflation increase above 4%, which would coincide with higher risk-free interest rates, then the equity risk premium could be in trouble. That is a long ways away at this point.

Whilst inflation has been increasing in recent readings, it has so far done so with intermittent and relatively meager gains. We have yet to see a runaway “hot” economy and the potential inflationary fiscal stimulus of the new administration is all but guaranteed. So while it makes sense to keep an eye on inflation readings in future years, the data has yet to support the real risk of rapid inflation on the near-term horizon.

Key levels to watch will be 4% inflation or 4% yield on the 10-year Treasury bond. Currently we are at 2% inflation and a 2.50% 10-year yield. Until we breach those levels, assuming a stable economy and corporate earnings growth, stocks will likely continue to hold their relative merits. We will continue to watch the data and tilt towards the equity risk premium in the interim.

Jack Holmes, CFA® & Todd Feltz, CFP®

WealthPLAN Partners

 Sources:

  1. https://insight.factset.com/hubfs/Resources/Research%20Desk/Earnings%20Insight/EarningsInsight_031717.pdf

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Advisory services offered through Feltz WealthPLAN, DBA of WealthPLAN Partners.  Securities offered through Securities America, Inc., Member FINRA/SIPC. Feltz WealthPLAN and Securities America are separate entities.