The first quarter was a favourable one for equities; companies, on the whole, beat earnings expectations, in some cases quite strongly. This is to be expected at this point in the business cycle; recovery is well underway, helped by a handful of highly effective Covid vaccines and an influx of cash to American pockets courtesy of the Biden administration. So why, then, are outperforming equities reaping so little reward from their stock prices?
The short answer is that this impressive performance was already priced in; market participants expected these stocks to do well, and so they were already valued quite highly. One of the consequences of valuations being elevated is that it makes it harder for shares to react positively to good news. In an ordinary earnings season, about 70% of companies reporting expectations-beating results will see a tangible reward in the form of higher stock prices. This time around, as evidenced by the solid line in the chart below, only around half logged a notable jump.
Companies are seeing sales rebound; they’ve gleaned operating leverage from the fact that they’ve reduced and controlled costs during the downturn of the past year. But market participants expected this, and so in many cases, these encouraging results were not enough to push prices higher.
This drives home the importance of considering valuation as a part of your stock-selection process. Prices are up in the current climate, and the business cycle is favouring equities. When you're making individual investments, don’t just look for companies that are delivering; you also have to understand how much you're paying for that company, and consider whether its value is warranted. Be patient with your purchases too: with markets and equities elevated, it could take a while to start seeing exciting returns.
“In truth, a temporary 10% rise in prices (followed by 2% rises thereafter) is a permanent 10% loss of your purchasing power.”
Philip Smeaton, Chief Investment Officer, on the long-term effects of ‘transitory’ inflation.
Investment View: How accurate is the term ‘transitory inflation’?
We’ve been hearing a lot about the potential problem of inflation ̶ and more specifically, how we haven’t got enough of it. In fact, it’s the spectre of deflation that seems to be spooking the developed world’s central banks.
But when looking at the data, for the US in particular, we can see the Federal Reserve has achieved its 2% inflation target relatively consistently over the past two decades; in some cases, they've overshot it. There seems to be a disconnect between the Fed’s perception of where inflation figures could go ̶ too low ̶ and where they have (rather comfortably) rested in recent history.
The central banks tell us that we need to have average inflation targeting in order to make up for past periods of disinflation. But this is confusing; as you can see from the chart below, inflation has remained essentially on target over the past six years. The blue line representing the consumer price index, which records the rise or fall in the price of goods, closely tracks the red line, which shows the Fed’s target of an annual 2% increase. In some cases, the blue line breaches the red line, indicating periods that saw inflation exceed 2%.
Still, monetary policy has been put in place to ensure that inflation drifts higher. Both the Biden and Trump administrations injected liquidity into the US economy by sending stimulus checks to every tax-paying American on three occasions over the course of the pandemic. This equates to a straightforward truth: inflation is coming, and it probably won’t be temporary.
To understand this, we need to take a closer look at the Fed’s concept of ‘transitory inflation’. At the moment, central banks are saying that even if inflation moves higher in the near-term, it will fade once the recovery has kicked in and things have normalised. Once supply chains have righted themselves and people have settled back into their routines, this temporary, ‘transitory’ inflation will return to 2% a year—a reasonable, benign thought.
But what is missing from this explanation is that a temporary, say, 10% rise in prices (followed by 2% rises yearly) is a permanent 10% loss of your purchasing power. Imagine this in an extension of the graph above: what will happen is the blue line will jump by 10%. And then, from that higher base, it will grow at a rate of 2% per year. It won’t readjust back down to the level we’re seeing now. Therefore, a one-off ‘transitory’ increase in inflation in fact represents permanently higher prices.
If we’ve learned one thing from the age of QE, it’s that central banks have a very low tolerance for economic pain. The question going forward is this: will the Federal Reserve raise rates, risking harsher economic conditions? Or will it accept higher inflation? This is something that can’t necessarily be predicted, but needs to be considered by investors.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by Sanlam. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.