Equity markets: In search of Goldilocks' inflation

  • Historically, monetary and fiscal easing periods tend to be favorable for equity investors, as equity tends to generate decent returns in periods of accelerating, but still manageable, reflationary pressures.
  • Rather than focusing on realized inflation numbers it seems more appropriate to look at market pricing of inflation expectations as the embedded traded nature of this inflation measure makes it reactive to changes in investors’ expectations.
  • Our proprietary model for 10y breakeven inflation rates suggests that US long-term market-based inflation expectations have little remaining upside potential and are bound for a reversion in 2021. In the case of the Eurozone, a +10 to 20bps temporary increase in long-term EUR inflation expectations can be easily penciled in as inflation pricing does not look as overstretched as in the US.
  • The US equity inflation expectations component, which exerted extreme downside pressures right after the initial March 2020 shock (-8pp), has finally turned positive, managing to reach +7.5pp upside pressure in February 2021. Additionally, inflation expectations numbers for March are hinting towards an even higher contribution of the inflation component to US equity performance.
  • The EMU equity inflation expectations component has recently turned positive, adding +2pp of upside pressure to the yearly equity performance in February. Nonetheless, as in the case of the US, March numbers suggest a far greater contribution of the inflation component to EMU equity returns.
  • Our equity decomposition methodology suggests that monetary policy has to remain highly accommodative for as long as real economic growth does not manage to catch up. By being prudent in its policy normalization policymakers will implicitly prevent a global equity market accident.
  • Our equity – economic growth analysis suggests that if real-GDP-to-equity-return dynamics remain intact, as it is the case today, both US and EMU equity markets are set to resume the upward sloping trend they have been following since mid-2010.
  • What do we expect moving forward? We believe equity markets will have a timid positive performance in 2021 (upper single digit total returns in the EMU and lower single returns in the US) that will accelerate in 2022 on the back of a healthier and more stable growth and inflation outlook. 

Contact

Jordi Basco Carrera
Allianz SE