The narrative of ‘transitory’ inflation has lost any creditability it may have had. Headline inflation in the U.S. has registered >5% for four consecutive months (chart below) and the excuses for its probably persistence keep growing. The evolving issue for financial markets is that even excluding the more volatile components of inflation, there is building evidence that inflation is becoming more embedded. U.S. core CPI is above its 50-year average and at its highest level since 1991.
Source: JP Morgan
It is true that some of the price surges responsible for the early rise in inflation readings are starting to moderate. However, there are now clear signs that this inflation dynamic is spreading to the historically less volatile and highly important components of inflation – rents and wages. The chart below shows that rents are finally starting to move higher, supported by an improving job market and house prices at all time highs. Price trends in housing/rental inflation tend to be more enduring and we would expect that the momentum in this inflation measure has only just got started.
Source: Strategas Research Partners
Similarly, the strength of job demand in the U.S, combined with the widely documented difficulties of attracting qualified people to fill these positions, is also leading to a marked acceleration in wage inflation (chart below). It should be noted that despite the recent surge in wages, the rate of increase is still not keeping pace with headline inflation which is relevant for the majority of people who spend a high percentage of their incomes on items such as fuel and food. There is little reason to expect this inflation measure to subside in the near future.
Source: Strategas Research Partners
It is therefore not surprising that longer-term inflation expectations are beginning to rise substantially (chart below). This is exactly the ‘embedded inflation’ that the Fed warned would temper their enthusiasm for maintaining a loose monetary policy. Persistent inflation numbers combined with recent comments by some Fed officials are combining to force markets to price in an earlier monetary tightening than what was expected even a few weeks ago.
Source: Strategas Research Partners
It is therefore not surprising that longer-term inflation expectations are beginning to rise substantially (chart below). This is exactly the ‘embedded inflation’ that the Fed warned would temper their enthusiasm for maintaining a loose monetary policy. Persistent inflation numbers combined with recent comments by some Fed officials are combining to force markets to price in an earlier monetary tightening than what was expected even a few weeks ago.
Source: Strategas Research Partners
We have explained in the past the negative impact that rising inflation and rising bond yields have on financial markets. We will go into a bit more detail on the impact on valuation. As we have noted in the past, higher inflation regimes do correlate with lower valuation multiples. This is a market wide phenomenon but obviously will impact those stocks selling significantly above historic and relative valuation norms. This is not some useless theory left to academic discussion. The chart below shows the impact that rising inflation and interest rates are already having on equity market performance. The U.S. market has posted strong returns for 2021 but as the chart shows valuation multiples have actually contracted and detracted from performance to the magnitude of-11.6%. Positive performance in 2021 has been driven by exceptional earnings growth. A very different pattern than the last 12 years where the vast majority of equity index returns came from the expansion of valuation multiples. There is one obvious question that arises from this observation. What is the outlook for equity returns should inflation and yields continue to rise in the context of an already highly valued equity market where earnings growth is bound to slow?
Source: JP Morgan
The simple answer is that index returns will probably look very different from the previous ten years and rely much less on multiple expansion and much more on earnings growth. A useful exercise is to locate those segments of the market most exposed to valuation risk so that they may be avoided. The chart below suggests that the largest index companies are a good place to begin. The chart shows the earnings multiple attached to the ten largest stocks in the S&P compared to the remaining 490 stocks and relative to its historical average. Very simply, the top stocks are more overvalued relative to their historical norm and the valuation gap compared to the remaining index stocks is stretched. Of note is that 8 of these 10 names are technology companies – Berkshire Hathaway and JP Morgan barely manage to make it into the top ten, at position #9 and #10 respectively.
Source: JP Morgan
Also of note is that these ten highly valued companies have never commanded such an influence over the direction of the largest equity index in the world. Their combined weight has surpassed the concentration risk of 2000. Passive investment strategies are highly exposed to this concentration and valuation risk. Index investors have been the beneficiaries of a zero-interest rate monetary regime that fed a ‘growth at any price’ investment approach over the last 12 years. Future returns will most probably look very different in a world of rising bond yields.
Source: Strategas Research Partners
Investment managers willing to deviate from an index-based approach should be able to benefit from this changing environment. The reality is that the valuation risk of equity indices is mainly concentrated in a limited number of sectors and stocks. The chart below tries to demonstrate this valuation dispersion. The green line plots the median earnings multiple of the index over the past 24 years and currently stands almost at period highs. The shaded area shows the earnings multiple of the most expensive 20% of companies in the index versus that of the cheapest 20% of companies in the index. Historically, whenever the gap between these two groups have been so wide (currently on par with valuation gap in 2000), it is a signal of real market mispricing and attractive investment opportunities for those willing to deviate from existing consensus. In our next update we will go into more detail on where we are finding the greatest mispricings that should allow for above average portfolio returns.
Source: JP Morgan
