Inflation, real rates and equity valuation
The worldwide increase in interest rates in the second half of February has surprised the market and had a negative impact on equities. The major focus was on US Treasury bonds and USA inflation which act as bellwether for the financial markets. However it is true that in the USA the current level of inflation and real yields is still well below the level that was historically considered problematic and became a structural headwind for equities. We report below the analysis published in a recent study by Morgan Stanley. On average higher yields are indeed bad for equities beyond a certain point: increases in CPI and real interest rates above 3% have historically been associated with lower P/E ratios. But current CPI in the USA is still below 2%, expected average inflation over the coming 10 years (measured by breakeven inflation on inflation linked Treasury bonds) is at 2.25% and real yields are at zero or negative across the curve - so there is still plenty of room for increases in both areas before multiples come under pressure. In Europe and Switzerland the inflation dynamic is more subdued and definitely less critical than in the USA.