Inflation and the Stock Market

In the weeks leading up to the June FOMC meeting, our biggest concern was that the Federal Reserve would risk a policy mistake and not pull forward its timeline for a tapering or reduction of asset purchases (over $120 billion per month) and raising its benchmark interest rate.  The Fed came through on both counts. Asset purchases will continue, though Fed Chairman Powell said “while meeting the standard for reducing bond purchases remains a ways away, the economy is making strong progress and the Committee will be assessing the appropriate time to begin scaling back the purchases at coming meetings.”  On the matter of raising rates, 13 of 18 Committee members indicated they expect to lift short term rates by the end of 2023 and seven members even see rates rising by the end of 2022. On current inflationary pressures, Mr. Powell said “as reopening continues, shifts in demand can be large and rapid, and bottlenecks, hiring difficulties and other constraints could continue to limit how quickly supply can adjust raising the possibility that inflation could turn out to be higher and more persistent than we expect.”

Both of these policy signals (on asset purchases and rates) could prove difficult for the stock market in the coming months.  Why is the Fed acting now?  In May, the Consumer Price Index (CPI) rose 0.6%, following big jumps in both April (0.8%) and March (0.6%). According to the Bureau of Labor Statistics, CPI has now risen 5.0% over the past 12 months, the largest increase since a 5.4% increase in the summer of 2008.  Inflation has long been a disruptor of bull markets. Mild inflation (at or near the Fed target of 2%) is an indicator of a healthy, growing economy that is functioning in line with long term trends.  (From a historical perspective, the highest real S&P 500 investment returns have been recorded when inflation is generally in the range of 2% to 3%.) High inflation, particularly if it is persistent, presents another set of challenges both for the economy and stock market. Inflation occurs when demand increases for goods and services at a rate that outpaces supply.   Demand has surged recently as the Covid pandemic has waned and Americans are shopping anew with savings accumulated during lockdowns and from government stimulus checks.  Supply chains have been impacted for many items including computer chips, building supplies and even used cars and trucks, the latter which accounted for over 1/3 of the May CPI increase. Surging demand requires businesses to hire more workers, invest in plant and equipment and purchase more raw materials – many of these purchases will come with bigger price tags, the cost of which must then be passed on to others.  Inflation is viewed as a negative for the stock market because it starts a chain reaction of increased borrowing and input costs (materials and labor), a subsequent lowering of expectations for earnings growth and the resultant downward pressure on stock prices.

Is inflation this time different than the past? It might be. If this is more the case of some transitory higher inflation, then the impact on stock prices should also be more muted and temporary. History suggests that stock prices react far more negatively when the economy is contracting or in a recession than when inflation occurs during a period of expansion or recovery. During contractions, revenues and earnings are already declining without inflationary concerns. During periods of expansion, earnings are higher and the economy should be able to better withstand some higher transitory inflation. With higher inflation we would expect to see sectors more closely tied to the economic cycle (Energy, Industrials and Materials) perform better than the consumer related sectors (Consumer Discretionary and Staples, Communication Services and Health Care). Lastly, sectors more sensitive to rising interest rates (like Real Estate and Utilities) are also more likely to suffer in periods of higher inflation than their more cyclical counterparts.