We don’t expect higher inflation to derail US equities

In the latest Global Markets Update from Capital Economics, they analyse the possible impact of inflation in the US on equity markets. While we think that inflation in the US will prove more persistent than both the Fed and investors appear to anticipate, we still expect the S&P 500 to make some further gains over the next couple of years.

The past few months have brought increasing evidence that price pressures in the US are rising. Headline and core CPI inflation have increased sharply in both month-on-month and year-on-year terms and reached multi-decade highs of 5.0% y/y and 3.8% respectively in May. Personal Consumption Expenditure (PCE) inflation has also risen substantially. What is more, survey evidence has pointed to growing shortages of inputs, increases in the prices firms pay for raw materials and intermediate goods and an acceleration in underlying wage growth.

The rise in inflation has not derailed the stock market so far

Two factors explain this in our view. Firstly signs of rising inflation have not sparked a reassessment of the outlook for monetary policy. This is largely because the Fed has stressed that it thinks this increase in inflation will be transitory and that it therefore will not act on it.

Secondly rising prices and shortages have not raised significant concerns about the economic recovery among investors so far.

However we think inflation in the US will prove more persistent than investors currently appear to anticipate and that this will cause the yield of 10-year Treasury Inflation Protected Securities (TIPS) to rise this year as investors start to discount sharper rate hikes later this decade. However, we do not expect this to cause the rally in US equities to go into reverse.

We still expect the yield of 10-year TIPS to stay very low by historical standards. What is more, stock market valuations have often only tended to fall when profit margins have been squeezed by a faltering economy.

Admittedly, a lot of good news on the economy already appears to be reflected in the current level of the S&P 500, however we think there is still scope for earnings in some sectors that have been hit particularly hard by the pandemic to surprise to the upside.

So, while our view that inflation in the US will prove persistent and is a reason why we forecast gains in the S&P 500 over the next few years to be small, we are not anticipating a repeat of the sharp sell-offs seen during the periods of high inflation in the 1960s and 1970s.

An excerpt from the Global Markets Update - Capital Economics, issued 11th June 2021

The opinions expressed are those of Capital Economics using their independent research and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast.

Past performance is not a reliable guide to future performance.

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