US inflation rose to 8.5% in the year to March 2022, the highest annual rate since 1981. Investors have been fretting for some time about rising inflation, and it appears that, now, the market is baking in higher-than-average inflation assumptions for the next 10 years.
The chart opposite shows average US ten-year inflation expectations since 2012.
What we can see from the chart is that inflation expectations over the past two years have been rising, from a low of 0.5% during the pandemic to 3.0% currently – i.e. inflation is expected to average around 3% annually for the next decade.
With 10-year inflation expectations rising to 3% (and potentially going higher), the market is effectively signalling that inflation is becoming embedded, and it expects it to be a long-term issue rather than a transient one.
How does this affect equity investors? Rising inflation, and fears that inflation will remain above average for a decade, is putting pressure on the Federal Reserve to raise interest rates and curb inflation. The possibility of higher interest rates is already having an impact on equity markets with the S&P 500 Index down over 13% year-to-date.
Inflation can affect equity values through two channels. Firstly, earnings have been exceptionally strong in recent years – driven in part by significant increases in government spending which has resulted in supernormal growth in US corporate profits. If inflation persists and interest rates rise to counter this, the US government, and the US consumer, may curtail spending, which would result in a slowdown – or even a fall – in corporate profit growth.
The second channel through which inflation affects equity prices is through earnings multiples. A higher US 10-year Government Bond yield of 3.09% starts to become an increasingly attractive option for investors. In effect, rising interest rates can cause price-to-earnings multiples to fall because investors sell shares to buy bonds with higher interest rates. An equilibrium is reached when share prices fall enough that they become attractive again relative to bonds.