#86 – Stock market behavior during high inflation

Stock Market – In this article let’s see:

• Stock Market – How inflation could impact the markets and businesses
• Stock Market – Which stocks are more impacted by a change in the rate of inflation
• Stock Market – Why inflation is not the devil after all
• Stock Market – What could be the Stock market behavior during high inflation

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Stock Market

Stock Market – Three Scenarios for Inflation and Markets

Inflation has emerged as the central macro issue over the past two of years. As most major central banks tighten policy, inflation trajectory will remain key to assessing the likely macro and market outcomes.

Higher sustained inflation in the context of slower but resilient economic growth appears to be the more likely one over the next 12-18 months, with mildly negative real returns for major asset classes.

The initial upswing in inflation in 2020 was narrow and its sustainability was met with skepticism. As we posited in our June 2020 note, the strength of consumer incomes aided by generous transfer payments, combined with the shift of consumer demand to goods from services, resulted in a rapid increase of demand for consumer goods. Supply shortfalls developed in many categories (most notably cars) as the lockdowns affected supply chains globally. As we expected, core goods CPI in the U.S. increased dramatically, exceeding 12% in February 2022 as higher oil prices also helped to lift headline inflation.

At this juncture, we see three possible near-term scenarios for inflation and, consequently, for the broader macro picture.

1. “IMMACULATE DISINFLATION,” to borrow a term, would be the most desirable outcome today. In this case, consumption shifts back to services and away from goods, while the aggressive policy stimulus that generated the initial inflation surge in 2020 is withdrawn smoothly.
2. “HARD LANDING.” Persistent and broadening inflation pressures have caused major central banks to turn more hawkish towards the end of 2021. Their change in rhetoric has led to a major repricing of market rate expectations: The Fed funds rate is now expected to exceed 3% in July 2023 and the ECB is expected to hike by 200 bps over the next two years.
3. “DOVISH ERROR 1960S STYLE.” After a series of rate hikes during the remainder of this year and quantitative tightening, the U.S. economy does not visibly decelerate. This is because while interest rates rise, so does underlying inflation, such that the real Fed funds rate does not increase sufficiently to achieve its goal.

From a historical standpoint, the second half of the 1960s presents the closest analogue when rate hikes lagged underlying inflation and were insufficient to slow the economy. Fed funds rose 3.5% in 1964 to 5.7% in 1968 but inflation accelerated from 1.3% to 4.2%. Thus, in real terms, Fed funds fell from 2.2% to 1.4%, economic growth remained strong as GDP growth decelerated from 5.8% to a still high 4.9%, and the labor market tightened further with unemployment falling from 5.2% to 3.6%.

Stock Market – Moody’s Analytics

Rising Rates Won’t Bring Golden Age of Banking

Deposit betas—the response of deposit rates to a policy rate change—have certainly declined in recent decades. Using the return on M2, adjusted for non interest bearing components, as a proxy for average deposit rates, banks passed on about 35% of the Fed’s hikes to depositors during the 1999 tightening cycle. By contrast, during the 2015-2019 cycle, banks passed on only 10%.

However, this argument is at odds with economic theory; short-term rates should respond more to policy rate hikes than long-term rates. Since bank liabilities have shorter maturities than their assets, rising policy rates should reduce net interest margins—the difference between interest earnings and expense—as a percent of earning assets. Empirically, average NIM behavior has varied across tightening episodes. For instance, when the Fed tightened in 2004, and in every cycle since the 1980s, the NIM fell. Consistent with theory, a flattening yield curve typically pushed deposit rates up quicker than longer-term lending rates.

On the asset side, banks had adjusted their portfolios since 2019. Conventional loan segments expanded at below pre pandemic rates, with some exceptions. At the same time, securities and cash holdings rose by 70% since 2019. This shift exposes banks to near-term capital losses and will act as a longer-term drag on interest earnings, as a larger share of funds are now stuck in low-interest reserves or securities. Securities sales, alternatively, create capital losses.

Stock Market – Groww

How does inflation impact the stock market?

As the inflation rate rises, speculation about the future prices of goods and services leads to a market environment that is highly volatile. Since prices are rising, many investors will speculate that companies will experience a drop in profitability. Hence, some investors might decide to sell the shares leading to a drop in their market price. At the same time, investors optimistic about the company making profits in the future might buy these stocks causing a volatile environment.

Value stocks are strongly impacted by a change in the rate of inflation. The market price of value stocks is usually directly proportional to the rate of inflation. Therefore, when the inflation rate rises, value stocks tend to perform better. On the other hand, Growth stocks have minimal cash flows. Therefore, they have a negative correlation with the rate of inflation. The market price of these stocks drops when inflation rates rise.

Lastly, if you look at dividend-paying stocks, then an increase in the rate of inflation can cause a drop in their market price. This is because, with rising inflation rates, dividends can fail to beat inflation making such stock less attractive to investors.

Inflation is not the devil that it is assumed to be. In fact, a controlled rise in inflation rates is a sign of a growing economy. If you turn the pages of history, you will find that on most occasions, a rising inflation rate is synonymous with an improvement in the Gross Domestic Product (GDP). It is important to remember that if the inflation rates are too high, then the purchasing power can erode drastically creating havoc in the economy. However, if the inflation rates are too low, then the growth of the economy can get stunted.

Therefore, investors must compare inflation rates in recent years to assess if the increase is sudden or sustained. If the inflation rates are rising steadily, then it can be healthy for businesses and the economy and be a good environment for stocks.

Stock Market – My conclusions and considerations

Personally I think that this situation will bring less returns in the markets over the next years, but at the same time (as always) will see which businesses is more solid than others and which causes determined their financial health or failure.

On the other hand, with businesses strengths and weakness there could be important key drivers on supply and demand in the businesses and our duty is to capture very analytically these changes and make there our strengths for taking the right choices.

• Higher sustained inflation in the context of slower but resilient economic growth appears to be the more likely one over the next 12-18 months, with mildly negative real returns for major asset classes.
• short-term rates should respond more to policy rate hikes than long-term rates. Since bank liabilities have shorter maturities than their assets, rising policy rates should reduce net interest margins.
• As the inflation rate rises, speculation about the future prices of goods and services leads to a market environment that is highly volatile.
• Value stocks are strongly impacted by a change in the rate of inflation. The market price of value stocks is usually directly proportional to the rate of inflation.
• Inflation is not the devil that it is assumed to be. In fact, a controlled rise in inflation rates is a sign of a growing economy.
• If the inflation rates are rising steadily, then it can be healthy for businesses and the economy and be a good environment for stocks.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.