High Tide for Equities amid Inflation Undertow

After selling off sharply in March with the outbreak of the Iran war, a number of global equity benchmarks—including the S&P 500 Index and MSCI World Index—have established new all-time highs in recent weeks. Driven by renewed enthusiasm around artificial intelligence and strong corporate earnings, equity investors appear to have adjusted to the impacts of the war.¹

As demonstrated by the Treasury curve’s bear steepening, bond markets have been more sensitive to the deteriorating inflation dynamic—the result of the war’s energy supply shock and the very large fiscal deficits facing the US and other major economies.² While headline inflation climbed to 3.8% in April, from 2.4% in February, higher energy and food prices have begun to seep into core readings as well; April core inflation (all items ex-food and energy) was 2.8% compared to 2.5% in February.³ Notably, bond markets have not priced in incremental credit risk, as spreads tightened back to where they were at the beginning of the year.⁴

This bifurcation of performance and risk perception reinforces the importance of investing in assets and businesses that can participate in nominal inflation over time. As fixed principal assets, the yield paid to investors for debt securities is fixed, as is the nominal value of the principal at maturity. While fixed principal has its merits, it also has its drawbacks, namely the inability to keep pace with inflation and pass through higher nominal prices the way assets that are fixed in supply can.

We remain skeptical that even a quick resolution in Iran would usher in a swift return to normal conditions given the damage to energy infrastructure and the need to incentivize production and development around the world. Energy prices may remain elevated for some time, in our view, with the impact continuing to diffuse across the economy. Assets able to leverage the inflationary dynamic to get better pricing may be positioned to benefit.