Financial markets are at a crossroads – with inflation being the dominant theme.

Partly due to the external shocks of the Ukraine invasion and China lockdowns, many global central banks have been caught off guard by the surge and persistence in the inflation data and are currently rushing to reverse erstwhile accommodative monetary policies. As it stands 63% of global central banks have recently removed monetary accommodation.

One of two scenarios will develop from here:

1. Either inflation will start to moderate allowing for bond yields to consolidate or fall which will then provide support for positive equity returns.
2. Or inflation data will remain persistently high, forcing central banks to go beyond a neutral monetary policy to one that is more restrictive and therefore negatively impacts on economic growth and equity valuations.

We have been producing the following two charts since early 2021 as we judged that the vaccine rollout would result in a normalization of economic activity leading to higher interest rates and a return to more sensible valuation multiples.

Both charts still point in the same direction – a market which needs to come down from the still excessive valuations which will likely be coupled with a resurgence of the value style of investing.

Source: Strategas Research Partners

Source: Strategas Research Partners

The above reversal of trends makes passive investing in equity indices, which have become dominated by growth stocks, a much more risky proposition. Despite the recent market correction, the chart below clearly shows that the US market still has a historically high allocation to extremely expensive stocks (selling for greater than 10x sales).

Source: Strategas Research Partners