Inflation & Stockmarket Returns

Global inflation was been above average for the past two years because of knock-on effects from the COVID-19 pandemic, Russia’s invasion of Ukraine and strong consumer demand. Whilst the market had expected inflation to ease – and interest rates to fall as a result, as the graph below illustrates – in the near future, in recent months global central banks have stated any reductions in interest rates may take longer than some anticipate.

There are a few reasons why inflation may remain higher than it has been over the past 15 years:

Energy - the global transition away from fossil fuels will be expensive.
Labour costs - cheap Chinese labour has been deflationary for the global economy for many years, but its workforce is now starting to shrink, with an estimated 11 million workers disappearing every year, leading to higher wages. The US economy also added 336,000 non-farm jobs in September 2023, nearly double what economists had predicted. It was the largest monthly increase since January 2023. This higher than expected jobs growth has fueled consumer spending and sustained overall economic growth.
Geopolitical - many countries are looking to secure supply chains by onshoring production. Whilst this may address national security concerns, it can be less efficient. It costs twice as much to make a solar panel in the US compared to China.

Recent central bank statements and jobs data have collectively resulted in the 10-year US Treasury yield jumping to 4.8%. It was 3.7% in July 2023. Central banks appear to be telling the market they would prefer to have interest rates stay too high for too long, rather than cut rates too early and have inflation become entrenched in global economies.

Ben Carlson recently wrote a great article examining what it could mean for stockmarket performance if interest rates remain higher than what we’ve been accustomed to since the Global Financial Crisis. We have reproduced most of Ben’s article below.

Ben used various interest rate and inflation levels to see how the stock market has performed in the past. Are returns better when rates are lower or higher? Is high inflation good or bad for the stock market?

The table below details the Starting Yields based on the 10-year Treasury bond (broken into 2% increments) against the subsequent one, five, ten and twenty year average returns for the S&P 500 going back to 1926. For example, if the 10 year bond yield was between 2% and 4%, on average the stockmarket return 12 months later was 13.6%:

Surprisingly, the best future returns have come from both periods of very high and very low starting interest rates while the worst returns have come during average interest rate regimes.

The average 10-year yield since 1926 is 4.8% meaning we are at that long-term average right now.

Twenty years ago, the 10-year treasury was yielding around 4.3%.

Yields have moved a lot since then:

In that 20-year period the S&P 500 is up nearly 540% or 9.7% per year. Not bad.

Ben had some thoughts about the reasoning behind these returns but let’s look at the inflation data first.

The table below details the average returns for the S&P 500 from various starting inflation levels in the past. For example, if prevailing inflation was between 2% and 4%, on average the stockmarket return over the next 12 months was 12.8%. (Note the previous table looked at US bond yields, whilst this table considers inflation only):

The average US inflation rate since 1926 was right around 3%.

These results might look surprising as well. The best forward long-term returns came from very high starting inflation levels. At 6% or higher inflation, forward returns were great. At 6% or lower, it’s still pretty good but more like average.

So what’s going on here? Why are forward returns better from higher interest rates and inflation levels?

The simplest explanation is we have only had one regime of high interest rates over the past 100 years or so and two highly inflationary environments. And each of these scenarios was followed by rip-roaring bull markets.

The annual inflation rate reached nearly 20% in the late-1940s following World War II. That period was followed by the best decade ever for U.S. stocks in the 1950s (up more than 19% per year).

And the 1970s period of high inflation and rising interest rates was followed by the longest bull market we’ve ever experienced in the 1980s and 1990s.

A simple yet often overlooked aspect of investing is a crisis can lead to terrible returns in the short-term but wonderful returns in the long-term. Times of deflation and high inflation are scary while you’re living through them but also tend to produce excellent entry points into the market.

It’s also worth pointing out periods of high inflation and high rates are historical outliers. Just 13% of monthly observations since 1926 have seen rates at 8% or higher while inflation has been over 8% less than 10% of the time.

This also helps explain why forward returns look more muted from average yield and inflation levels. In a “normal” economic environment (if there is such a thing) the economy has likely already been expanding for some time and stock prices have gone up.

The best time to buy stocks is after a crash and markets don’t crash when the news is good.

Since the start of 2009, the U.S. stock market has been up well over 13% per year. We’ve had a fantastic run.

It makes sense that higher-than-average returns would be followed by lower-than-average returns eventually.

It’s also important to remember that while volatility in rates and inflation can negatively impact the markets in the short-run, a long enough time horizon can help smooth things out.

Regardless of what’s going on with the economy, you’ll fare better in the stock market if your time horizon is measured in decades rather than days.

Author: Rick Walker

Source: Higher For Longer vs. the Stock Market - A Wealth of Common Sense