Market Outlook

March 31, 2021

Inflation Not Likely To Rise Enough To Really Hurt Stocks


John Boyd

In their response to the pandemic-induced recession, it’s clear that the Federal Reserve (and Congress) is committed to erring on the side of too much stimulus — at the risk of igniting inflation — rather than too little at the risk of another recession and deflation. I believe that is the correct approach. Inflation can be broken; it is painful, but it is fairly straight forward, whereas deflation is a much harder problem to solve.

In the debate over the recent stimulus program, the opposition argument was that the economy is already recovering from the pandemic, the end of which is in sight, so further stimulus is not needed and would just be inflationary. The bond market seems to be worried about this as yields have risen sharply.

However, as the impact of the first stimulus program has waned, we have seen a downward reversal in many economic indicators. Personal income fell 7.1% in February, retail sales slumped 3.0%, industrial production dropped 2.2%, existing home sales dropped 6.6%, (though slim inventories of homes for sale takes some of the blame), and new orders for non-defense capital goods fell 0.8%, the first decline there since last April.

From my vantage point that suggests that the new stimulus bill is well-timed. It does not mean we absolutely could not have done without it. Perhaps there was already enough momentum in the economy to keep the recovery going until the pandemic is actually under control. But what if one of the more contagious (and potentially more deadly) variants takes hold. Or the easing of restrictions prompts a new surge in cases and we have to go back to more restrictive actions once again. In that case, having the “backstop” of the additional stimulus program would be welcome indeed.

But What About The Inflation Risk?

Last month I argued that there were still too many deflationary forces at play to allow inflation to really break out. Analyst Eric Basmajian looked at it in a different way by examining the conditions at the start of the previous two periods of lasting (10-years) inflation, 1941-1951 and 1972-1982, compared to today. In the prior two periods, GDP was on a tear, rising at a 5-year annualized rate of 7.1% in the 40s and 3.3% in the 70s, but it is just limping along at 1.1% today. (We will see a temporary spike in GDP growth this year thanks to easy comparisons to 2020.)

Demographics are not favorable, either. Long-term GDP is a product of population growth and productivity. To sustain, say 4% GDP growth with long-run productivity of around 2%, we would need 2% population growth. But population growth is just 0.6% today. Slow population growth can be offset by a rising employment-to-population ratio, which would boost GDP as it did in the 1970s. However, that figure has instead been on a sharp decline since the late 1990s. In short, today’s environment does not look likely to foster a sustained period of inflation.

How Much Inflation Is Too Much?

How much inflation would it take to really damage stocks? Walt Czaicki and David Wong of AllianceBernstein analyzed the returns of the S&P 500 under different inflationary periods. When inflation was in the 2-4% range, the S&P 500 averaged an annual gain of 11.2%. In the 4-6% range, that return dropped to 4.1%. And when inflation was over 6%, the return was just 2.8%. While inflation could spike higher in the months ahead — as individuals start spending their accumulated savings from the stimulus programs — a sustained period of inflation higher than 4% is unlikely. So ignore the noise and stay with a well-diversified portfolio.

 — John M. Boyd