How worried should we be about inflation risk?

Hindsight should help assuage investors’ fears

Investors’ current worry list is pretty long. They face the daunting prospect of the combination of rising interest rates, rising inflation, higher capital gains and corporate tax rates and overbought share prices. Each on their own would be enough to scare many people, but investors facing them all simultaneously find themselves in a complex and unsettling situation. It is not surprising that markets have responded with the volatility seen over the last few weeks. But considering the big picture, investors can take heart from lessons learned from history, and keep hold nerve.

Should we fear rising interest rates?

History has taught us that, overall, rising interest rates have been associated with attractive equity returns. We ran some analysis to compare the changes in interest rates over time with the growth in the S&P500 Index. During periods where the treasury yield rose, there were attractive annualised returns in the S&P500 index. Indeed, in all but one example (in the early eighties), rising interest rates resulted in fair share price returns. (Source: Stonehage Fleming Investment Management (SFIM), Bloomberg, May 2021).

A similar analysis looked at periods since 1962 when treasury yields grew more than 1.5%, versus the annualised gains and losses in the S&P 500. Again, barring one example, the result was positive. (Source: SFIM, IPL Research, Factset, March 2021)

What if the Fed tightens monetary policy earlier than expected?

Many investors have raised concerns as to whether the US Federal Reserve (the Fed) will have to take action to control inflation sooner than expected - raising interest rates to dampen demand and economic growth, in order to slow domestic inflation. This could potentially derail the economy’s fragile recovery. However, it seems the Fed is staying on its accommodative course for now. And even if it does, investors most probably need not fear too much.

Historically, the periods following the first rate hikes in a new cycle have been positive for equities. Although the first three months usually show quite a bit of uncertainty (the S&P 500 on average, up 0.5%, median down 1.1%), the figures for the following six or twelve months show reasonable – almost normal – returns, with six-month returns up 7.1% average, 6.6% median; and 12-month returns up 10.2% average, 6.0% median. (Source: LPL Research, Bloomberg, April 2021).

How much store should we set by inflation expectations?

Consumer spending, or personal consumption expenditures (PCE), is the Federal Reserve’s preferred measure of inflation in the US economy. It reflects the value of the goods and services purchased by, or on the behalf of United States residents.

Figures show the ten-year breakeven rate shooting up 2.5% (reflecting the level of inflation expectations). A comparison with the period following the global financial crisis suggests there is nothing strange in what’s happening today in response to Covid; PCE had exactly the same response then. (Source: Bloomberg, SFIM, May 2021).

Indeed, with PCE still relatively low at 3.1% off a very low base, it has been following the expectation line quite well. Seeing as the Fed uses the PCE as a decision-making metric, there is nothing to suggest that it needs to make any imminent rate-hike decisions.

Main causes for US inflation.

Tactically, inflation threats are certainly perceptible now. Strategically, though, the situation seems more acceptable. We expect inflation to rise quite a bit over the next few months, but to drop once the world returns to normal economic circumstances.

We conducted some subjective analysis plotting a number of tactical factors that might affect inflation, including the base effects, supply chain issues, unemployment, capacity utilisation, oil price, commodity prices, fiscal support, monetary support, currency issues and import tariffs. For each effect, we allocated a subjective score to evaluate what we understand to be its current and future potential impacts.

The base effects came out at ‘full blast’ levels. We see these effects already in fast-rising prices for lumber, car rentals, hotels and airlines. The same is true of supply chain issues. Against this, unemployment and capacity utilisation issues are less of a threat.

Commodity prices with full fiscal support and monetary support are also pushing inflation levels. There are also some effects from currency and import tariffs, but against that, the technological effects are seen to be rather negative on inflation. (Source: SFIM, Bloomberg, May 2021).

Should we fear high share prices?

Currently we are probably close to the best scenario for equity ratings. Analysis comparing the S&P 500 Index trailing price-to-earnings ratio with headline CPI inflation over the period from 1948 - 2020 shows rating levels presently at the top of the curve. After a 4% inflation level, the rating curve drops quite quickly as inflation rises further. Thinking in terms of sustained inflation rather than current tactical effects, ultimately it seems that we might land with inflation between 1 and 3%, which can almost be seen as the sweet spot for equity ratings. (Source: Kohlberg Kravis Roberts & Co LP April 2020).

Should equity investors fear higher taxes?

We all know that following a crisis of this scale, capital gains tax rises will be on the way to help finance the economic damage the pandemic has caused. But what do tax rises do to equity markets? An analysis of the S&P 500’s performance following increases in capital gains tax rates shows that there have been four such occasions since 1969, which by and large have shown equity market returns to have been muted but generally positive. (Source: LPL Research, Ned Davis research, Factset, April 2021).

Corporate tax hikes too are inevitable. But looking back as far as 1940, the average median effects of a corporate tax rise - assessed three months before it has been implemented, then six and 12 months subsequently -­ shows positive equity returns numbers. Although not stellar, they have been ‘good enough’ and certainly not the disaster scenario some perceive them to may have been.

Gerrit Smit is the Head of Equity Management at Stonehage Fleming UK and Fund Manager of Global Best Ideas Equity Fund.

Disclaimer: The opinions or views expressed are for information purposes only and are subject to change without notice. The information does not constitute legal, tax or investment advice, it is neither an offer to sell, nor a solicitation to buy, any product or services. All investments risk the loss of capital. Past performance should not be used as a guide to future performance. Whilst every effort is made to ensure that the information provided is accurate and up to date, some of the information may be rendered inaccurate in the future due to any changes. Issued by Stonehage Fleming Investment Management Limited, authorised and regulated by the Financial Conduct Authority, and registered with the Financial Sector Conduct Authority, FSP No: 46194. © Stonehage Fleming 2021.