Inflation has become an obsession for professional investors and consumers alike since 2022.
Concerns about the economic impact of rising prices—and their remedy, higher interest rates—have weighed on stocks, plunging the US S&P 500 into a bear market towards the end of 2022.
On September 13, Wall Street dropped to its lowest levels in two years as a result of higher-than-expected inflation figures. The US Consumer Price Index report showed that headline inflation rose by 0.1% in the month of August, shocking economists who had anticipated a slight contraction of 0.1%, and prompting a global sell-off.
Australia was not immune either, with some $60 billion wiped off the value of Australian stocks as a result of the US inflation news. (Australia’s inflation rate is currently 4%). Since then, the stock market has regained ground, with the ASX entering bull market territory in 2023. While there have been peaks and troughs, as of mid-2024, the S&P/ASX 200 accumulation index—which includes dividends—has delivered a total return of 47% in the five years to May 2024, or 8% per annum.
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 always a disaster for investors.
To be sure: the current spike in inflation has lasted longer and been more challenging than anyone expected, least of all the Federal Reserve and the RBA. There’s little doubt that elevated prices create 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 RBA aims for a Goldilocks zone of 2-3% annual inflation growth, which is why it has been raising interest rates on Australian mortgage holders to attempt to bring it down. The current cash rate is 4.35%—up from 0.1% some two years ago.
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.
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, as mentioned above, 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 US-based Harris Financial Group, says the negative stock market trend of 2022 was actually more about 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
Turning to the US in 2022 as a case study, inflation didn’t hurt the business performance of the companies in the S&P 500 nearly as much as it has hurt their stock prices (and subsequently the ASX closer to home).
S&P 500 component companies reported 6.7% earnings growth and 13.6% revenue growth in the second quarter of 2022, but you wouldn’t know it by looking at the S&P 500 index’s year-to-date performance at the time.
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, says the 2022 stock market weakness was driven by early fears about the US Fed’s monetary policy response to elevated inflation and subsequent concerns over higher interest rates tipping the US into a recession.
Inflation-Resistant Stocks
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.
Returning to the bear territory of 2022, the Vanguard Growth Index Fund ETF (VUG) was down 18.8% for the year to date, while the Vanguard Value ETF (VTV) was 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.
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.
Then there are those companies that ride the groundswell of technological change, such as GPU giant Nvidia. The stock was worth more than $US1000 earlier this year before a stock split in June brought the price down to $US135. As of July 4, 2024, it was worth $US128.
Has Australian Inflation Peaked?
Inflation peaked at 7.8% in the December quarter, and has fallen to as low as 3.6% in monthly CPI updates. However, the most recent CPI came in at 4%, highlighting how sticky inflation has proven to be over the past two years.
The next update in inflation will be on July 31, and it will be a more comprehensive quarterly update, which will allow the RBA to determine if inflation is abating or increasing.
Over the past two years, the RBA has raised the cash rate some 13 times and until only recently, most economists predicted the next move would be down. However, with inflation stubbornly high, some economists have now changed tack and believe at least one more rate rise is on the cards.
The current cash rate is 4.35%, as of July 2024. The RBA next meets on August 5-6.
For tailored financial advice and insights, reach out to BOA & Co. Financial Group. Contact us at 1300 952 286, email us at info@boanco.com.au, or visit our website at www.boanco.com.au. Let our experts help you navigate the complexities of the market and secure your financial future.