Yes, we expect it will. We anticipate global inflation expectations will remain stable or increase modestly amid rising economic growth, which would allow the equity market rotation into cyclicals to continue. The rally could reach a tipping point if inflation compels central banks to tighten monetary policy.
Cyclicals—such as energy, materials, and banks—typically outperform in rising inflation environments, to the detriment of defensives and bond proxies. Since late 2020, we’ve watched this scenario play out in markets, aided by changes in earnings estimates. For instance, analysts have upgraded next 12-month (NTM) earnings forecasts for cyclical industries at a much higher rate than the broader market. Since November, NTM earnings per share growth expectations for energy, materials, and banks have improved by 63 percentage points (ppts), 36 ppts, and 19 ppts, respectively, compared to just 13 ppts for the broad market.
Historically, share prices for technology companies have not been sensitive to rising inflation expectations. Over the long term, earnings upgrades for tech have generally kept pace with the broad market in cyclical upswings, as was the case coming out of the 2007–09 recession. However, tech’s performance has been uneven since November 2020. This is likely linked to the unprecedented increase in earnings for technology-related companies last year, which investors viewed as difficult to sustain as pandemic restrictions eased. Also, even as earnings showed strength during the pandemic, valuations escalated, making tech stocks more vulnerable to rising rates. Furthermore, tech stocks are more defensive/less cyclical today, and defensive stocks typically perform poorly in cyclical upswings.
Equity duration also seems to be an important factor for relative market performance in rising inflation environments.* Long-duration stocks, which outperformed for most of the last decade, are more attractive when inflation, interest rates, and economic growth are low because investors have incentive to move out on the risk spectrum to find growth opportunities that may improve return prospects. Further, a reliable stream of cash flows may be less important in the short term, as there is little risk that inflation will eat away at real portfolio values. As inflation has risen, shorter-duration cyclical stocks (with more certain short-term cash flow distributions) have become more valuable, while longer-duration stocks, especially tech-enabled growth companies, have fallen out of favor.
If inflation continues to rise on economic optimism, it is likely that equities markets will go along for the ride and the rotation into cyclicals will continue. Based on the dividend discount model, the intrinsic value of a stock will remain stable if earnings growth increases at the same pace as the discount rate. Should inflation increase faster than expected, pushing up the discount rate, companies that are able to increase earnings in such an environment, like cyclicals and value stocks, should perform disproportionately well.
As the economic cycle progresses, once faced with both an increase in inflation and full employment, central banks will eventually tighten policy. Such a tightening of financial conditions would likely cause discount rates to increase faster and earnings growth rates to slow for cyclicals, which would ultimately put an end to the rally and usher in the next phase of the investment cycle.
Joe Comras, Associate Investment Director on Cambridge Associates’ Global Investment Research Team