Elevated inflation may linger, but earnings should drive equities higher

What did we learn this week?

US inflation reached a 30-year-high…

US consumer price inflation for October rose to 6.2% year-over-year, the highest since November 1990. Energy and food prices contributed significantly, but stripping these out, core CPI still rose 4.6% year-over-year.

The US yield curve bear flattened…

The 5s30s yield curve flattened by 5 basis points (bps) to 68.5bps on the day of the CPI release, the flattest since March 2020. Market pricing for the timing of a first rate hike was brought forward to July 2022. The S&P 500 pulled back, but still closed the week just 0.4% below its record high.

Earnings growth continued to beat expectations…

With the third quarter US earnings season drawing to a close, a greater than average number of companies have beaten profit expectations.

How do we interpret this?

Last week’s brief spike in equity volatility and the bear flattening of the US yield curve (when rates rise, but short-term rates increase more than longer-term rates) point to concerns that elevated inflation could prompt abrupt policy tightening that may choke off growth. Each inflation release that comes in above expectations has the potential to cause further bouts of volatility in rate and equity markets.

But while elevated inflation may linger, it should still fade over the course of next year…

Inflation is proving broader and longer-lasting than expected, and above-target prints are likely to continue in the coming months. But, in our base case, we think inflation will fall from currently high levels over the course of 2022, as supply-demand mismatches gradually resolve, energy prices stabilize, and more workers return to the labor force. This will reduce the pressure on consumers, interest rates, and corporations, and should contribute to a favorable backdrop for stocks.

…and the Fed is likely to retain its patient approach...

Faced with an uncertain economic backdrop, the Federal Reserve is likely to err on the side of caution and remain patient on rate rises. A key message from the FOMC’s November meeting was that economic data—both on inflation and employment—were being distorted by the pandemic, and policymakers needed to avoid overreacting. So, while the Fed’s patience will be tested by higher inflation, we believe policymakers will be eager to avoid harming the economy with premature policy tightening that would stymie growth.

…allowing focus to remain on solid corporate fundamentals, which should support the equity rally.

With 92% of S&P 500 companies having reported third-quarter results, 80% have beaten profit expectations, versus a five-year average of 76%. Revenue growth was 17% y/y, and the median company beat sales estimates by 2%, despite supply chain issues. Robust demand is making it easier for companies to handle cost pressures: 3Q S&P 500 profit margins have stayed flat at an all-time high. Overall, 3Q earnings are up more than 38% year-over-year, about 10 ppts better than expected. In Europe, around 89% of companies have reported, and 72% have beaten profit forecasts. Globally, we forecast earnings per share growth of 43% in 2021 and 9% in 2022. We expect robust corporate earnings to provide a tailwind for equities over our forecast horizon.

What does this mean for investors?

Although the S&P 500 remains close to record highs, we think strong economic and earnings growth, coupled with an accommodative policy backdrop, should win out over inflation concerns and support further upside for equities. We favor the winners from global growth, including energy and financial stocks, US midcaps, along with Eurozone and Japanese equities.

With inflation staying elevated for a few months yet and rates expected to remain low, real wealth destruction looks likely for those holding cash or high-quality bonds. But we see opportunity to earn positive real returns in US senior loans; Asia high yield; select currencies; and other unconventional yield sources like private credit.

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