Equity returns: where growth tells most of the story

Inflation and especially liquidity impact stock market performance. Historically, however, the business cycle has been the key determinant for equity returns. A recession or marked growth slowdown alongside disinflation and central bank liquidity withdrawals could cap equity upside in the shorter-term. That said, central bank caution to not over-tighten could yield a soft- or no-landing scenario, with equities holding their ground vs fixed income. This should keep insurance asset allocators on their feet, given the high exposure of the industry to the latter.

Key takeaways

• Historically, economic activity has been more important than inflation as a driver of equity returns. Current US equity strength mirrors the economic resilience seen to date.
• But bad macro doesn't necessarily mean bad markets: equities generally profit from central bank liquidity expansions, even when economic momentum is subdued.
• A recession, ongoing disinflation and central bank liquidity withdrawals could cap the upside of equities in the shorter-term.
• However, a soft-landing scenario where central banks manage to not over-tighten could avoid a deeper equity sell-off.
• Insurance asset allocators may want to consider such a scenario given the large share of fixed income investments in their portfolios.

Equities have been performing well despite the ongoing monetary policy tightening cycle, the fastest in over 40 years. This has fueled debate around how stock markets perform under inflationary environments and why, given looming recession fears, a longer-lasting equity sell-off has so far proven elusive. Figure 1 is revealing for the former: historically, changes in economic activity rather than in inflation have been more important drivers of US stock market performance. Using data since 1955, our analysis shows that in all cases, and irrespective of inflation dynamics, returns are positive when an economy is in expansion or recovery mode, and negative when the business cycle signals a downturn or a contraction.^[1],[2]  This is an important result, and consistent with the current macroeconomic environment. Strong second quarter US GDP, personal spending and consumer confidence data, and a positive change in the OECD leading indicator, all point to environment that we label as "recovery" in Figure 1. In the past, such periods have typically been characterised by positive returns in equity markets, especially when coupled with high but decreasing inflation.

Figure 1: Average monthly S&P 500 equity returns, sub-classified into phases of the economic cycle and the inflationary regime

But "bad macro doesn't necessarily mean bad markets". The liquidity backdrop influences the behaviour of risk assets too (see Figure 2). Ample liquidity is an especially favourable scenario for equities under environments of recovery and expansion, where returns are boosted compared to the inflation regime analysis. Importantly, and in contrast to different inflation regimes, equities also perform decently during economic downturns with increasing liquidity. This helps explain the overall strong performance of stocks over the last decade of sluggish economic growth, coined with the expression "secular stagnation". That said, high levels and rising liquidity cannot prevent significant equity drawdowns during an economic contraction, as was the case in the 1980s, the dot.com bust and during the global financial crisis.

Figure 2: Average monthly S&P 500 equity returns, sub-classified into phases of the economic cycle and the liquidity regime 

When we overlay our analysis with our economic outlook, it appears that the upside to stocks is capped in the shorter-term. We continue to expect a significant economic slowdown around the turn of the year, given ongoing disinflation and that central bank liquidity is decreasing. Historically, such an environment has been associated with muted or negative returns.

A key question for insurance asset allocators is how serious monetary policy makers are around bringing inflation back to the 2% target, and whether monetary policy lags will bite forcefully soon. US insurers hold more than 60% of their asset allocation in fixed income and slightly more than 10% in equities.^[3] An environment where policy makers want to avoid "over tightening", do not withdraw liquidity too aggressively and tolerate above-target inflation for the sake of growth for a while, may favour equity over fixed income investments. This is not our baseline, but something that investors should nonetheless take into consideration.