Nominal growth matters more than real growth – for now

In the latest instalment of Simply put, we examine the recent resilience across equity markets and reason this is due to nominal growth having greater influence during periods of inflation than real growth. 

Since mid-March, the equity market has bounced back from a very rocky start to the year even though many factors point to the opposite result. Indeed, a commodity shock is usually detrimental to real growth and profits, while central banks’ hawkish actions to slow down inflation are typically a mid-term headwind for equities. To top it off, the future is not looking particularly bright as European and US sanctions against Russia are increasing. Nevertheless, equities are showing resilience. How can this be explained? First and foremost, we believe this is because corporate profits benefit from the nominal growth component of the economy – which is even more apparent today.

Chart 1 shows the decomposition of growth expectations between real growth and inflation in Europe and the United States in 2022.  Real growth clearly shows the first signs of a decline (about 0.5% over the last quarter in both regions). This is no surprise as GDP growth expectations have been revised down recently due to a combination of the Ukraine situation, higher commodity prices and higher rates – all of which are real growth headwinds. Yet, nominal growth is still increasing significantly thanks to inflation. Consequently, the real economy may be slowing down, but the nominal economy is still growing as inflation is rising faster than real growth declines. So, what matters most real growth or nominal growth?

Chart 1. Growth expectation decomposition in Europe (left) and the US (right): nominal versus real growth

Source: LOIM. Bloomberg. 2020-2022

To see which factor can explain equity movements, we regressed corporate profits for both nominal growth and real growth. Interestingly, both types of growth have equal explanatory powers (both long-term averages of the R-squared ≈ 50%) over the 1946-2022 period. The explanations however differ depending on the underlying regime. During inflationary periods (the ugly 1970s, 2007-2008 and 2022), nominal growth appears to determine corporate profits more than real growth. This could be explained by the fact that companies manage to pass on increasing prices to their customers: inflation is the reflection of what corporates do with their selling prices, as consumers show an acceptance of steeper prices. This has been apparent during the known periods of inflation shock – and the latest datapoint in Chart 2 looks to be comparable. Today, analysts anticipate a 9% rise in earnings, which corresponds to the 9% expected increase in nominal growth seen in Chart 1. Historically, a basic regression of earnings on nominal GDP growth would show that earnings progress by slightly more than 1.5x nominal growth. From this standpoint, analysts’ forecasts look conservative.

Chart 2. 3-year rolling R-square of corporate profits regressed on nominal growth and real growth

Source: LOIM. Bloomberg. 1952 - 2022

However, investors must be careful because these effects are temporary. For the moment, nominal growth is increasing but as central banks continue on their path to tame inflation, growth should also slow down to a point which is difficult to anticipate. Also, corporate costs are rising, so not all sales growth will become earnings growth. We expect both effects to be echoed in companies’ profit warnings for the quarter ahead during the current earning’s season.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

In terms of macro data, this week has been light. In the US, the Service ISM index was expected to be 58.5, progressing from February’s 56.5 reading, and came in at 58.3. The service sector is clearly conveying the message that growth remains strong (see below chart). The combination of last week’s manufacturing ISM and this service component paints the picture of a very solid US economy. The Federal Reserve’s (Fed) minutes of its latest meeting, published on 6 April, added to this impression: the Fed intends to use quantitative tightening to slow down the economy, by selling USD 95 billion of bonds per month. This amount would be split between USD 60 billion of Treasuries and USD 35 billion of mortgage-backed securities, which compares with the peak rate of USD 50 billion a month the last time the Fed trimmed its balance sheet from 2017 to 2019. Over that period, it is worth noting that the Fed pushed 10-year rates to 3.26% on 12 October 2018. Back then, real rates increased to about 1.15% while inflation breakevens only rose to 2.17% – a very different situation from today. Our monetary policy nowcasters continue to indicate that central banks should keep on surprising investors with their hawkish tone in the months to come and the Fed’s James Bullard’s latest message hints at a net rise in short yields to 3.5%, which would imply a 100 bps curve inversion. This is a message all investors need to hear. However, the 2-10 slope declined to -200 bps in the 1970s and we are still very far from that.

In Europe, the macro data has probably been less negative than many expect. Retail sales in March remained on an uptrend, growing by about 5%, a high number by historical standards. Following on from consumer inflation reaching 7.5% , this week saw the publication of PPI inflation rising to 31.4%, one of the largest gaps ever seen between these measures. Finally, both German and French industrial production progressed year-over-year by about 2.5%, which is close to the historical average of the time series. Consistent with that, our growth nowcaster for the Eurozone remains strong and surprise indices are still in positive territory. The expected negative impact of the Ukrainian invasion is still nowhere to be seen but should start to appear by the end of April.

Finally, the Chinese economy continues show signs of distress: the Caixin PMI survey for the service sector showed a severe plunge (declining from 50.2 to 42). Recent lockdown measures are probably responsible for a large part of this collapse, but our nowcasting indicators still place China in a complex position from a macro standpoint.  The next weak point for the economy could be a slowdown in exports, as the rest of the world slows down but this is yet to come, as detailed previously.

Factoring in these new data points, our nowcasting indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. Eurozone and Chinese data show a moderation and a renewed decline, respectively. This remains a very limited evolution.
• Inflation surprises should remain positive and all three zones (US, Eurozone and China) are rising. This is bad news for China, as the rise in commodities could further weaken consumers.
• Monetary policy is set to remain on the hawkish side. Recently our indicators have all moderated, even though it remains hard to read during this early evolution.

 
World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
   
World monetary policy nowcaster: long-term (left) and recent evolution (right)Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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