Inflation is the Highest in 40 Years. How does this affect stock market returns?

The Consumer Price Index for the month of January hit a 30 year high at 7.5% annualized rate or 0.9% within the month of January. This further illustrates the impact of the supply chain disruptions and shortages and indicates that this is not a problem that will be solved quickly.

Figure 1


Source: Bureau of Labor Statistics, Data as of January 1st 2022

As shown in Figure 1, the largest increases are Gasoline, Natural Gas, and New Cars, each of which are at decade or multiple decade highs. These increases are the next domino to fall in the chain of events that have prevented us from returning to “normal” and has further motivated the Federal Reserve to use a word other than transitory. That being said how impactful are these increases on the US economy and how significant are these increases?

Shown in Figure 2 is total CPI charted with CPI less food and energy, which are its most volatile constituents. This chart shows two things, first of which is that sometimes CPI fluctuates based on very volatile categories such as in the financial crisis total CPI plummeted while the other had little change. The second thing is that the current inflation is much more impactful on the economy than an oil shock or drought, this inflation has affected nearly every category in the index. So, inflation is here, and it’s not certain how long it will stay, so the question becomes how will markets perform in light of the highest inflation in 30 years?

Figure 2


Source: Bureau of Labor Statistics, Data as of January 1st 2022
To answer this question, we must look at the historical relationship between markets, more specifically real returns, and inflation. After looking at data going all the way back to 1914, as shown in Figure 3, and looking at different relationships between these two data sets, there is no significant correlation between inflation and the real returns of the S&P 500.

Figure 3


Source: St. Louis Federal Reserve, Bureau of Labor Statistics, Standard & Poor; Data as of January 1st 2022
Also, there was no meaningful relationship between the level of inflation and correlation, implying that very high or low inflation does not change the relationship between inflation and returns. There was also no meaningful relationship between excess real returns for different sectors and levels of inflation. That being said, inflation and correlation, at least what little correlation there is, have both been trending toward zero over the past hundred years as shown in Figure 4.

This trend can be attributed to the fact that inflation has trended downward since the 1970s inflation crisis while real returns have remained relatively stable. One explanation for this is that there are simply more assets to choose from to put in the S&P 500. According to the SEC there were only about 1,000 public companies in 1935 which grew to be over 8,000 in 1995 and about 4,000 now. It is possible that the S&P might not be the best indicator of market performance simply because of its limited size which might not include a lot of the fluctuations in markets. Another possible explanation is that the mega corporations in the S&P index are far more concerned with producing steady stable returns now that over half of all Americans are invested in markets, compared to a mere 10% back in 1929.

Figure 4


Source: Minneapolis Federal Reserve, Bureau of Labor Statistics, Standard & Poor, Data as of January 1st 2022
Either way the result is significant for investors because it means that inflation on its own has little effect on markets, but rather the underlying economic conditions that cause it. The outcome of this inflationary spike will be difficult to anticipate, but in principle inflation is not bad for the economy or markets. Despite the current supply constraints this inflation is nothing new, in fact it is even common exiting a recession to have high inflation, and in essence it is the heat the economic engine gives off. Although this inflationary spike highlights some problems in the US economy that will not evaporate quickly, the underlying indicators for recovery are strong but hindered by some fog on the horizon. Whatever the outcome of this inflation markets will endure, and investors will just have to get a little more creative in the short run. Overall, the economy is just letting off a little steam exiting the fastest economic recovery in history and it is expected that there will be a few bumps on road to recovery.

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