Inflation is on the rise everywhere. Citi's economists think that it is a transitory phenomenon that should dissipate as supply chains start to function more normally and demand growth slows from the initial post-lockdown spurt.
History suggests that, outside the 1970s, equity returns usually beat inflation. In the report, Citi's Research team notes that entry valuations have been a better predictor of equity returns than inflation levels in the past. Within equities, traditional cyclical and commodity stocks historically have been the most effective hedges.
Rising inflation has been reflected in higher bond yields. Even with the recent drop, US 10-year bond yields are still 40bp up from the start of the year and 75bp higher than August 2020 lows. Much of this rise has been driven by higher inflation expectations (break-evens). The story has been similar elsewhere in the world.
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US 10-year Yields |
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Source: Citi Research, DataStream |
What does higher inflation mean for margins?
Equity investors often express concern about the impact of inflation on profits. If corporate costs rise faster than revenues, then surely that will put pressure on margins? This has been an apprehension at the start of previous economic cycles, but the positive impact of operational leverage has usually offset the impact of rising input costs.
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Operating Margin by Regions (ex-Financials) |
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Source: Citi Research, FactSet, Worldscope, grey bars = first two years of EPS recovery |
That’s why margins rise at the start of the cycle. At the end of the cycle, they tend to fall. A sustained upturn in wages could be of more concern over the longer term, given that they account for 60-70% of overall corporate costs.
The report examines if rising prices are a global issue, looking at how the inflation story is playing out in different regions. In a sector-by-sector analysis, real estate is cited as having historically defended against inflation—even during the hyperinflation of the 1970s. However, using real estate for inflation protection has required exposure in the right sub-sectors.
For more information on this subject, please see Multi-Asset View - Ripple Effects - Inflation, Pricing Power & Supply Chain Dynamics.
Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.