Yes. We should always be worried about inflation, or its equally ugly twin, disinflation.
However, it is likely going to be easier for us to deal with higher inflation levels brought on by excess stimulus and easy monetary policy than the alternative, which is a critical perspective to keep in mind as we consider the market risks.
We have noticed that the financial press has recently picked up a new theme on the risks of inflation following the next round of stimulus ($1.9 trillion seems most likely) over the last few weeks.
The argument appears to be that inflation would be bad for stocks.
However, historically that hasn’t been true. Rising inflation and rising stocks tend to go together because they are both frequently caused by economic growth.
The exception to the rule that inflation, interest rates and stocks rise together is “stagflation” when there is no economic growth but lots of inflation.
A spike in oil prices and extraordinary government spending in the early 1970s led to such a situation during the 1970 recession and the market declines in 1973-1974.
From our perspective, the potential for inflation (or much less likely, stagflation) is worth watching, but we don’t need to panic yet.
Treasury Yields
If investors become more fearful of that issue, we should get an early warning sign from Treasury yields, which rise with inflation and commodity prices.
As you can see in Fig. 1 below, the 10-year Treasury yield and oil prices are up 99% and 400%, respectively, since the market bottomed in late April, which is probably why investors are talking about inflation.
However, the good news is that both indexes are still well below their highs just before the Covid-19 pandemic crash.
For now, these are indexes worth watching, but we don’t see anything too worrisome yet.
Ironically, the market had a rocky start on Wednesday because the government’s CPI inflation report was surprisingly low.
Core inflation on a month over month basis was reported as 0%. Core inflation excludes food and energy prices because they can be too volatile.
As mentioned previously, investors know that inflation is connected to growth, so low inflation is not a good sign.
Investors want to see prices rising in a “Goldilocks” zone of 2%-3%. Lower than that zone indicates low growth, and higher suggests the potential for volatility.
What if Inflation Gets Worse?
Although we don’t see any short-term signs that inflation will be an issue for stock prices, we should consider some contingency plans that can be deployed if the situation worsens.
- Inflation is a disincentive for savings because your money is losing value. Therefore, consumer spending should rise with inflation. If consumers are spending to avoid losing the value of their income, we should continue to target retail and technology stocks. We think this is the most likely outcome if inflation does start to tick up higher in 2021.
- The less likely scenario is expecting the Fed to pull back on easing if inflation rises. Although this seems unlikely in 2021, we think the real fear investors have is that the threat of inflation will cause the Fed to pull back on their bond-buying program again. If that happens, we expect borrowing costs to rise, which should be good for the banks in the short term, but we would also want to pull back a little from retail stocks.
The Bottom Line
Earnings season continues to surprise to the upside. According to Factset, the surprise ratio for the S&P 500 is over 80%. On average, earnings and revenues are up on a year over year basis.
With more than 60% of the S&P 500 reporting, we think it is likely that the positive growth numbers will stick for the fourth-quarter reports. This is a surprise because the comparison is the fourth quarter of 2019, before the pandemic, so the bar is still relatively high.
Clearly, the stimulus and very easy monetary policy play a role to end the “earnings recession,” but this is all still good news.
At this point, we expect the S&P 500 to remain above its key support level near 3,700 and most likely within its recent channel as shown in Fig. 2 above.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.
