Low inflation may sound appealing, but as Russ explains, it has drawbacks for investors.

By any account the U.S. equity market is having a stellar year. Stocks have benefited from easier financial conditions, which have in turn pushed up market multiples. By a happy coincidence, gains in market multiples have exactly matched the 15% gain in the S&P 500 Index.

But while stocks have benefited from cheap money and higher multiples, they have more recently been constrained by concerns over growth. The challenge is that the same slowdown that led the Federal Reserve to pivot and stop raising rates also puts earnings at risk. Recent developments in the inflation-linked bond market (i.e., Treasury Inflation Protected Securities, or TIPS) suggest that investors are right to be a bit more cautious.

Inflation expectations embedded in the TIPS market are signaling that already low inflation will fall even lower. In late April, the 10-year TIPS breakeven (BE), i.e. the amount of inflation TIPS investors expect during the next decade, was about 1.95%. Today, the 10-year BE is below 1.70%. The outlook for the next five years is even softer, roughly 1.50%. And while inflation expectations are higher using different market measures, such as inflation swaps, the direction is still down (see Chart 1).

As I highlighted back in March, in the post-crisis environment long-term BE rates and U.S. equities have been closely correlated. The reason is that inflation expectations provide a rough proxy of corporate pricing power and, by extension, margins. During the past 20 years, profit margins have averaged 6.5% in periods of below-average inflation expectations, defined as less than 2%. Conversely, in periods of above-average inflation expectations profit margins have averaged over 8%.