U.S. Treasury Secretary Janet Yellen may be open to seeing a period of hot inflation fueled by the one-two punch of President Biden's infrastructure plan and the natural effects of an economy trying to rebound from a bruising pandemic.
But history shows that such a robust inflationary period isn't too kind to the portfolios of investors, as they stand on guard for the inevitable higher interest rates (which tend to depress market returns) from the Federal Reserve that follow. Since 1962, both before and after 1980, Goldman Sachs Chief U.S. Equity Strategist David Kostin found the median monthly U.S. equity market real return during high inflation backdrops has been an annualized 9% vs. 15% during periods of low inflation.
The median monthly real return for the market has been 2% annualized in phases where inflation was high and rising compared to the 15% when inflation was high and falling.
During periods of elevated inflation going back to 1962, careful stock picking becomes more important as tried and true volatility plays (see tech) tend to lag. Kostin's research shows that the health care, energy, real estate and consumer staples sectors perform the best during high inflationary environments. Materials and tech stocks have fared the worst.
“Inflation can become a headwind to valuations if it leads to expectations of Fed tightening and thus higher real interest rates. S&P 500 returns have been consistently positively correlated with breakeven inflation but valuations have typically contracted alongside sharp increases in real interest rates,” warns Kostin.
Market participants haven't had to look too far to find worrisome levels of inflation.
The core personal consumption expenditure (PCE) price index increased faster than expected, up 3.1% in April, according to the U.S. Commerce Department. Federal Reserve officials view the index as among the best indicators of pricing pressure in the economy. The Fed believes 2% inflation is a healthy level.
On the other hand, the April Consumer Price Index (CPI) rose at the fastest pace since September 2008, clocking in with a 4.2% increase versus a year ago. And as Yahoo Finance's Sam Ro notes in the Morning Brief newsletter, consumer expectations on inflation are on an upswing.
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Even with these concerning inflation prints, Kostin said investors have started to look past them and buy into the Fed's view that inflation is transitory.
“Despite noisy economic data, rising commodity prices, and climbing labor costs, recent equity returns actually show an unwinding of investor inflation concerns. In the past few weeks, low pricing power stocks have outperformed high (7% vs. 3%),” Kostin said.
Cooling inflation fears has opened the door for Biden officials to float higher interest rates borne from rising inflation as being a good thing for the economy (and perhaps contrary to history, stocks).
“If we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view and the Fed’s point of view,” Yellen said in a weekend interview with Bloomberg News. “We’ve been fighting inflation that’s too low and interest rates that are too low now for a decade,” said the former Federal Reserve chief.
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