Mid-year outlook: Inflation holds the key to future stock market returns

As of mid-year, investors must be in awe of the returns U.S. equity markets have generated since the COVID-19 pandemic struck in the first quarter of 2020. Cumulative returns for large cap stocks exceed 70 percent, while those for small cap stocks have more than doubled. This partly stems from inflation being well contained, as it has enabled the Federal Reserve to keep interest rates at zero. Going forward, however, the outlook for inflation will play a pivotal role in influencing investment returns.

While some of the cumulative gains represent recovery from steep declines during the onset of the pandemic, the indices for the S&P 500 and the Russell 2000 are now up 30 percent or more from their pre-pandemic peaks. Moreover, they posted strong returns in the first half of this year of 16 percent and 19 percent, respectively, even as bond yields rose since the beginning of this year. 

The key driver of the stock market thus far has been the recovery of the economy and corporate profits from the pandemic. During the first quarter, forecasts for U.S. economic growth for 2021 were upgraded to 6 – 7 percent, from 4 percent previously.  This mainly reflected passage of two COVID-19 relief packages totaling nearly $3 trillion and rapid progress in disseminating vaccines to the public that enabled many businesses to re-open.

The upward revisions to growth are warranted: Estimates for the second quarter are about 10 percent at an annual rate. If so, actual growth during the quarter would be 2.5 percent, which would exceed the average annual rate over the previous decade. 

Looking ahead, the pace of economic growth is expected to run about a 5 percent annual rate in the second half of this year and to average 3 – 3.5 percent next year. If so, economic growth would run well ahead of the economy’s potential rate of about 2 percent per annum.

This brings the prospects for inflation back into the equation. The main surprise thus far is that both headline and core CPI inflation (which excludes food and energy) reached 5 percent and 3.8 percent, respectively, in May over a year ago.

Federal Reserve Chairman Jerome Powell and other officials contend that the recent spike reflects the effects from demand-supply imbalances resulting from the pandemic. A vivid example is the four-fold increase in lumber prices through May 2021, which has been followed by a 40 percent decline since then.

Another example is the 30 percent rise in used car prices in the 12 months that ended May that has been linked to a global shortage of computer chips that impacted new car production. Excluding such highly volatile items, the trimmed median price increase has been contained, and the Fed anticipates that supply shortages will be alleviated as economic activity is restored.

The alternative view is that higher inflation is likely to persist, because monetary and fiscal policies have been highly accommodative to combat the pandemic, and they could cause the economy to overheat.

On the monetary side, the Fed changed its operating procedures last summer to target an average annual inflation rate of 2 percent, and it no longer plans to raise interest rates pre-emptively when unemployment falls to low levels. On the fiscal front, the cumulative tally of government programs to combat COVID-19 now is in the vicinity of $6 trillion to $7 trillion. This is substantially greater than the $800 billion stimulus program enacted in the wake of the 2008 Global Financial Crisis.

On top of this, the Biden administration is seeking to enact the largest expansion in federal programs since LBJ’s Great Society, although there is considerable uncertainty about how much of the agenda will be enacted.    

When the debate about inflation is framed in these terms, two things stand out.  First, investors should be able to determine the impact of demand-supply imbalances as more businesses reopen in the balance of this year. Second, it will take longer to ascertain the impact of policy changes: The outcome will ultimately hinge on whether the pace of activity exceeds the economy’s potential growth, the Federal Reserve’s response and how much of Biden’s fiscal programs are enacted. 

Thus far, views of market participants are in line with the Fed’s thinking that higher inflation will be transitory. The Treasury yield curve flattened during the quarter, with the 10-year yield ending the second quarter about 25 basis points below the 2021 peak above 1.7 percent. Should the acceleration prove temporary, bond yields may increase somewhat due to stronger economic activity (and credit demand), but not by enough to derail the stock market rally.

The main risk to the stock market is that inflation could stay at 3 – 4 percent into next year, in which case investors and households would likely revise their expectations higher. This, in turn, could bring the Fed into play sooner than it currently envisions. 

The first step would be for the Fed to announce that it will taper its bond purchase program, beginning with mortgage-backed securities. This is long overdue, with home prices in May rising by more than 15 percent over a year ago. If so, equity markets are likely to turn more volatile, as they did immediately after the June FOMC meeting when the Fed raised its outlook for inflation. Meanwhile, the stock market could grind somewhat higher until investors become less complacent about the threat of inflation.

Nicholas Sargen, Ph.D., is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business. He is the author of “Investing in the Trump Era; How Economic Policies Impact Financial Markets.”