Inflation makes it harder to stay positive on stock returns for the year. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The fear that controlling U.S. inflation will require more Federal Reserve tightening has sent a shock wave through world equity markets erasing most year-to-date gains. Higher interest rates are not per se an impediment to higher stock prices. Rates could go up by 1% (or slightly more), and the relationship between interest rates and price-to-earnings ratios would be close to normal, historical levels. The primary risk to a moderate return to the equity market is that investors come to believe that earnings levels revert from historically high margins to more normal margins due to the slower growth precipitated by higher rates. At this point, we are sticking with the belief that the earnings story has not been derailed and that investors will continue to value companies based on relatively high margins. Until there is some clarity on the direction of inflation, this uncertainty will probably lead to continued volatility.

Review and outlook

Forecasting what the Fed was going to do to interest rates used to be so easy – another meeting, another 25 basis points. Once the Fed funds rate reached 5%, however, the job became a lot more difficult. This is in part due to the data that has become more confusing with the aging of this economic cycle. Over the past few weeks, we have received the message that the economy seems to be slowing down. Unfortunately, until the “benefit” of slower growth – lower inflation – shows up, the market will have to tolerate a high level of uncertainty.

Over the last few weeks, speeches by the Fed chairman and governors had sounded fairly balanced between the thought that inflation was or wasn’t under control. Lately however, the Fed leaders seem to be, at least verbally, flexing their muscles, indicating that they will be tough on inflation. The market is very good at handling bad news when the scope and scale of what’s behind the news is known. For example, the market rallied after Katrina flooded New Orleans. Uncertainty, however, it handles poorly. Until there is evidence that slower growth will contain inflation, market price movements will probably be quite “choppy.”

The stock market is down about 5% from its recent top. Markets are supposed to correct periodically by 10%, according to people who look at charts. So, we should not be surprised to see the market experience a short-term jolt like this given the environment. This sort of movement, however, would bring the price-to-earnings ratio on the market to a little over 15 – a level the market has not seen since 1993. This is a point where we hope logic would overtake emotion, and the market could focus not only on a reasonable valuation but also on a relatively healthy earnings picture.

There are two critical questions worth asking that have to do with the duration of the pain and the potential for pleasure. First, let’s consider the pain. The key question is, “How bad is inflation?” Then we will examine the potential for pleasure (as defined by an equity investor) and ask, “How strong will corporate earnings be in the face of slower growth?”

Let’s take a look at inflation first.

Out of control?

Which way is inflation heading? Unfortunately, there are many ways to measure inflation, and the data is positive in some circumstances and negative in others. Having said this, a number of the factors and measures of inflation have weakened over the last few weeks.

Let’s start by looking at the most common measure of inflation – the consumer price index (CPI). The CPI is served just like Philly cheesesteaks – “wit and witout.” In the case of cheesesteaks, this would refer to onions. In the case of the CPI, this would refer to “wit or witout” food and energy. Many Philadelphians would argue that there is no point to a cheesesteak without onions. Many economists would make a similar statement with regard to measuring inflation without taking into account the prices of food and energy.

Inflation, including food and energy, has been on a tear over the last two years. It is now running at an annual rate of 3.6%. The market, though, likes to look at the CPI “witout” food and energy (a.k.a. “core inflation”). The thought here is that inflation is only really a problem if prices on all goods and services are going up together. Price shocks in food and energy tend to abate after a while and even reverse.

Unfortunately, we started the month of May with a core inflation number that was worse than expected. Core inflation came in for the month of April at 0.3% instead of 0.2%. Investors had been operating under the assumption that, while food and energy prices were at high levels, the underlying core rate of inflation was under control. To their minds, this 0.1% changed the whole story, and the market has fallen ever since.

The graph below shows the total CPI and the Core CPI on a twelve-month moving average basis. The green line shows the core number move up as of the last month. Can you see it? Look closely now? There now, do you see it? No? For crying out loud, go to the other room and find your reading glasses. They should be hanging around your neck – if we could just end this silly denial stage. Can you see the upward move now? No, it’s not a very big move. It is, however, the market’s job to see it and, as my daughter would say, “obsess” over the little things and add and remove billions of market value based on data blips.

|image1| Now, don’t start complaining about eye strain. We need to look at a few more of these charts. Let’s look at a leading indicator of inflation – the ISM survey of the prices being paid by manufacturers to acquire the goods that they will need to make finished goods. According to the latest results, 56% of manufacturers are seeing higher prices while only 2% are seeing lower prices. No way to spin those numbers – it’s bad.

|image2| But wait. There are two parts to putting together a manufactured good – the raw materials and the labor. Here the news is a little better. Average hourly earnings have been rising from very low levels a few years ago. There are two important qualifications. First, unemployment claims have risen recently, and the latest data on average hourly earnings indicate that the rate of increase is slowing. Second, some economists feel that this number not only shows workers are getting paid more but also that they are moving into higher-wage jobs. The Employment Cost Index, which adjusts for this movement, has actually shown slower growth versus a year ago.

|image3| This is only part of the story on wages, however. Productivity (or output per hour worked) has been growing steadily over the past four years. As that has happened, growth in “unit labor costs” has been very low. Unit is actually a term used by economists to describe the labor cost per unit of goods or services produced. While wages may be rising, productivity allows companies to produce more goods for the same cost. This is a very “deflationary” influence. And what is causing this?

|image4| Please cue the stirring patriotic music. Productivity has spread throughout the world thanks to America’s commitment to the free enterprise system and its willingness to trade freely with other countries. (A good educational system, a well-established legal and regulatory framework, a diverse and empowered workforce and a measure of stability derived from social insurance programs probably hasn’t hurt either.)

The positive impact on inflation from this global spread of trade and free enterprise shows up most clearly when we look at import prices. Excluding energy (which is the root cause of most of the current problems with inflation), import prices have risen at only a modest rate. Over the past twelve months, import prices, excluding petroleum, have risen by only 1.5%.

|image5| After looking at this seemingly endless supply of charts, it would appear that the Fed could, with a half a percent to a percent of tightening, lower inflation back to relatively low levels. Will these rate increases derail the equity train? That depends.

Rates and P/E ratios

One of the accepted pieces of wisdom on Wall Street is that stock prices and P/E ratios can stay high as long as interest rates are low. When rates go up, P/Es and stock prices go down. The idea here is that stocks and bonds compete for investment dollars. So, when bond yields move higher than stock prices, then values need to become more attractive. Is this true? Yes, it is to a certain degree, with some caveats.

The chart below shows the average and range of P/E ratios at various interest rate levels. When interest rates are between 5 and 6%, the average P/E ratio on the market is 20.5. The current P/E ratio on the market is 15.8 (at an S&P 500 index level of 1260). Looking at history, the P/E ratio on the market would have been lower only 19% of the time. This would tell us that stock prices don’t necessarily have to decline if long-term interest rates rise to 6%. Interestingly, stock prices and P/Es hold up fairly well when interest rates are between 6% and 7%.

|image6| We suspect that comparing interest rates and P/E ratios isn’t really the truly correct comparison. That is because companies can pass on the effects of inflation through higher earnings. Fixed income pays only “fixed” coupons. An apples-to-apples comparison would look at the relationship between P/E ratios and real bond yields (that is, the difference between bond yields and inflation).

The relationship between P/Es and Real Bond Yields is very interesting. When real bond yields are at moderate and reasonable levels, 2% to 4%, the average P/E ratio is actually a quite high 17. However, when real yields are either very high or very low, the economy is usually stressed. This makes P/E ratios and stock prices move down to fairly low levels. Here the news is good. Real Yields by our estimate are at 2.5%, well within an acceptable band. On balance, higher interest rates alone are not necessarily going to levels which would require a large decline in stock prices or P/Es.

Unfortunately, higher interest rates can potentially have an adverse impact on economic activity and, worse, from our perspective, earnings levels.

Back to normal so soon

As the market sinks, P/E ratios based on current earnings levels are beginning to look more and more attractive. The P/E ratio based upon trailing earnings is now about 15.8, which puts the market well within typical historical ranges.

If earnings continue to stay at current high levels and companies continue to produce high profit margins, the market will look quite reasonably priced to most investors. There is an “if” in that statement, unfortunately. Thanks to above-average profit margins, earnings (by our measures) are well above cyclical levels as shown in the chart below. Whether the stock market is cheap depends a lot on what level of earnings you use to determine valuation. Valuing the market based on “normal” or trendline earnings yields a much less compelling result. The P/E based on normal earnings and average profit margins is about 18.8.

We began the year with the thought that the market would focus on near-term earnings results, which have been and continue to be quite good. The determination by the Fed to reduce inflation has sent stocks down on the fear that the great earnings story and results are about to be derailed. At this point in time, we are inclined to think that the inflation-fighting moves required by the Fed may reduce economic growth to more moderate levels and, perhaps, slow down earnings growth somewhat.

We don’t yet, however, foresee a point where earnings revert to more normal levels over the next few years. This generally happens after the end of the cycle when companies overspend on capital goods and hire too many people. The only place in the American economy where we see substantial overcapacity is the housing market, and these stocks are a small percentage of total market capitalization and already discount a very large drop in activity. (They trade at 4 times to 6 times next year’s earnings.)

Given that 1) inflation still seems to be at a level where it can be controlled by some moderate Fed action; 2) interest rates should stay at levels that don’t require a massive lowering of P/E ratios and stock prices; and 3) the earnings story is not yet derailed, we are sticking with a moderately positive view for stock returns for the year. We do so with the knowledge, however, that until there is some sign that inflation is moderating, that the market may be quite volatile. –FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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