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Inflation has become an obsession for professional investors and consumers alike in 2022.
Concerns about the economic impact of rising prices—and their remedy, higher interest rates—have weighed on stocks, plunging the S&P 500 into a bear market for a spell in June.
At first glance, it may not be obvious whether rising prices are bad for stocks. While elevated inflation can have severe negative consequences for the broader economy, it isn’t a disaster for investors.
The current spike in inflation has lasted longer and been more challenging than anyone expected, least of all the Federal Reserve. Fortunately, data suggests peak inflation may have arrived, although there’s little doubt that elevated prices should remain a lingering problem for stocks.
How Does Inflation Work?
Inflation is the broad, gradual increase in prices across an entire economy. When prices rise, inflation lowers the purchasing power of money.
Central banks consider a moderate amount of inflation necessary to sustain economic growth. The Fed aims for a long-term target of 2% annual inflation growth, for example, as measured by the core personal consumption expenditures price index (PCE).
However, when inflation runs too high for too long, it’s a sure sign that an economy is overheating.
Hot inflation indicates that consumer demand is outpacing supply, driving prices higher—so-called demand-pull inflation. Alternatively, supply chain problems may make goods more expensive—that’s cost-push inflation.
Either way, an overheating economy will eventually push prices to the point where spending declines. And when spending falls, the economy can easily tumble into a recession. In fact, an overheated economy has been one of the most common recession triggers in the U.S. since World War II.
When Inflation Rises, Interest Rate Hikes Follow
Higher inflation by itself isn’t necessarily bad for stock prices. Rising prices boost corporate profits, especially if companies can pass on higher input costs to their customers via price hikes.
Higher interest rates are an entirely different story for stocks when inflation gets out of hand. The remedy is higher interest rates, and rising rates make credit more expensive for companies and consumers, discouraging them from spending and investing.
Jamie Cox, managing partner for Harris Financial Group, says the negative stock market trend recently has more to do with interest rates than inflation.
“Markets tend to worry more about the remedy for inflation—interest rate increases—than inflation itself,” Cox says. “Markets discount earnings and make adjustments to multiples based on the level and rate of change in interest rates, so the cure shows up pretty quickly in markets.”
Inflation’s Impact on S&P 500 Stocks
Inflation has impacted both the business performance of the companies in the S&P 500 as well as their stock prices.
S&P 500 component companies have an average earnings decline of 4.6% in the fourth quarter of 2022, the first year-over-year drop since the third quarter of 2020 (-5.7%).
You’d hardly realize that by looking at the S&P 500 index’s year-to-date performance—up nearly 6% as of this writing. But over the last 12 months, the benchmark index is down nearly 4%, driven lower in part by inflation and higher interest rates.
Remember, the stock market is a real-time reflection of investor sentiment and aggregate expectations for the future rather than a representation of current economic conditions.
Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, confirms that the stock market weakness has been driven by fears about the Fed’s monetary policy response to elevated inflation.
“Since the consumer price index and PCE data remain well above 2% to 3%, the Fed will continue to raise interest rates, and all things being equal, higher interest rates are bad for the stock market,” Zaccarelli says.
Rising interest rates are generally bad news for most stocks, but certain ones are negatively impacted more than others.
Growth stocks are particularly sensitive to rising interest rates. Fund managers and financial analysts use discounted cash flow models to value a company’s future earnings. The higher interest rates are today, the less value these models assign to a growth stock’s future cash flows.
So far in 2022, the Vanguard Growth Index Fund ETF (VUG) is down 18.8% year to date, while the Vanguard Value ETF (VTV) is down just 5.1%.
Certain stock market sectors have also performed relatively well during periods of elevated inflation. Since 1973, energy stocks have been the top-performing sector during periods of high and rising inflation.
This trend has certainly held true in this period of elevated inflation. The Energy Select Sector SPDR ETF (XLE) is up more than 14% over the last 12 months, and some of the top-performing stocks in the S&P 500 have been oil and gas companies.
Consumer staples, financial, and utility stocks have also historically held up well when inflation has reared its head.
Bank of America recently screened for S&P 500 stocks with the highest positive correlations to inflation going back to 1975. Metals and mining company Freeport-McMoRan (FCX), chemical company Mosaic (MOS) and oil and gas company Devon Energy (DVN) topped their list of pro-inflation stocks.
Has Inflation Peaked?
Over recent months, investors have gotten good news from the Labor Department regarding inflation. The December and January CPI readings were 6.5% and 6.4%, respectively, well off peak inflation of 9.1% in June. Experts agree that U.S. inflation has finally peaked.
These two most recent key inflation reports have kept stocks in the green year to date, but Bill Adams, chief economist for Comerica Bank, says investors aren’t quite out of the woods just yet.
“By mid-2023, year-over-year CPI inflation likely will have slowed to below the federal funds rate,” says Adams. “But if inflation surprises to the upside again, or if the unemployment rate falls further, the Fed could hike more than in our forecast.”
After enjoying a bear market rally in the first months of 2023, stocks are having trouble rising further. According to John Lynch, chief investment officer for Comerica Wealth Management, a combination of persistent inflation, higher interest rates and poor earnings is weighing on investors.
“While the transitory nature of inflation has manifested in the form of improved supply chain dynamics and easier year-over-year comparisons, the “stickiness” of prices has been evident in both consumer and wholesale metrics, suggesting the cooling trend is moderating,” said Lynch.
The Fed Will Keep Raising Rates
It’s important to remember that just because inflation may have peaked, that doesn’t mean interest rates have peaked too.
According to CME Group, the bond market is currently anticipating the Federal Open Market Committee (FOMC) will raise interest rates by another 25 basis points at the March meeting.
The market is also pricing in a more than 60% chance that the Fed will raise interest rates by another three quarters of a percentage point between now and the end of the year.
The rate of decline in inflation has really cooled off over recent months. If more big declines show up in the data, it would be further evidence to investors and the Fed that U.S. inflation is truly under control.