The PACER PERSPECTIVE
August 2022

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Inflation and Equity Valuation

- Danke Wang, Portfolio Manager

The Consumer Price Index (CPI) number continued to surprise and jumped 9.1% in June, and rose to the highest level in 40 years.

Source(s): fred.stlouisfed.org
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

What does that mean for the equity market?
It is widely accepted that moderate inflation levels are needed to drive economic growth. From 1992 to 2019, the year-over-year inflation averaged about 2.25% and exceeded 5% only twice. Investors should be cautious whenever inflation is negative or too high.

The impact of high inflation on equity markets comes in 2 forms: corporate earnings and stock valuations.

Without the backdrop of a recession and earnings dropping, corporate cash flows tend to keep pace with, or even outpace, inflation. That is particularly true when inflation increases, and companies pass on higher costs to customers. An example is the “great inflation” period in the 1970s, when corporate net cash flow grew faster than inflation. In a scenario like this, long-term investors should consider equities as a store of value for inflation protection.

Source(s): fred.stlouisfed.org
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

Although corporate profits might not be hurt by inflation, equity valuation levels are the second aspect to watch in equity markets during high inflationary periods. Because when inflation turns higher, stock P/E ratios go lower.

Source(s): fred.stlouisfed.org
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

For example, from 1966 to 1980, the cyclically adjusted P/E ratio of the S&P 500 index dropped from the 20s to below 10. Such pressure of multiple contraction might happen when there is persistent high inflation which is the biggest concern for equity investors.

Source(s): multpl.com/shiller-pe
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

As a result, in the high inflationary period in the 1970s, value stocks delivered much better performance than growth stocks and the broad market.

Source(s): fred.stlouisfed.org, mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html Fama/French Research Portfolios: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

Going forward, the equity discount rate will likely increase due to Fed rate hikes, inflation, and increased interest rate volatility. The relationship between inflation and P/E ratios indicates either the S&P 500 dropping by 37% or earnings growing by 59%. Today’s P/E is 59% higher than the historical CPI vs. P/E relationship.

Multiple contraction partially explains the market downturn year to date and the underperformance of growth stocks relative to value stocks. Because value stocks trade at a discount, they are subject to less multiple contraction impact.

Source(s): Bloomberg
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

Stock duration*
This year, in response to high inflation, the Fed raised interest rates by 75 basis points (bps) in July after a 25 bps hike in March, a 50 bps rise in May and another 75 bps rise in June.

Before the June sell-off (due to recession concerns), the year-to-date market movement was driven mainly by the waning appetite for long-duration (or growth) stocks associated with higher interest rate expectations.

Short-duration stocks usually outperform long-duration stocks during periods with high and rising inflation. Value stocks (especially ones with high levels of current cash flow) or growth stocks with elevated current profitability have comparatively shorter durations and, therefore, less vulnerability to rising interest rates.

On the other hand, fast-growing firms valued entirely on long-term growth expectations have a longer duration. And they can be more vulnerable to the risk of rising interest rates or disappointing revenues.

Until the end of 2021, the S&P 500, which growth stocks have dominated, has essentially become a 30-year zero coupon bond. Such duration risk means that the S&P 500’s sensitivity to changes in interest rates is the highest it has been in history.

As of 6/30/2022, companies in Pacer US Cash Cows 100 ETF, on average, trade at a much lower P/E multiple (7.08) relative to the market (18.08 Russell 1000 Index) and generate higher current free cash flow (FCF) relative to their enterprise value (FCF Yield 12.79%). These companies offer attractive value in the current macro environment.

Pacer US Cash Cows 100 ETF

Is a strategy driven exchange traded fund that aims to provide capital appreciation over time by screening the Russell 1000 for the top 100 companies based on free cash flow yield.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
This document is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. The user of this information assumes the entire risk of any use made of the information provided herein.
Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The index was developed with a base value of 200 as of August 31, 1992.      
Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The index was developed with a base value of 200 as of August 31, 1992.
Russell 1000 Index is a market-capitalization weighted index representing the top 1000 large-cap stocks in the Russell 3000 Index.
S&P 500^® Index measures the performance of the large capitalization sector of the U.S. equity market and is considered one of the best representations of the domestic economy. Utilizing a market-cap weighting structure, this index invests in the 500 largest U.S. firms.
The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.