Why inflation is unlikely to spoil the equity rally

Deeper dive


The equity bull market is entering its tenth year this month. The S&P 500 has quadrupled since hitting a low on 9 March 2009 and the rally is now the second longest on record, surpassed only by the bull market from October 1990 to March 2000. Such longevity naturally raises the question of what could bring the rally to an end.

The absence of significant US inflation, despite the unemployment rate having fallen to a 17-year low of 4.1%, has been a notable feature of the long US economic expansion. A return of inflation, leading to faster-than-expected interest rate hikes, is one of the key risks for the bull market in its tenth year. Indeed, higher-thanexpected growth in US average hourly earnings (AHE) in January was a key catalyst for February’s 10% equity market correction.

While we will continue to monitor the data closely, we believe that the evidence for significantly higher inflation is so far limited:

  • First, the data does not show a clear acceleration in wage or price inflation. The Atlanta Fed Wage Growth Tracker is currently showing wage growth of 3%, but the index was as high as 3.9% last November. After January’s surprise, AHE increased by a more modest 2.6% in February and the earlier figure was revised lower to 2.8%. Similarly, in January the US core consumer price index (CPI) rose by a higher-than-expected 0.3% month-on-month, but inflation pressure eased somewhat in February. Core CPI rose 0.2% month-on-month and the year-on-year gain was 1.8% for the third consecutive month.
  • Second, there are signs there is greater slack in the labor market than previously thought. US non-farm payrolls grew by 313,000 in February, the largest increase since July 2016, yet unemployment did not fall as the participation rate, which measures people in work or looking for a job, rose to 63% in February from 62.7% the previous month. Strong demand for labor appears to be encouraging more people to rejoin the workforce.
  • Third, wage growth does not automatically translate into higher inflation, and higher productivity could prevent wage growth from feeding through to prices. With the economy already likely close to full employment, it’s not unreasonable to expect the pace of hiring to slow. At the same time, GDP growth is set to pick-up in part due to fiscal stimulus, with the net result that productivity should
    increase.

The Fed remains a believer in the Philips Curve – the economic relationship that states that as unemployment falls inflation rises, and vice versa. As such, the Fed is likely to continue to increase rates gradually in order not to fall behind the curve and have to raise rates more sharply later. But we see little in the data to prompt the Fed to tighten faster than our expected speed limit of one 25-basis-point hike per quarter this year. The Fed meets this week, and we expect it to hike rates while making only small adjustments to its inflation and interest rate forecasts. In our view, this pace of tightening is not fast enough to derail an equity market supported by strong economic and corporate earnings growth, and we remain overweight global equities in our global tactical asset allocation.

Mark Haefele

Global Chief Investment Officer WM

Bottom line

As the second-longest equity bull market on record enters its tenth year, it’s natural to ask what could end the rally. Higher US inflation leading to faster rate hikes is one of the key risks. But so far there is little in the data to make the Fed fear overheating. We expect the Fed to hike rates this week, in line with our view for one 25bps rate hike per quarter this year.

 

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