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Few equity investors have experience in an inflationary environment and this makes new research from Credit Suisse global strategist Andrew Garthwaite all the more timely.

His recent report serves as an inflationary road map to guide investors through the potential pitfalls of the new market backdrop, complete with important indicators that may warn of impending weakness in equities.

In short, Mr. Garthwaite believes inflation pressure will be positive for equity markets until U.S. core inflation – which excludes volatile food and energy prices – runs above 3 per cent on an annualized basis for several months. The U.S. Labour Department reported on Wednesday that it reached that threshold for the first time during this economic cycle in April.

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The overall consumer price index showed prices climbing at an annual rate of 4.2 per cent, the fastest pace since 2008, prompting a steep sell-off in equities. The CPI report followed an April survey of U.S. small businesses suggesting 36 per cent of small businesses were planning to increase prices, the highest number since 1981.

Mr. Garthwaite expects the benchmark 10-year U.S. Treasury yield will reach 2 per cent at some point in the near future (it was hovering at 1.65 per cent Thursday afternoon). Importantly, however, he believes the inflation-adjusted U.S. yields that have been driving equity prices will climb only marginally.

The strategist uses the forward-looking new orders component of the monthly U.S. Institute of Supply Management survey of manufacturing companies to indicate the path of nominal Treasury yields. The two data sets are plotted in the first accompanying chart. Note that the ISM index is a diffusion index, meaning that a reading above 50 signals month-over-month growth in new orders for goods.

Some perspective on inflation fears

U.S. 10-year Treasury yield (%)

U.S. ISM Manufacturing New Orders Index (right scale)

3.5

80

3.0

70

2.5

60

2.0

50

1.5

40

1.0

30

0.5

0

20

2013

2015

2017

2019

2021

S&P 500 forward P/E ratio

10-year TIPS (right scale, inverted, %)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2019

2021

2018

2020

THE GLOBE AND MAIL, SOURCE:

SCOTT BARLOW; BLOOMBERG

Some perspective on inflation fears

U.S. 10-year Treasury yield (%)

U.S. ISM Manufacturing New Orders Index (right scale)

3.5

80

3.0

70

2.5

60

2.0

50

1.5

40

1.0

30

0.5

0

20

2013

2015

2017

2019

2021

S&P 500 forward P/E ratio

10-year TIPS (right scale, inverted, %)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2019

2021

2018

2020

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

Some perspective on inflation fears

U.S. 10-year Treasury yield (%)

U.S. ISM Manufacturing

New Orders Index (right scale)

3.5

80

3.0

70

2.5

60

2.0

50

1.5

40

1.0

30

0.5

0

20

2012

2013

2014

2015

2017

2019

2020

2016

2018

2021

S&P 500 forward P/E ratio

10-year TIPS (right scale, inverted, %)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2019

2021

2018

2020

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

The two lines have tracked closely together over the past decade, implying a consistent relationship between new orders and inflation expectations as reflected in bond yields. There is a sizable divergence at the end of the chart that implies bond yields are set to climb to match the accelerating U.S. economic recovery.

But it’s inflation-adjusted bond yields, not nominal yields, that have been most associated with equity performance in recent years. Bond yields well below the rate of inflation, ensuring a loss of spending power for investors holding bonds to maturity, have increasingly motivated assets toward equities, pushing stock prices higher.

Our second chart shows how this works. The blue line represents the yield on 10-year Treasury Inflation-Protected Securities (TIPS), an effective proxy for inflation-adjusted rates (it is plotted inversely to better show the trend). The purple line is the forward price-to-earnings ratio for the S&P 500.

Correlation calculations confirm that the equity market P/E ratio has been climbing as real rates fall; investors have been willing to pay higher prices for stocks as the inflation-adjusted returns on bonds decline. Real 10-year bond yields remain in deeply negative territory and this should continue to support equities.

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The Federal Reserve’s assurances that monetary policy will remain extremely loose and supportive will help keep TIPS yields low – they won’t raise rates to combat a rising consumer price index. In addition, as inflation fears climb, more investors will buy TIPS to guard against weaker bond prices and this should also keep their yields down.

The combination of rising but contained nominal bond yields and TIPS yields mired in negative territory represents “somewhat of a goldilocks scenario,” according to Mr. Garthwaite. It reflects both a recovering U.S. economy and renewed profit growth while maintaining ample incentives to buy equities over bonds.

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