Call them brazen, call them naïve, but stock investors are giving no sign of being daunted by the hottest inflation in decades or the accompanying surge in bond yields.
Their boldness has sent analysts in search of ways to explain how the S&P 500 Index has managed to rally in five of the last six sessions, even as the Federal Reserve promises higher rates while war rages in Europe and Treasury rates see the biggest two-day jump in two years.
One theory gaining traction is that equities are among the best assets to hold when consumer prices are spiraling.
“In inflationary environments, stocks have a distinct advantage over bonds -- they’re linked to companies that can adjust pricing -- whereas bonds, not so much,” said Lawrence Creatura, a fund manager at PRSPCTV Capital LLC. “Companies, on the other hand, can raise prices and you only have to go to your local 7-Eleven to observe that.”
The S&P 500 rose 1.1% Tuesday, led by the consumer discretionary and communications sectors. Meanwhile, the rout in U.S. Treasuries deepened after Federal Reserve Bank of St. Louis President James Bullard told Bloomberg News that monetary policy needs to be tightened quickly in order halt inflation, and reiterated his call for interest rates to rise above 3% this year. That came a day after Chair Jerome Powell said the central bank wouldn’t rule out raising rates by a half point at its May meeting.
Between Powell and Bullard, the fixed-income market is starting to believe a 50-basis-point hike is no empty threat, said Ellen Hazen, chief market strategist and portfolio manager at F.L. Putnam. Meanwhile, “the stock market is telling you that the economy is not going to be broken by these higher rates,” she said by phone.
A look back at the 1970s and early ’80s inflationary period gives clues on the divergence. Nicholas Colas, co-founder of DataTrek Research, found that inflation ran at 159% during that period, while a home-prices index rose by the same amount. Yet the S&P 500 returned an aggregate 169%, showing that earnings can keep up with inflation even if macro growth slows, he said.
“As much as equity markets might not like it in the near term, seeing 10-year yields continue to rise would be a very healthy long-term signal about the state of the U.S. economy,” he said.
There are certainly other forces helping drive market optimism, from strong American manufacturing data to robust hiring and the continued lifting of Covid-era restrictions.
And then there’s the bull case that has stood throughout this year’s market turmoil -- the resilience of corporate America. After riding inflation to record profits in 2021, S&P 500 firms are expected to deliver another year of profit expansions, thanks to their ability to pass on costs to customers. Over the past month, analysts have raised their 2022 profit estimates by more than 1% to $225.70 a share, data compiled by Bloomberg Intelligence show.
Jonathan Golub, chief U.S. equity strategist and head of quantitative research at Credit Suisse Securities, says the profits backdrop is “broadly supportive.” While some say higher commodities and other input costs put pressure on company margins, the data indicates that margins move in tandem with higher materials prices. That’s due to pricing power as well as operating leverage, and the recent surge in commodities is consistent with firmer margins this year, he wrote in a note.
Economist expectations for nominal GDP growth have risen to 8.7% for the year, from 7.5% at the start of 2022, he wrote, meaning that “S&P 500 revenues should be extremely robust.”
While recession talk has swirled in recent weeks, there’s little evidence at the moment that it’s going to materialize this year.
“The bond market may be starting to send some warnings, but the prospect of a recession further out is still less than 20%,” said Chris Weston, head of research at Pepperstone Financial.
It may not be fear of inflation that is convincing people to buy stocks, but a belief that someone is finally about to do something about it, according to Weston. He believes equities have perked up precisely because of the Fed’s stiffening resolve to bring prices under control.
“The fact is a Fed bringing out the big guns in May and using forward guidance to set the scene ahead of this may be welcomed by the equity market -- they’ve weighed up the outlook and feel a credible Fed is a strong Fed, and higher rates are better than entrenched inflation,” he said.
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