Growth Stocks Are Being Helped by Inflation Expectations

Inflation is high. The yield curve remains inverted. The Federal Open Market Committee (FOMC) is expected to raise rates by at least 50 basis points (bps) for a fourth consecutive time at its next meeting. Growth estimates for full-year S&P 500 index earnings are being reduced.

Yet, the stock market is in the midst of a very strong summer rally.

Mr. Market never tells you when it’s time to get back in. Rather, he looks forward. Current sentiment and prevailing stock prices are weighed against what could be coming over the horizon. If gloom is currently being perceived and sunnier skies are expected to appear in the future, stocks often rally in anticipation of a change.

One such anticipated change is inflation. June’s 9.1% increase in the consumer price index (CPI) is being perceived as a peak. July’s 8.5% increase in the CPI, while still high, was a welcome step in the right direction.

But it’s not just the CPI that is suggesting the rate of inflation could be coming down. Yields on the benchmark 10-year Treasury note peaked on June 14, 2022. Since then, they’ve pulled back. The 10-year note’s yield has not exceeded 3% for five consecutive weeks.

On the equity side, there has been a shift in favoritism. Growth, which had been underperforming most of the year, has been outperforming this summer. Value, which had been a leader, has become a laggard.

Consider the returns of the S&P 500 Pure Growth and the S&P 500 Pure Value indexes. From the start of the bear market on January 4, 2022, to the bottom set on June 16, the growth index plunged by 32.1%. The value index declined by just 9.8% over the same period.

Since then, the pendulum has swung in the other direction. S&P 500 Pure Growth has rebounded by 21.7% (though Wednesday’s close) while S&P 500 Pure Value has rebounded by just 9.8%.

While one could, rightfully, argue that growth stocks were more oversold, interest rate expectations cannot be ignored either. Lower expected interest rates boost what future earnings are worth today. Investors will demand less compensation in terms of expected returns when they perceive a comparatively lower rate of inflation (and thereby interest rates) in the future.

Consider a company expected to earn $100 per share five years from now. If you apply a 15% discount rate to them (as compensation for investing in such a company), the present value of those earnings is approximately $50. Let’s say inflation expectations change and you are now willing to apply a 12% discount rate instead. The present value of those earnings would increase to about $57. The higher present value will justify a higher price for the stock assuming the multiple (e.g., the price-earnings ratio) you base your valuation on stays unchanged.

This is an overly simplistic example, but it can help to explain why growth has experienced a bigger rebound. Since growth stocks, by definition, have stronger growth rates, their valuations are more dependent on the present value of those future earnings relative to value stocks. When the assessed present value of future earnings increases, so should the stocks’ prices—all else being equal.

None of this means we’re out of the woods. Many consumers are struggling under the weight of still-high gas prices and big grocery bills. The yield curve is on pace to be inverted, on average, for the entire quarter—a harbinger of a recession. Supply issues are continuing. One month’s deceleration in the CPI’s rate of increase does not guarantee that inflation has peaked. And, as noted above, full-year earnings estimates are being reduced.

Yet, there are reasons to be optimistic. The benchmark 10-year Treasury note’s yield again failed to stay above 3% for an extended period. (The last such attempt prior to this year was in 2018.) The S&P 500 has recouped more than 50% of its bear market losses. According to Sam Stovall at CFRA Research, the large-cap index has “never set a lower low in any post-WWII bear market” following such rebounds. The large-cap index is also on pace to record a double-digit percentage gain for the months of July and August for only the fourth time since 1989. Ryan Detrick of the Carson Group noted that the previous three similar summer rallies (1989, 2009 and 2020) were all followed by additional double-digit gains during the final four months of the year. The fourth quarter of midterm election years has previously been good for stocks.

Plus, it is possible that the “inflation has peaked” narrative is correct with future price increases being smaller. Only time will tell, but fingers crossed …