Does higher inflation mean lower stock returns?
INSIGHT ARTICLE |
Authored by RSM US LLP
The answer to this question is not straightforward. Over the past 20 years, stocks1 have generally performed very well when inflation — as measured by the year-over-year change in the Consumer Price Index (CPI) — was under four percent, averaging the highest returns over the subsequent 12 months when readings were under two percent. However, the inflation trends also provide insight about its impact on stock performance. As the chart above illustrates, when inflation was below two percent at the beginning of the period, it tended to rise very modestly over the following year (green bar) which resulted in strong equity performance (blue bar). When inflation was in the 3-4% range it tended to revert towards two percent over the following year. Though relatively lower, the data show stocks posted a still-respectable 7.4% average return in this environment. Most notable were periods where inflation was above four percent, which saw significant negative performance over the following year, on average. However, CPI growth quickly stalled, averaging just 0.7% one year later.
It’s worth drilling down further on this last segment because CPI readings have been in this range recently. Looking at the high-level data may lead to investor angst about whether the Fed could begin hiking interest rates prematurely in an effort to rein in inflation, potentially stifling equity performance.
During the three broad periods exhibiting inflation of four percent or more, 1991 and 2007-2008 were characterized by a loosening of monetary policy (declining fed funds rate), yet performance in the former period was positive while the latter — taking place during the Financial Crisis — saw stocks post significant declines. In contrast, the Fed was in the midst of raising interest rates in 2005-2006, yet equities provided above-average returns2.
So while inflation, as well as the Fed’s interest rate policy, certainly influence equity prices, other factors may have a greater influence on stocks. So when the Fed announces its intention to begin raising the fed funds rate, be it sooner or later, expect market volatility to ensue; however, don’t expect higher rates or higher inflation to necessarily prevent stocks from posting additional gains. In this case, higher inflation and interest rates would likely come on the heels of above-average economic growth. Consequently, we would not expect either to serve as likely catalysts for a sustained drawdown in equities. For additional insights on current inflation trends and our thoughts on whether they are likely to persist, please see our recent Investor Insights: Inflation is back: Is it here to stay?
1S&P 500 Index
2The Index posted an average rolling 12-month return of 16.0% during the period versus an average of 13.0% during the overall sample period.
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This article was written by RSM US LLP and originally appeared on 2021-06-11.
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