The stock market has recently experienced mild turbulence due, ironically, to concerns about too strong an economic recovery.
This has heightened concerns about rising inflation and interest rates. Interest rates are important for investors because they set the baseline for returns and evaluation of financial assets. The Federal Reserve has an important role in influencing interest rates in our economy by setting rates on various operations within the banking system.
Federal Reserve Chairman Jerome Powell recently stated that in his opinion, inflation could accelerate as the economy recovers but that he does not expect sustained high inflation. This has spooked the financial markets a bit of late. The concern is if inflation goes up, interest rates will also rise and thereby result in reduced valuations for financial assets like stocks and bonds.
I believe the concerns over a significant increase in inflation are overdone and that the chance of a “70s style” high inflation scenario is low.
First, there continue to be major deflationary influences on the global economy. These include the impact of technology, massive increases in sovereign debt, and aging populations.
Also, despite the recent improvement in employment, unemployment remains high and many jobs lost to covid will never come back meaning stress on the labor market which could drive up wages is not currently acute.
Third, I believe there is a behavioral element to inflation, not well understood in academia in my opinion, that is a driving element for inflation. This behavioral element is not strong as corporations continually find ways to reduce or contain rising wage costs and consumers have been conditioned over the past four decades to expect low prices.
Further, the inflationary impact of the $1.9 trillion covid relief bill, now in the Senate, appears low. The investment firm Goldman Sachs recently issued a report in which their economists estimate that of the expected $1.9 trillion in spending in the bill, only about 18% of that money will actually get spent on goods and services, which means the potential inflationary impact of the spending bill is low.
As financial planners, we track inflation closely because it has a material bearing on clients’ financial plans. Every economic recovery results in some upward pressures on pricing and inflation.
Currently, I would expect inflation to remain within the Fed’s target of 2-2.5%. This should not be overly harmful to valuations of financial assets, particularly stocks, if it is perceived to be driven by healthy economic growth. Despite the concerns, history does show that stocks can and do rise in a rising interest rate environment.
Current rates, reflected in the 10-year Treasury bond, remain at historically low levels and modestly higher rate levels should not necessarily be a hindrance for further increases in stock prices within the context of an improving economy. Additionally, I would consider a mild increase in inflation to the 2-2.5% a positive because it reflects a strengthening economy and, as the Fed believes, moderate inflation is healthy for the economy.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.