How will inflation and rising rates affect the market?
October 26th, 2021 | Posted in Investing
Are Inflation and Rising Interest Rates Going to be a Problem for Markets?
Inflation is everywhere, and there’s a possibility it may not be as ‘transitory’ as the Federal Reserve had once hoped.
In a Labor Department report released last week, September’s consumer price index posted a 5.4% increase from a year earlier, which maintains a pace seen throughout the summer months. The core index, which excludes food and energy, was up 4% from September 2020.1 It’s plain to see from the chart below that inflation has not seen these levels in at least the last decade:
Source: Federal Reserve Bank of St. Louis2
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These are stout inflation figures, but it’s fair to point out they are being compared to a year ago, when the economy was reopening but still in the early stages of recovering from the short, steep recession fueled by a global economic shutdown. The issue there is that inflation is still relatively high even when compared to 2019, before the pandemic was a factor.
Labor issues and snarled supply chains are causing shortages of product components and putting price pressures on raw materials and finished goods. It currently takes about 80 days to transport goods across the Pacific Ocean, which is twice as long as pre-pandemic. Once cargo ships make it to major U.S. ports, they are often stalled there for days or even weeks. The problem is significant enough that some major U.S. retailers like Walmart, Home Depot, and Costco have resorted to chartering their own cargo ships to move goods, particularly in time for the holiday shopping season.
Supply chain constraints are combining with rising energy prices to put additional cost pressures on businesses. Crude oil prices are up over 60% this year, natural-gas prices have doubled over the last six months, and coal prices are at records.4 A key factor to watch in Q4 and beyond is whether supply chain issues and rising energy costs persist for longer-than-expected, squeezing corporate profit margins and ultimately resulting in downward earnings revisions. Corporate earnings forecasts remain very strong for now, but these are factors to watch closely.
The pandemic is partly driving bottlenecks, but the bigger factor in our view is that corporations and supply chains simply cannot keep pace with demand. The U.S. consumer has a record $142 trillion in net worth5—fueled by a rising stock market, a strong housing market, and accumulated savings over the last year and a half—and the global economy is in the midst of a rolling reopening. While there are reported shortages of all types of goods and services, there is no shortage of demand. In our view, that’s a good problem.
To the extent higher inflation drives higher interest rates, we would actually view interest rate ‘normalization’ as a healthy sign, particularly if the economy is still in growth mode. Rates are still very low in a historical context. The speed of the adjustment in rates may create temporary consternation in markets, as certain over-leveraged investors and speculators have to adjust their positioning. To the extent higher rates take excessive froth out of the market, however, we ultimately view the volatility as a good outcome.
Rising bond yields may drive downside volatility in certain high valuation multiple stocks, but for stocks in general, rising rates have not necessarily been a bad omen, historically. LPL Research crunched the numbers. Over the last ~60 years, the S&P 500 rose an average of +17% during periods of rising bond yields, which lasted an average of 25.8 months.
LPL Financial6
Bottom Line for Investors
Inflation has been higher than expected and has been lasting longer than expected. In the minutes of the Fed’s September 21 and 22 meeting, there was more evidence that officials are noting this ‘sticky’ inflation, which makes the likelihood of ‘tapering’ and perhaps interest rate increases in 2022 more likely.
We do not think investors should fear this outcome. To take a bit of a contrarian view, we would welcome a Fed announcement to taper and eventually end QE purchases. Fed intervention keeps downward pressure on long-dated U.S. Treasury bond yields, which squeezes bank profits and removes incentives for more bank lending – not great for the economy. An underappreciated effect of reducing monthly purchases is lower demand for long duration Treasury bonds, which should put upward pressure on yields. The end result may be a steepening yield curve, which is generally a positive leading indicator for economic activity.
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1 Wall Street Journal. October 13, 2021.
2 Fred Economic Data. October 13, 2021.
3 Zacks Investment Management may amend or rescind the Revolutionize Your Retirement guide offer for any reason and at Zacks Investment Management’s discretion.
4 Wall Street Journal. October 14, 2021
5 Wall Street Journal. October 13, 2021.
6 LPL Financial. March 8, 2021.
7 Zacks Investment Management may amend or rescind the Revolutionize Your Retirement guide offer for any reason and at Zacks Investment Management’s discretion.
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