Inflation Expectations Increase Mildly

The market believes the high CPI readings in April and the next few months will be temporary. It’s not a contrarian opinion to bet inflation will fall. The reflation trade has become more popular than last year, but last year was an extreme example. You can’t anchor yourself to 2020 in which a bubble formed in innovation stocks. It’s best to take a longer term approach.

As you can see from the chart below, Wednesday’s CPI report caused the 5 year forward breakeven inflation rate to rise sharply in the near term and rise slightly in the long term. Every high CPI report causes slight changes to long term expectations. We think each strong CPI report in the next few months will cause economists and investors to challenger their own views of long term inflation. That doesn’t mean the long term rate will actually change though. The pandemic lowered the birthrate which hurts the inflation cause.

On the positive side (for CPI), it has become more acceptable for the government to spend more on transfer payments. If there has been a long term shift in policy, we might see higher inflation. Furthermore, more economic support for families could push the birthrate up. Finally, Fed policy has certainly shifted towards being extremely stimulative. The Fed isn’t concerned with inflation at all. There should be a point where low rates allow inflation to sustainably increase. If there was ever a time for inflation to be strong, it would be when fiscal policy is stimulative, rates are low, and the economy reopens.

Higher Inflation Bad For Stocks?

In short, higher inflation is bad for stocks especially growth ones. As you can see from the chart below, the S&P 500’s highest PE ratio occurs when CPI is between 1% and 2% which is where it has been for much of the past 10 years. The good news is when CPI rises to 2% to 3%, the S&P 500’s average PE ratio only falls from 17.7 to 17.1. That’s not a huge deal.

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