Back in January, CBA economist Gareth Aird said the inflation story will be ‘very much one to watch’ in 2021.

What does it all mean for equity investors? Recent research by UBS helps illustrate the connection between stocks and inflation.

What is inflation?

It’s a good question and Stockhead asked leading economist Alex Joiner last year — what’s actually in the inflation basket?

No less than 87 different items is the answer, which in turn make up the different components primarily comprised of retail goods, housing, and health/utilities.

A 2018 presentation from the RBA showed that retail is the largest weighting, at around 30 per cent of the basket.

Central banks globally target an inflation rate of between 2-3 per cent. Ideally, steady CPI growth is a by-product of strong employment, healthy wage growth and high productivity per capita.

But a feature of the global economy in the decade-plus since the 2008 financial crisis is that inflation growth has laid dormant below two per cent.

Now, economies are emerging from the COVID-19 crisis while central banks and governments still have the stimulus taps on.

That combination means the prospect of some long-awaited inflation has become a topical theme for professional investors.

Here’s an explainer on how the outlook for inflation is linked to asset prices.

What does inflation have to do with bond yields?

Before getting to the inflation/equities link, it’s worth discussing the inflation/bonds link.

Since bottoming out last October, 10-year government bond yields in Australia and the US have been climbing. (When yields rise it means bonds are being sold, and vice versa).

The rise in yields has been “largely driven by higher inflation expectations”, said UBS. And it was the talk of markets in the last week of February.

US 10-year bond yields — regarded as the global benchmark for government debt — jumped again. In addition, an auction of US 7-year bonds failed to get many buyers.

Upward pressure on yields is partly the bond market’s way of saying that it wants a higher return, to offset the risk of rising inflation.

UBS drilled down by looking at inflation-linked swaps (ILS) on 10-year government bonds in the US and Australia.

To complete an ILS, one party assumes the risk of rising inflation in return for a fixed payment.

By aggregating ILS activity, analysts can calculate a “break-even” inflation rate, based on the prices set for fixed payments compared to inflation-linked payments.

In January of this year, something changed — the risk premium being paid to protect against inflation rose above zero.

“For the first time in about three years, markets started to fear a strong comeback of inflation,” UBS said.

Once the risk-premium rose above zero, Australian 10-year bond yields starting playing “catch up” and rose sharply to start the year.

Then at the start of March, Australia’s central bank caught the market by surprise.

Since November, the RBA has been buying around $2bn worth of government bonds a day as part of its $100bn QE (quantative easing) program. But on March 1, it upped that amount to $4bn.

In response, 10-year bond yields promptly slumped as markets assessed the impact of increased RBA participation.

Martin Whetton and the CBA rates team said the recent volatility was a “welcome to the jungle” reminder from the bond market.

They added that things are likely to calm down from here. But further analysis from UBS shows why equity investors should take note.

What do bond yields have to do with stock prices?

Rising yields can be a good thing if they accompany steady inflation driven by increased growth and productivity.

What equity investors need to be on the lookout for is bond market volatility and unexpected yield spikes, UBS says.

If yields rise “suddenly, pushed higher by flows from rapid repositioning”, it can affect stock prices.

Why are yield spikes bad for equities? As the largest asset class in the world, the interest rate set by bond markets is a key input into how stocks are valued.

Most professional investors value stocks using discounted cash flow (DCF) analysis. To do that, they estimate how much income will be generated years into the future.

Valuing a company based on all of that projected income added together would be a bit too good to be true.

To calculate what those future cash flows are worth now, investors apply a discount rate. Bond yields are a broad proxy for the cost of money, which makes them a key input.

The higher the rate of government bond yields, the higher the discount rate applied on future income. Therefore, the cheaper the current value.

Another valuation technique used for stocks is the price/earnings (PE) multiple (more on that here).

UBS says bond yields and PE multiples are “inversely related”, because “rising discount rates drag on valuations”.

The inverse relationship is particularly prevalent for Australia’s high-growth tech sectors, UBS said.

That’s because tech stocks — such as the ASX-listed BNPL cohort — have high prices relative to their earnings.

For companies like that, their present value is derived from an expectation that they will generate much more income in the future than they do now.

As a result, tech companies with high PE multiples are “more sensitive to changes in the bond yield”, UBS says.

Lastly, the effect of rising yields on stocks with high PE multiples is more exacerbated when those yields are rising from a low base.

As UBS notes, that is “exactly where we are now”.

What happens next?

Are inflation indicators flashing a warning signal for investors? In separate research earlier this year, UBS said there isn’t actually much to worry about.

The bank does expect annual inflation in Australia to jump to 3.2 per cent in the June quarter, but the spike is expected to be temporary because “base effects” are in play.

(That means the nominal gain will be magnified, because it’s coming off a low base from the previous year.)

“With record low wages growth, the end of several one-off government policies, and weak rents, we think there is little risk of persistent inflation,” UBS said.

In that context, activity in the inflation-linked swaps (ILS) market suggests the “risks of an outbreak have been overpriced”, the bank said.

They assessed the prospects for the ASX within the framework outlined above — steady inflation growth compared to unexpected spikes.

Viewed through that lens, it’s a “modest positive”.

Aside from a projected Q2 spike, “inflation is unlikely to rise to a level that would be detrimental to equity returns”, UBS said.

If inflation tracks at a similar to level to nominal bond yields, it means ‘real’ yields — nominal yields less inflation — will stay close to zero.

Such a dynamic has “traditionally shown strong equity market returns”, UBS said.

The bank put a year-end target for the ASX200 of 7,600, which marks a gain of around 12 per cent from its February closing level.

While UBS doesn’t expect inflation to climb back above two per cent this year, neither does the RBA.

The central bank hasn’t flagged any recent changes to its plans to keep interest rates on hold at (almost) zero through to 2024.

But as the RBA’s surprise re-up in the bond market shows, policy makers face some delicate challenges in managing the economy out of the pandemic.

So Aird’s prognosis remains valid — inflation will be ‘one to watch’ for investors in the months and years ahead.