Stagflation Is the One Combination Equity Markets Cannot Shrug Off

Stagflation risk is what equity markets cannot absorb, because it attacks valuations and earnings at the same moment rather than one at a time. Equities have proved resilient in the face of a hawkish Federal Reserve, recovering an initial selloff and returning above their pre meeting levels, and the resilience rests on corporate profits growing quickly enough to offset the drag from higher bond yields. Remove the growth, and the offset disappears with it. That is the condition worth watching, not the policy signal itself.

Fawad Razaqzada is a StoneX Media Market Analyst based in London with more than 12 years of trading and analysis experience across forex, indices, commodities and cryptocurrencies. He works across the cross-asset relationships this theme runs through, combining macroeconomics, technical analysis and price action in his coverage of equity indices, oil and precious metals.

Key Themes

• Equities and precious metals recovered their post meeting losses and returned above pre meeting levels.
• Falling oil prices pulled bond yields lower, easing one source of pressure on equity valuations.
• Markets are not currently behaving as though a stagflationary environment is expected.

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Corporate Earnings Growth Offsets the Pressure From Higher Bond Yields

"If corporate earnings continue to grow strongly, rising profits can offset some of the pressure coming from higher yields", and that, in Razaqzada's account, is essentially what investors are betting on. Rising bond yields do compress the multiple investors will pay for a stream of future profits, which is why a hawkish Federal Reserve normally weighs on equity valuations. Valuations, however, are only one side of the calculation, and a faster growing earnings base can carry a higher discount rate without the price having to fall. Oil prices helped from a second direction, falling for a second consecutive day and taking bond yields down with them, which eased the strain on the valuation side. For equity investors, the practical consequence is that the earnings trajectory, not the policy statement, is the variable holding the market up.

Stagflation Squeezes Equity Valuations and Earnings Expectations Together

Stagflation risk is the specific combination that would remove the offset equities are relying on, and it requires two conditions arriving together rather than either one alone. Weakening economic activity on its own tends to bring policy relief, and expensive oil on its own can be absorbed while demand holds, but the pair together leaves nothing to lean on. "If economic data starts to deteriorate while oil prices remain elevated or move even higher, then stagflation concerns could quickly return to the market", Razaqzada says. Consequently, equity valuations would come under pressure from the inflation side at the same time as earnings expectations weaken from the growth side, which is a materially harder setup than higher yields alone. Oil is the variable that carries the signal, because higher petrol prices squeeze household budgets, reduce disposable incomes and eventually weigh on consumer spending.

 

--- Written by Gus Farrow, Senior Manager, StoneX Media

--- Expert: Fawad Razaqzada, StoneX Media Market Analyst