As the US and global economies expand, we are seeing inflation return. Many people are nervous that we are entering a period of hyperinflation. However, this inflation is long overdue and part of an overall cyclical trend. While it is not considered hyperinflation, it will most certainly affect the financial markets.
The bond markets are beginning to feel the effects of this inflationary cycle. When rates were slashed to combat the financial meltdown of 2008 and 2009, and deflation was the greater worry, bonds surprisingly continued to provide good returns. These returns were driven more by capital gains, while yields and bonds were trading more like equities. With moderate inflation creeping back into the market, we believe bond repricing will begin.
Higher inflation also leads to higher interest rates, which can affect equity returns. Previously, the advance of equities was partially driven by cheap dollars, low volatility and rising corporate profits. Rising interest rates can put a damper on this economic environment.
We believe this creates a situation in which the broad market will not fare as well, but certain market sectors will benefit greatly. We have already witnessed the market favoring value stocks. These include cyclical sectors such as industrials and financials which underperformed prior to 2016.
Growth companies in particular fared well during the market run-up. Low interest rates and a favorable labor market with little wage inflation increased corporate profits. However, a tighter labor market, increased wages and higher interest rates will likely put a squeeze on corporate profits. This is coming at a time when the price to earnings ratios are above historic norms.
This environment might be setting the stage for a market pullback, even though equities may continue their march forward in the near term. We should expect increased volatility and slightly decreased returns. It is important to keep in mind that certain market sectors may fare better and ultimately reward companies able to execute in this environment.