Investment narrative: Inflation is firmly under control but corporate profit margins might be under attack in Europe. Time for high yielding equities to start out performing?

Two interesting charts today from the cross-asset research team at Morgan Stanley. The first reminds us that although inflation expectations have fallen sharply globally, the really big moves have been in Europe where these rates have “fallen 30 basis points year-to-date to within 5 basis points of their all-time low” according to the MS analysts. Now what’s odd about this is that most European corporates are telling us a very different story – the chart below also shows those inflation expectations plotted against the frequency of mentions of “cost inflation” in European company transcripts, which has moderated a bit from last years’ highs but remains far higher than we saw in 2016 when inflation expectations were last this low.

I think this might hint at a potential challenge for many European corporates. They probably are seeing increased cost pressures, but the disinflationary environment means that their ability to pass on these cost pressures is very limited. European consumers just don’t have enough spare cash kicking around. Thus corporate profit margins might get squeezed in the next year or so.

The plunging inflation rate is also a contributor to the rock bottom – or should we say negative – yields on German bonds at the moment. These have crashed as investors have sought protection in German bonds. This, in turn, could have a knock-on effect on investors desperately searching for any/some nominal positive yield. Equities might seem rather appealing. But what kind of equities? The Morgan Stanley analysts reckon that European high yield equities with robust balance sheets might be a good place to look. “ Exhibit 7 shows that historically the relative performance of the MSCI Europe High Dividend Yield index has been closely tied with moves in bond yields. The German 10Y is now 2.4 standard deviations below its 12M average, yet the relative performance of high yielding stocks is merely in-line with the 1Y average.” Might we be about to see a wave of disgruntled German investors slowly siphon money away from their low yielding bunds and into German dividend payers?