By any account the U.S. equity market is having a stellar year. Stocks have benefited from easier financial conditions, which have in turn pushed up market multiples. By a happy coincidence, gains in market multiples have exactly matched the 15% gain in the S&P 500 Index.
But while stocks have benefited from cheap money and higher multiples, they have more recently been constrained by concerns over growth. The challenge is that the same slowdown that led the Federal Reserve to pivot and stop raising rates also puts earnings at risk. Recent developments in the inflation-linked bond market (i.e., Treasury Inflation Protected Securities, or TIPS) suggest that investors are right to be a bit more cautious.
Inflation expectations embedded in the TIPS market are signaling that already low inflation will fall even lower. In late April, the 10-year TIPS breakeven (BE), i.e. the amount of inflation TIPS investors expect during the next decade, was about 1.95%. Today, the 10-year BE is below 1.70%. The outlook for the next five years is even softer, roughly 1.50%. And while inflation expectations are higher using different market measures, such as inflation swaps, the direction is still down (see Chart 1).
As I highlighted back in March, in the post-crisis environment long-term BE rates and U.S. equities have been closely correlated. The reason is that inflation expectations provide a rough proxy of corporate pricing power and, by extension, margins. During the past 20 years, profit margins have averaged 6.5% in periods of below-average inflation expectations, defined as less than 2%. Conversely, in periods of above-average inflation expectations profit margins have averaged over 8%.
The Goldilocks zone
Stocks have rallied this year as investors have returned to a common, post-crisis theme: Goldilocks. In other words, growth that is slow enough for the Fed to provide cheap money, but not so slow that earnings slip or the economy falls into recession. For most of the past decade this has been the case. While growth has slowed on numerous occasions, we have never approached recession and corporate earnings have remained remarkably resilient.
Today, although there are few signs of an imminent recession, a sharper-than-expected deceleration in growth does put earnings at risk. Investors should not ignore the signals from the bond market, or more precisely the inflation-linked bond market. Rapidly falling inflation expectations are a symptom of a broader set of challenges: long-term secular disinflation (which is good) combined with a cyclical slowdown (not so good).
To be clear, to the extent growth stabilizes the bullish themes supporting stocks remain in place. However, should inflation expectations continue to fall companies may find themselves more challenged than forward earnings estimates suggest. In that scenario, falling inflation may shift from a tailwind for stocks to a headwind.