Up goes inflation, down go equities

The US inflation data didn’t enchant investors much at yesterday’s release. Investors were ready to uncork the champagne with a figure below 5%, which would have confirmed the idea that inflation is only transitory, and the liquidity party should continue, but alas, the consumer prices grew 5.4% y-o-y in June, the fastest since 2008. The core inflation advanced to 4.5%, the largest in thirty years. Naturally, the latest inflation figures revived the worries that the Federal Reserve’s (Fed) ‘transitory inflation’ rhetoric is more of a wishful thinking, and something must be done before things get worse. It’s certain that the Fed can not make a meaningful U-turn on its monetary policy due to the rise in second-hand car prices, yet other components such as surging energy and commodity prices, and rising leisure and travel activity could continue boosting inflation in the coming months.  

As time goes by, and inflation goes high, the Fed’s commitment to the ultra-supportive monetary policy will be severely tested. Even though the actual inflation levels are transitory, how long could the Fed wait before hitting the brake? 

The market reaction to inflation was as expected. Investors didn’t, or couldn’t, ignore the rising inflation problem following the inflation print. All three major US indices fell off their all-time highs, but slightly. All three of them lost some 0.30%; the market reaction wasn’t gory.  

And the Chinese tech stocks came to the rescue of investors yesterday. JD.com jumped some 4.5%, Alibaba closed near 2% higher and Didi rallied 11% as the recent slump in Chinese ADRs’ prices due to the government crackdown started looking appetizing to investors willing to take a chance in promising Chinese tech that currently trade at a meaningful discount. 

Activity in European futures hint at a slow start to the session. Though, the softer euro and pound could counter a part of the weakness following a post-CPI appreciation in US dollar. 

The US 10-year yield rose to 1.40%, and the long-end of the US yield curve flattened with the very long-end coming close to inverting as investors increased their bets that the Fed will need to hike rates sooner rather than later to remedy to the rising inflation, whether it’s transitory or not.  

What now? Will we see equities tumbling from here with expectations of tighter Fed policy?  

Hardly. These is still a good amount of excess liquidity in the market. Realistically, the US equity prices could come off from their historical highs, but that doesn’t mean that they will do badly in the foreseeable future. There are bubble warnings, the valuations are stretched, but the latest reports also show that the forward PE ratio on S&P500, for example, is less stretched than the beginning of the year. Therefore, solid earnings growth and the monetary stimulus - though lessened, should continue pushing the stock prices higher.  

There is no doubt we will see downside corrections on equity prices, but the overall sentiment remains bullish for a reason: real yields on most less risky assets are low, or negative.  

And gold? In theory, gold is a good hedge against inflation, but gold has been sputtering lately despite super-low US yields and a meaningful rise in inflation. Return on risk is too appetizing for investors to remain seated on gold given the actual market environment. Therefore, an eventual surge in gold prices could remain capped approaching the 200-day moving average, near $1826 per oz.