Elevated inflation is poised to limit equity downside in the next recession and the following cycle.
It’s time to get real. Several decades of relatively benign inflationary conditions have led to a blurring of the difference between real and nominal values, with predominant focus on the latter. But their growing divergence as inflation has risen has made it imperative to consider real values in order to successfully navigate and understand financial markets.
Recency bias likely means most investors are working off the recession playbooks from the near past. That means stocks sell off steeply through the downturn, before Federal Reserve easing stabilizes the situation. The next recession, though, is highly likely to be accompanied by elevated inflation, meaning stocks – in nominal terms - may not fare as badly as in recent downturns, and are poised to remain supported after it.
To understand why, we can break down the price of equities as being the product of the P/E multiple, the profit margin, and revenues. This year, the rise in the P/E multiple has driven the market higher (led by AI stocks, but beginning to broaden out), as it did in 2020/21.
But the rise in P/Es is unlikely to last.
Inflation is down but not out, and extremely tight labor markets, weak productivity, rising profit margins and incrementally more easing in China mean that inflation in the US is poised to re-accelerate as soon as by the end of the year. That would mean multiples falling again and, you might suspect, a reason to sell.
But looking at the 1970s, it’s not so simple.
In that decade, the market rallied all through the second half after bottoming in the 1974 recession, but the P/E multiple did not trough until the early 1980s. This seeming paradox is resolved in the world of real-market variables.
The principal issue is that P/Es are nominal variables but, especially in times of high inflation, they should be looked at in real terms.
Specifically, define the real P/E as the price-to-book ratio over the real return on equity. Real RoEs should remain constant with inflation, which is why real P/Es should also be stable (ex the effect of taxes).
Equities therefore managed to be almost flat in real terms through the second half of the 1970s as the impact from relatively stable real P/Es was superseded by increasing profit margins and real revenues, which rose with inflation. In nominal terms, equities delivered a respectable return (38% between 1975 and 1980).
Nominal P/E multiples fell in the 70s as equities faced greater competition from bonds. Stocks are de facto a fixed-coupon (the RoE), infinite-duration asset, whereas bonds offer the opportunity to re-negotiate the coupon on the bond’s maturity date. P/Es thus fell until the real equity yield was sufficiently above real bond yields to make equities attractive again.
Stocks did take a big hit in the 1974 recession. However, they have less formidable headwinds today. In 1974, real rates were much more restrictive. Moreover, inflation was still rising, while in the current cycle the next recession has a good chance of hitting when inflation is lower.
Looked at over the whole cycle, equities are therefore not the obvious sell they usually are in a recession (again, in nominal terms).
And if they experience a milder selloff than average in the slump, history shows they are primed to rally in the following elevated-inflation period.
We have several of the same dynamics today as in the 70s. Profit margins are rising, with the risk of a profit-price-wage spiral developing, and they may be stickier this time due to the influence of more monopolistic/oligopolistic industries. Further, revenues are rising quickly - driven by inflation - with the revenue-weighted S&P recently making a new high ahead of the standard index.
Where things could go seriously awry for stocks is if Powell’s immediate response to re-accelerating inflation is to go “full Volcker”. But I find that unlikely. Volcker was path dependent: we had to go through Arthur Burns and William Miller to get to the point where their successor had a mandate to cause a deep recession to neuter inflation. Powell isn’t there yet. On top of that, next year is an election year, and resisting cutting rates as the economy weakens might be the closest the Fed gets to hiking.
I have emphasized throughout that equities may do better than expected than in a more garden-variety downturn - but only in nominal terms. In real terms, equities are likely to be one of the poorest performing asset classes, as they were in the 1970s overall (although there will be a great variation between different equity sectors).
Still, old habits die hard, and positive nominal returns are likely to be greeted with the same fanfare as those seen in pre-inflationary days. But those living in the real world will know better
