Why are investors not bothered about inflation?
Inflation, inflation everywhere – CPI in the US the highest in 30 years, in Japan the most in 40 years. Producer price inflation is also soaring across the board – last week’s Chinese PPI shot up to a 26-year high. Friday saw yet more evidence as German wholesale prices also jumped. In October German wholesale selling prices rose by 15.2% year-over-year. This was the highest annual rate of change since March 1974 after the first oil crisis. It also marks a steep acceleration in recent months as in September and in August the annual rates of change had been +13.2% and +12.3%, respectively. University of Michigan one year ahead consumer inflation expectations rose again to 4.9% from 4.8%. Meanwhile, the consumer sentiment figure dropped to a 10-year low – worse even than at the peak of the market panic a year and a half ago. On Friday the US 10 year break-even inflation rate rose to 2.76%, its highest since 2006. Real yields meanwhile sank to record lows.
Yet investors don’t seem that bothered, as a combination of weak consumer sentiment and higher inflation is somehow not weighing on stocks: US and European equities keep making new records. Ultimately, the market remains fairly comfortable with fundamentals as earnings growth has been better than expected, as companies seem broadly able to maintain margins by passing on their higher costs to consumers.
Monetary policy remains incredibly accommodative and although inflation is high the market thinks a) the Fed and others won’t crack and raise rates early or more importantly, aggressively (a couple of hikes next year would still leave policy very loose) and b) inflation probably is transitory – markets are largely buying the central bank line for now as evidenced by the lack of movement in the bond market. TINA – there is no alternative – is still at work since you can’t get any real return on govt bonds – real rates are so low (negative) that you have to stick your money into equities to avoid the erosion of inflation. Inflation coupled with benign central bank policy so far seems good for stocks since the real risk-free rate is so low. The crux of it is that nominal rates should be a lot higher to compensate for inflation, but central banks are keeping them artificially low, which is suppressing everything and letting equities go higher. And longer-end yields are not marching higher since there is no great confidence in the ‘roaring twenties’ steepener trade that was talked about a lot at the start of the year but has since become overshadowed by the slower growth, stagflation narrative.
When a pullback? The S&P 500 closed up 0.7% on Friday but did end the week slightly lower, breaking a 5-week win streak. And while lower on the week, it closed on Friday well off its lows and is just 0.8% off its all-time high. It’s a pretty mild pullback if it only lasts a couple of days. Bank of America is not so optimistic for Europe: “We expect the anti-goldilocks combination of weakening growth momentum and rising real bond yields to weigh on European equities, with a projected 10%+ downside by early next year, leaving us negative.” European stock markets are mixed at the start of trading on Monday – mild gains in Paris; London and Frankfurt flat. Rising cases and new lockdowns in Europe are something to watch, though as I said earlier consumer sentiment does not equal stock market sentiment. Nevertheless, the BofA analysis is to be considered.
This week the focus around the inflation narrative switches to the UK with the release on Wednesday of the latest CPI data. The Bank of England could use a hot reading to finally act, but there is yet a lot of uncertainty about where the MPC is on raising rates. As I have discussed several times, it’s got a communication problem. Inflation fell to 3.1% in September from 3.2% in August but the drop was a blip – expect prices to continue to rise. Economists and the BoE think 5% is possible in the coming months. There seems be no excuse for the Bank not to pull the trigger, but the MPC remains divided. Supply chain problems can’t be solved by central banks, but I find it hard to reconcile ZIRP with inflation persistently so high.