Why Stocks Can Withstand Inflation

A warmer-than-expected inflation reading has failed to bring a Valentine's Day massacre for stocks. A deeper dive into bond yields should bring investors more comfort.

ON-CK518_nyse02_D_20180205165151.jpg Bloomberg News

Consumer prices rose 0.5% in January, ahead of an expected 0.3%, the Labor Department said Wednesday morning. For the year, prices are up 2.1%. The gains came from expected sources, like gasoline, and unexpected ones, like clothing, for which prices had recently been falling.

Wage inflation was modest. That's important, because the recent correction was sparked by a report that suggested higher-than-expected wage gains.

Rising inflation is a concern for stock investors because a Federal Reserve that views inflation as picking up might be tempted to accelerate its pace of interest rate hikes. That could result in higher bond yields, meaning bonds would compete more effectively with stocks for investor affection.

But the starting point matters. Here's Daniel Chung, CEO and chief investment officer at Alger, in a recent note to investors:

The earnings yield of equities is more than 300 basis points greater than the yield of the 10-year Treasury, as compared to the 55 basis points median for the half-century prior to the Global Financial Crisis. If stocks had been trading at very high P/Es or low yields, such as those of Treasury bonds, then a rise in bond yields would hurt stocks dramatically. To the contrary, however, stocks have remained cheap relative to bonds. Essentially, stocks never fully priced in low interest rates, so it stands to reason that they shouldn't be hurt by higher rates.

In other words, yes, bond yields could be headed higher over the long term, but with the 10-year Treasury paying just 2.86% after Wednesday's inflation reading, we could have a long way to go before the bull market rolls over, no matter where Wednesday's trading takes us.

At the same time, don't expect a return to raging stock gains from here. Expect shares to rise slower than the 18% earnings growth expected this year. Think positive, but single digits.

At last check, the S&P 500 was up 0.5%, to 2675.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas

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