Why inflation isn’t always bad for the stock market
If you've been keeping up with financial news sources like the Financial Times or Reuters, you've probably come across headlines like "Stocks slide as inflation scares investors." At first glance, this theory seems to hold some truth. With inflation running rampant over the past 18 months, the Federal Reserve has raised interest rates to historically high levels. This is generally seen as unfavourable for businesses and, consequently, the stock market.
However, as with most things in life, the situation is more nuanced and complex than it appears. While investors often feel compelled to sell whenever troubling inflation data is released, historical data suggests that high inflation alone is not solely responsible for market downturns. The relationship between inflation and the stock market is multifaceted. Inflation, on its own, can be tolerated, but frequent and significant fluctuations in interest rates inevitably instil fear in investors and push them away from stocks.
This insight is not groundbreaking news. Back in 1983, Martin Feldstein, an advisor to multiple US presidents, proposed that the correlation between stock prices and inflation should be understood not in terms of the extent of inflation but rather the direction of inflation. For instance, if inflation drops from 8% to 6%, despite 6% inflation still being relatively high, the stock market tends to respond positively.
A recent analysis conducted by the Leuthold Group supports this notion. They found that when inflation reaches high levels, stocks tend to perform well after the inflation rate peaks. In summary, a deceleration of inflation tends to result in rising stock prices.
Furthermore, equities can serve as a hedge against inflation over the long term. Tony DeSpirito, a director at BlackRock, recently stated, "We believe stocks are one of the best places to be in a rising inflation world." After analysing stock data dating back to 1920, DeSpirito found that as long as inflation remains below 10%, equities generally perform relatively well. The challenge with inflation, according to DeSpirito, is that it often leads to increased volatility in the stock market, making investing more challenging.
During periods of high inflation, individuals should consider investing in value stocks with stable near-term cash flows, as they have an advantage over growth stocks in such environments, advises DeSpirito. A comparison between the S&P 500 Growth Index, which tracks stocks with the best three-year revenue per share growth, and the S&P Value Index, which tracks stocks with favourable valuations, reveals that the former has experienced a 15% decline in the past year, while the latter has only dropped by 4.8% over the same period.
From 1961 to 1981, a period characterised by stagflation, investors in the US stock market experienced losses of over 35% after adjusting for inflation. However, those who took a long-term approach and weathered the slump from 1966 to 1999 enjoyed nominal annual returns of 12.3%, compared to an annual inflation rate of 5%. This meant investors earned an annual return of 7.3% over a span of 34 years.
It's worth noting that inflation has had a particularly noticeable impact on the housing market. Despite a slight decrease in US mortgage rates, they remain relatively high, reaching levels not seen since the late 2000s, with around 7.4% for a 30-year fixed-rate mortgage. As a result, inflation has deterred potential homeowners from entering the market.
The consequences are evident. Just a year ago, a buyer who put down a 20% payment on a median-priced $390,000 home and financed the rest through a 30-year fixed-rate mortgage at an average rate of 2.9% would have had a monthly payment of $1,300. However, after a year of rampant inflation, a similar potential homeowner today, with an average rate of 5.3%, would pay $1,730 per month. The problem becomes apparent.
Prospective homeowners may find some solace in the fact that mortgage applications are declining, and the housing supply continues to increase. According to the law of supply and demand, this should eventually lead to price decreases. However, the exact timing of this shift is uncertain.
Overall, it is important to understand that the impact of inflation on the stock market is not always straightforward. While inflation can create challenges and volatility, it doesn't always spell doom for stock investments. With a strategic approach and a focus on value stocks, investors can navigate the effects of inflation and potentially find opportunities for growth.
