If you’re relatively new to markets—or, well, let’s be honest, even if you’re not—the unusually high rate of inflation we’ve seen in 2022 and the massive hit stocks have taken at the same time could make you think that high inflation is always bad for stocks. If you’ve been in markets for less than two decades, you could still think that, because we haven’t really had above-2% inflation for any sustainable period since the 1990s and more recently this year.
But anyone who remembers earlier periods—most significantly the 1980s—knows that stocks and inflation have a much more complicated relationship. And there have been times in the past when inflation was rising and stocks were soaring.
To understand why that isn’t happening now, we need to understand the three major reasons why inflation is killing stock valuation—because these dynamics are very different from those of the past.
The first and most important is the anticipation towards a stagflationary economy. That’s a situation where there is no growth and high inflation—usually a function of supply-driven price gains. That happened in the late 1970s, and it was a disaster for just about everyone in just about every way possible. If high inflation today is caused by supply forces and is not driven by demand (known as “demand pull” versus the supply-driven “cost push” inflationary trend), the market and our lives are heading towards a prolonged misery. Selling makes sense in that case.
There’s evidence to suggest this isn’t the case (record low unemployment and strong wage growth), and the few cases of supply-driven inflation (the Ukraine war and oil prices, supply chain shocks and the pandemic) suggest more event-driven, temporary issues than fundamental problems with the economic system. Still, the worry is enough to cause a selloff whenever inflation is strong.
The second reason is a bit more esoteric, but crucial: the Federal Reserve. The Fed’s dual mandate is to maintain low inflation and low unemployment. The latter is done and dusted, but the former has been out of the Fed’s grasp for a while now—and the Fed, after failing to anticipate the major inflation of 2022, is aggressively fighting back with historically high interest rate hikes. Hike rates too high and funding for R&D, business development, and other growth-inducing activities will decline, and the economy will hit recession. Again, a big worry, and an unpredictable one (since no one can know where rates are too high for most profit-seeking investments), which makes the Fed an even more central player in this drama.
The third reason is the most esoteric, and it explains why the tech-driven Nasdaq 100 (QQQ) has badly underperformed the broader S&P 500 (SPY) during this inflationary period. Wall Street has historically (although this is changing) relied on the DCF model type of valuation of companies, which relies on a risk-free rate that future returns are compared against. Because of the mechanistic relationship of these two amounts in the math of a DCF model, lower RFRs translate into lower stock price targets, especially for companies driven more by growth than by rising profit margins. Anticipating these changes in valuations, traders have bid down stocks anticipating lower price targets from Wall Street, causing losses just about everywhere.
Since inflation will push the Fed to hike rates, the latter two factors will remain in play until the rate hike cycle is over (which, the Fed has hinted, should be early next year). The first concern is much more driven by CPI figures itself. For as long as we are way above the 2%-3% rate of inflation that has been the norm throughout history, this concern will remain a drag on investors and their optimism for the future.