A Moderate Rise in Inflation Alone is Unlikely to Derail The Stock Market | Capital Group

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A Moderate Rise in Inflation Alone is Unlikely to Derail the Stock Market

By Darrell Spence
Capital Group Economist

Ever since inflation catapulted into the national psyche in the 1970s, even the slightest uptick in consumer prices has tended to stoke investor angst. Unchecked inflation, after all, grinds away at Americans’ purchasing power, drives up interest rates and eventually takes the wind out of the economy. After several years of relative dormancy, inflationary pressures have edged up recently, igniting fear of a larger outbreak that could ultimately short-circuit the equity market. The jitters are understandable given the potential downside, but I believe the likelier path for the economy and financial markets is more encouraging.

It’s not surprising that inflationary concerns have ramped up amid the vitality in the U.S. economy. Falling unemployment, vigorous consumer spending and the stimulative effect of tax cuts have pushed up growth expectations. Given that backdrop, it’s doubtful that consumer prices will remain as muted as they have been in the past few years. The likelier scenario is that inflation and interest rates will both drift higher in 2018.

However, any upswings are likely to be moderate and gradual, with inflation and rates remaining low by historical standards. There are several reasons for this. The underlying forces that have helped to muzzle inflation — including globalization and the aging of the U.S. workforce — remain in place. Also, some of the factors that contributed to the recent inflationary readings are likely temporary and thus should recede.

Overall, we are returning to a more-normalized environment in which inflation is an expected by-product of economic vigor. The 2008 financial crisis, and the subsequent years-long mopping up by the Federal Reserve and other central banks, led to a number of economic and policy anomalies, including extraordinarily accommodative monetary policies. That period is coming to a close, and we are once again in a world in which inflation is likely to become more of a factor as economic growth continues.

Periods of moderate inflation have been positive for the stock market. These conditions should provide a solid underpinning for stocks this year.

The synchronized global expansion is driving up corporate profits, which I believe may climb a cumulative 25% over the next two years. Furthermore, stocks historically have registered solid gains when consumer prices have risen at a measured pace. An economy that’s neither too hot nor too cold — in other words, with sufficient energy to drive earnings but not so much as to unsettle the Fed — has been favorable for the equity market over time.

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The accompanying chart illustrates this trend. Dating back to 1820, the S&P 500 index has notched a 9.6% average annual return when inflation ranged between 0.1% and 2.5%. It gained an average of 5.9% a year when inflation ran between 2.5% and 5%, and 4.1% when consumer price jumps were 5% to 10%.

Compensation costs are picking up as unemployment falls.

The inflation scare stemmed partly from signs of rising employee compensation. Wage growth in the current upturn has been slower than in past expansions. But with unemployment at a 17-year low and potentially descending even further, a tighter labor market is forcing businesses to boost compensation to lure and hang on to employees. The brief but sharp equity market correction this past quarter was triggered by a government report showing a 2.9% year-over-year pickup in compensation costs.

The rising tab for labor won’t all be passed through to consumers. Given their strong profits, companies have some leeway to absorb the higher costs without raising prices. Thus, after several years in which inflation fell shy of the Federal Reserve’s 2% annual target, I expect consumer prices to rise about 2.25% in 2018. Barring something unforeseen, a more abrupt jump appears unlikely. Not surprisingly, the economic vigor has had an effect on interest rates, which began climbing at the start of the year as the market began to acknowledge the strength of the global economy. The yield on the 10-year Treasury note, which began 2018 at 2.41%, ended the first quarter at 2.74%.

Certainly, there are risks on both the upside and the downside. An exogenous shock or geopolitical event could throw the economy off course. Conversely, a steadily rising economic trajectory could nudge up long-term interest rates and pressure the Fed to swing into action. After lifting short-term interest rates six times since late 2015, the central bank has indicated that it will hike an additional two times this year. I believe that’s the likeliest scenario. The outlook for 2019 is less clear, as ongoing growth could intensify pressure on the Fed. Still, the near-term outlook appears favorable. A recession seems unlikely anytime in the immediate future, and ongoing earnings growth should continue to support stock prices.

DTS

Darrell Spence is a Capital Group economist who covers the U.S. and global economies. Based in Los Angeles, he has 25 years of investment industry experience, all with Capital Group.

The above article originally appeared in the Spring 2018 issue of Quarterly Insights magazine.