For the stock market, inflation dynamics remain crucial. These ultimately determine the level of interest rates required to bring inflation under control. The higher the required interest rate, the greater the risk of recession and the smaller the corporate profits. High interest rates are also bad for stock valuation levels. However, some companies have managed to increase their profit margins with high inflation, as we noticed last year.
It’s no coincidence that the stock market had a bad year in 2022 when inflation and interest rates rose sharply. The graph below (in which inflation is plotted on an inverted scale so that a declining line represents rising inflation) shows that the stock market struggled when inflation became a real problem at the end of 2021. The chart also clearly illustrates that prices have recovered since inflation began to decrease. Investors apparently quickly gained confidence that inflation would be brought under control without too strong an increase in interest rates, and thus without significant damage to the economy.
Correlation
In the Western world, we haven’t had such high inflation in 40 years as in the past two years. No wonder uncertainty struck, both in financial markets and among central bankers and the broader public. Among economists, a somewhat bizarre discussion broke out with diverging opinions on whether the inflation would be temporary or not, what exactly caused the inflation, and what the best policy response would be.
A comparison with the 1970s and 80s is obvious, as inflation was also high then. For stock investors, it was not a pleasant time. Between 1973 and 1983, they faced two bear markets. The U.S. S&P 500 was lower in mid-1982 than at the beginning of 1973, while the dollar’s purchasing power fell by nearly 60% over this period due to persistent inflation.
That devastation was caused by ongoing high inflation. Ultimately, aggressive monetary policy, meaning interest rates that exceeded the highest level of inflation, was needed to control inflation. This was accompanied by a severe recession and thus painful consequences for stock prices.
US inflation
The crucial question to me is whether the current inflation differs enough from that in the 1970s to justify stock investors› optimism. The differences are numerous, but the following two seem the most important to me.
Firstly, energy prices in the 1970s kept rising, albeit at varying rates. Now, the oil price is about 30% below last year’s high, and European gas prices are even over 90% lower. So, energy prices are currently pushing inflation down, unlike then. That’s good, but this downward pressure is temporary. Energy prices will not keep falling indefinitely. In fact, if oil and gas unexpectedly become more expensive, inflation could quickly go in the wrong direction.
Inflation vs energy prices
A second important difference from the 1970s is that unemployment is now lower, and the labor market is structurally tighter. This increases the chance that wage growth remains too high to achieve 2% inflation in the medium term. Don’t underestimate the intentions of the labor movement. The treasurer of the FNV (Dutch trade union) said just last week that it’s time to push forward with wage demands, and that his strike fund is «ready.»
Inflation expectations remain remarkably moderate, which is true and positive. However, the basis for the apparent optimism about inflation among stock investors seems very shaky to me. Fairness requires me to say that the uncertainty is currently substantial.
Han de Jong is the former Chief Economist of ABN Amro. He writes weekly for Investment Officer about economics and markets. You can read more about his views on Crystal Clear Economics. This article was originally published in Dutch on InvestmentOfficer.nl.