Why Investors Can Ignore The Inflation Bogeyman

Today, the U.S. economy is three times more open than it was during the 1970s. Greater trade openness places far more downward pressure on nominal wages given that tradeable goods and services can be offshored if wages become too uncompetitive. This also goes some way to explaining the general frustration with globalization from many sections of the electorate.

Exhibit 3: Annualized change in earnings vs trade openness

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Some firms’ profits are bigger than others

Given that the inflation outlook remains subdued, investors are faced with a further conundrum as equity prices in February bounced back to all-time highs despite the economic slump. The quarterly Credit Capital Advisory dashboard indicates that construction, manufacturing, and trade remain negative. The trade sector is likely to be impacted by a massive jump in new business starts, which may dampen future profit growth. On the plus side, financials show robust growth and business services including technology is also showing a slight increase, although the regulatory outlook for big tech remains challenging.

Exhibit 4: Near term profit expectations for the U.S. economy

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Source: Refinitiv Datastream, Credit Capital Advisory

Another issue impacting sectors most affected by the pandemic is the potential jump in expected defaults and hence increase in credit risk. This is something that the bond market has not yet factored into account with CCC spreads reaching record lows in February.

Exhibit 5: U.S. bond yields by rating band

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However, the idea that credit risk has been eliminated due to extraordinary monetary policy support does not tally with reality. This can be observed by comparing the relationship between the upgrades and downgrades by banks who have exposure to loans in the North American corporate sector through time.

Using the period of 2018/2019 as a proxy for “normal conditions,” it is possible to observe how the credit risk of obligors has shifted during the last nine months of 2020 based on Credit Benchmark data.

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